This report was originally published on 11/8/09.

In a recent letter to Warren Buffet, we voiced our concerns about what seem to be growing regulatory issues at Washington Post Company (WPO 444.32 ↓2.02%)’s most important division, Kaplan Higher Education.  From an outsiders perspective the magnitude and rate of increase in 2-year cohort default rates at many of the company’s schools is alarming in the context of the rapid rate of growth for Kaplan Higher Education and the number of acquisitions the company has completed over the past 4-5 years.  Additionally, Kaplan Higher Education is currently subject to three separate qui tam actions (lawsuits brought by private citizens on behalf of the US under the false claims act), which is a fairly high number compared to other publicly traded for-profit postsecondary education providers.  The plaintiffs in one qui tam include two former instructors at a Kaplan Career Institute who allege that the school inflated job placement statistics, falsified grades, and manipulated attendance records.  These are serious accusations, particularly in the context of the issues being raised at the Department of Education’s Negotiated Rulemaking sessions and the SEC’s informal inquiry into Apollo Group (APOL 62.99 ↓0.58%)’s revenue recognition practices.

We also recently raised concerns about inconsistencies in Kaplan Higher Education’s total enrollment disclosures.  You can read more here.  As a reminder, in the table below we detail how the company originally disclosed its total enrollments as of quarter end and then what that same figure was stated to be a year later.

Source: WPO, PAA Research

For example, for 2Q09 Kaplan said the following in its press release:

“At June 30, 2009, KHE’s enrollments totaled 103,300, a 31% increase compared to total enrollments of 78,700 at June 30, 2008. All KHE divisions contributed to the enrollment growth in the first half of 2009, with Kaplan University’s online offerings growing the strongest at 45%.“

31% growth sounds great, and reasonably matches the company’s 34% YOY growth in revenues. The only catch is that a year ago in the company’s press release Kaplan Higher Education had 83,400 students enrolled as of 9/30/08.

“Enrollments increased 18% to 83,400 at June 30, 2008, compared to 70,800 at June 30, 2007, due primarily to enrollment growth in the online programs.“

The company added another wrinkle in 3Q09.  In the third quarter, Kaplan completed a reorganization of its organizational and internal reporting structure.  As a result, Kaplan expanded its reporting segments to include the following:  Higher education, Test  Prep, Score, Kaplan International, Kaplan Ventures, and Kaplan corporate. We welcome the additional detail on Kaplan, which is far and away WPO’s most important division strategically and financially.  As part of the additional disclosure, the company provided histrical enrollment figures for Kaplan Higher Education.  The company will no longer include students attending its international postsecondary institutions in its total enrollment figures for Kaplan Higher Education (they are now part of Kaplan International). In the table below, we provide a comparison of total enrollments for Kaplan Higher Education as they were  originally disclosed and what the company has provided now.

Source: Company reports, PAA Research

With the company’s most recent change in its total enrollment disclosure,we can “back into” what enrollments have been for the past 11 quarters at WPO’s international higher education institutions. Based on the most recent data, we estimate total enrollments at Kaplan International declined 23% in 2Q09.  Of course this new set of data does nothing to clarify the enrollment discrepancies we described above, if anything it makes it more difficult to reconcile the company’s historical enrollment disclosure.  At a time when there is intense scrutiny from investors and regulators about how enrollments are defined and calculated, we think the variance in WPO’s historical total enrollment disclosure warrants close attention, if not a full explanation from the company.

WPO Changes Revenue Recognition Policy from a “Weekly Convention” to a “Daily Convention” for Kaplan Higher Education

The other major disclosure in WPO’s 3Q09 10Q was that the company plans to change its revenue recognition policies from a “weekly convention” to a “daily convention”.  Here is the relevant paragraph from WPO’s 10Q:

“In the third quarter of 2009, Kaplan Higher Education (KHE) modified its method of recognizing revenue ratably over the period of instruction as services are delivered to students from a weekly convention to a daily convention, on a prospective basis. If KHE’s revenue recognition convention had been on a daily convention in prior periods, revenues and operating income in the first quarter of 2009 would have increased by $7.0 million and $6.5 million, respectively, and revenues and operating income in the fourth quarter of 2008 would have decreased by $7.8 million and $7.3 million, respectively. The Company has concluded that the impact of this change was not material to the Company’s financial position or results of operations for 2009, 2008 and 2007 and the related interim periods, based on its consideration of quantitative and qualitative factors.“

The manner in which total enrollments are calculated and revenue recognition policies have become an ENORMOUS issue in the for-profit postsecondary education space. We recently discussed some of the complexities of revenue recognition related to student withdrawals here.  In general, there is a fairly large discretionary element of determining when a student should be considered withdrawn.  For example, the following is a brief summary of Kaplan University’s attendance policy from the school’s student catalog:

”The specific requirements for attendance are the following:

• Any first-term student or any student seeking reentry who does not register attendance within the first 7 days (online)/14 days (onsite) of the term will be withdrawn from his or her classes and his or her enrollment will be cancelled.

• Students who have not participated in class by failing to log in for 21 consecutive calendar days (excluding scheduled breaks) will be administratively withdrawn from their program. Students who fail to log into any class within the first 21 days of the term will be dropped from the class or classes. Students in any graduate business program may not exceed 14 consecutive days of nonattendance. Nonattendance may affect financial aid eligibility.“

Now let’s take a look at revenue recognition and tuition refund policies at Kaplan University based on the percentage of a term completed.  In the chart below, we assume that Kaplan recognizes revenue based on the tuition that is nor refuned (i.e. for a student that is enrolled from 10-25% of the term and withdraws, the company recognizes 50% of revenues).  Remember these policies are determined at the state level in accordance with each school’s accrediting body.

Source: Kaplan University

In our view, there is a significant incentive among operators in the for-profit postsecondary education sector to maintain that a student that dropped out was enrolled at the institution for at least 60% of the quarter, term, or semester. After a student has completed 60% of an academic period, tuition is considered “earned’ for the purposes of federal financial aid and the school can keep all of the title IV funds disbursed for that academic period, which significantly reduces collection risk and bad-debt expense.  At Kaplan University, it’s not clear whether or not someone is considered a withdrawal or drop-out for revenue recognition purposes at the start of the 21 consecutive day measurement period, or at the end of that period. Based on how revenues are recognized this could represent a big difference in the amount of tuition that the student can be billed.  Additionally, how does the school handle an issue where a student attends one class and not others.  This would likely be a bigger issue for modular programs, similar to those offered by the University of Phoenix (APOL owned) and Everest Institute (COCO (17.25↓1.37%) owned).  The change adds one more item to our growing list of concerns about Kaplan Higher Education.

Let’s review our primary conclusions to see if we are justified in our concerns:

• Kaplan Higher Education has witnessed explosive growth over the past 4-5 years through a combination of rapid expansion of its online programs and acquisition
• In the aggregate, the  schools owned by Kaplan Higher Education have the highest cohort default ratesamong publicly traded for-profit postsecondary education institutions
• The company has three separate qui tam actions against it alleging a variety of serious violations
• There are discrepancies in the company’s historical total enrollment disclosures
• Kaplan Higher Education changed its revenue recognition policy during a period of heightened regulatory scrutiny in the space

From our perspective, any item on this list should be viewed as a significant “red flag” for any WPO investor.  Considering the list in it totality should raise substantial concerns about the manner in which growth has been achieved at Kaplan Higher Education, in our opinion. We do think it is important to note that two of the largest operators in the for-profit postsecondary education sector have recently changed meaningful and long-standing accounting policies (ESI (108.78 ↓0.65%) recently indicated it would no longer capitalize marketing costs).  Is this a coincidence or an indicator of greater scrutiny from regulatory authorities behind the scenes?  We’re not sure, but in context of everything else on going in the sector, we think it adds yet another reason for concern.

It is unclear whether or not WPO’s decision to change its revenue recognition policy for Kaplan Higher Education to a daily convention is the first sign of a new standard in the sector.  According to the company’s 10Q, the change in revenue recognition policy would not have had a material effect on the company’s financial position.  In the context of everything else we have gleaned about Kaplan Higher Education it adds one more element to what is a growing pile of concerns.  From a longer term perspective, we think the company will need to dramatically alter its enrollment policies at many of its schools in order to maintain compliance with regulatory standards under a 3-year cohort default rate calculation.  We anticipate this could be a significant headwind for the company over the next several years.  Should the company choose to continue on its current path, it is our opinion that a number of the company’s schools could run the risk of losing access to Title IV funds in the next 3-4 years.  In a scenario in which some of the regulatory issues are not addressed we anticipate the intrinsic of value of Kaplan could be impaired by as much as 30-40%, which would imply WPO shares would be worth as little as $275-$300. Conversely, we anticipate the neccesary remedies we proposed in the past could reduce the growth profile of Kaplan for 3-5 years, but perhaps only impair the intrinsic value of the company by 10-20%. Stated another way, should these regulatory issues go unchecked we estimate peak cycle earnings for WPO of $18-20 per share, assuming earnings recover for the company’s newspaper, magazine and broadcasting divisions. The stakes are incredibly high for WPO shareholders.

As always, please act accordingly….