This report was originally published on 12/9/09.

We have expressed our concerns in the past about the impact the transition from a 2-year to a 3-year cohort default rate calculation could have on the for-profit education sector.  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.  Compliance with the 3-year 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).  However, in order to help schools prepare for the transition to a 3-year cohort default rate the Dept. of Education will provide preliminary 3-year cohort default rate data to schools in the sector so that institutions can better understand the impact the change could have on their cohort default rates and regulatory compliance.

Based on data provided in the GAO report entitled “Stronger Department of Education Oversight Needed to Help Ensure Only Eligible Students Receive Financial Aid“, the transition to a 3-year calculation will significantly increase cohort default rates for proprietary/for-profit postsecondary institutions.  We think the 3-year calculation brings public disclosure one-step closer to lifetime student default rates, which we estimate are considerably higher than what has historically been captured by 2-year cohort default rate calculations.  Based on our analysis of the data provided by GAO on FY04, the transition from a 2-year to a 3-year calculation could have the effect of increasing the cohort default rate by 94% for proprietary schools.  We think it should be noted that the impact on private and public, non-profit institutions is not nearly as large.  In the table  below we outline the summary data from the GAO report:

Source: Department of Education, GAO

Based on the final 2-year cohort default rate data provided by the Department of Education, we think a number of schools owned by COCO (17.42 ↓0.40%) and WPO (451.55 ↓0.43%) could have difficulty maintaining compliance under the 30% threshold for cohort default rates starting in FY12.  Applying the average increase in cohort default rates in FY04 for proprietary schools witnessed by GAO in the transition from a 2-year to 3-year calculation, we estimate the following:

• 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

Unofficial 3-year Cohort Default Rates Have Been Released to Schools and Will be Released to the Public December 14th

On Monday, the Department of Education released unofficial FY07 3-year cohort default rate data to institutions.  The data will be made available to the public on December 14th.  Two publicly traded companies have issued press releases related to the unofficial 3-year cohort default rate data provided to them by the Department of Education: BPI (20.07 ↑0.45%) and LINC.

Bridgepoint Education

Bridgepoint Education, provides primarily online degree programs through Ashford University and University of the Rockies.  As of 9/30/09, BPI had 54,894 students enrolled at its two schools.  The company has witnessed explosive enrollment growth over the past few years and has been subject to heightened regulatory scrutiny, including an investigation from the OIG.  According to BPI, Ashford University’s 3-year unofficial cohort default rates were 8.8%, 6.1%, and 17.4% for FY05, FY06, and FY07, respectively.  This compares to 4.1%, 4.1%, and 13.3% under a 2-year calculation.  Overall, the default rate increase under a 3-year calculation for FY07 was less than that suggested by the GAO report.  BPI management expressed confidence that its investment in internal default management specialists and the hiring of an external default management consultant would enable the company to maintain compliance with cohort default rate regulatory standards by FY12.

Lincoln Educational Services (LINC 26.58 ↑2.31%), Inc.

Lincoln  Educational Services, Inc. is a leading for-profit provider of technical and career oriented diploma and degree programs.  The company’s most well-known brand is the Lincoln Technical Institute.  Lincoln offers degree and diploma programs in five principal areas of study: automotive technology, health sciences, skilled trades, business and information technology and hospitality services. Lincoln currently operates 43 campuses in 17 states under 11 brands: Lincoln College of Technology, Lincoln Technical Institute, Nashville Auto-Diesel College, Southwestern College, Euphoria Institute of Beauty Arts and Sciences, Connecticut Culinary Institute, Americare School of Nursing, Baran Institute of Technology, Engine City Technical Institute, Briarwood College and Clemens College. Lincoln had a combined average enrollment of approximately 31,500 students as of September 30, 2009.

In a press release issued this morning, LINC outlined its unofficial 3-year cohort default rate data.  Based on the data LINC has received from the Department of Education, the impact of the transition from a 2-year to a 3-year cohort default rate calculation would be consistent with the data provided by GAO for FY04.  The company’s weighted average cohort default rate increased from 8.69%, 12.3%, and 13.42% for FY05, FY06, and FY07 under a 2-year calculation to 21.07%, 24.41%, and 25.72% under a 3-year calculation.  Additionally, the company indicated that one school, two schools and three schools would have exceeded the 30% threshold in FY05, FY06, and FY07, respectively.  One of the company’s schools had an unofficial 3-year cohort default rate in excess of 40%, which under the new Department of Education regulations would prompt immediate revocation of access to Title IV funds.  Similar to BPI, LINC expressed confidence that it would be able to improve its collections efforts with its former students and maintain compliance with regulatory standards under a 3-year cohort default rate calculation.

Self Regulation Can Be As Impactful On Enrollment Growth as Third-Party Regulation

We wanted to highlight a few statements from LINC’s press release this morning:

“Our three schools with the highest default rates are all focused on providing technical programs. The mission of these schools is to provide technical skills and an educational foundation for students so they can differentiate themselves as they enter the job market, in most cases for the first time. The programs at these schools typically range from 10 to 15 months and specifically serve a non-traditional, economically disadvantaged student body.In the event that one of our schools is at risk of failing to meet the new standards, we will seek to improve our cohort default rates by increasing the creditworthiness of the students we enroll at that school.” (bold added for emphasis by PAA Research)

We think the last statement is the single most important comment in the entire press release.  Other senior executives of leading for-profit postsecondary education providers (most notably Greg Capelli ofAPOL (63.44 ↓0.60%)) have alluded to the concept of “self-regulation” or curtailing enrollment grow in order to improve credit quality and compliance with regulatory standards.  We anticipate that those companies that own institutions whose cohort default rates exceed 15% on a 2-year calculation must enact significant changes to their enrollment and default management practices TODAY in order to maintain compliance with new regulatory standards.  We think the sell-side and to some extent investors have yet to fully grasp the financial implications of “self-regulation”.  We recommend investors review the operating history of CECO (29.95 ↑0.10%) from 2004 to present.  The company was once the fastest growing, publicly traded for-profit postsecondary education provider but ran into some regulatory issues in 2004.  It’s interesting that ACTUAL regulatory sanctions against the company were limited, but the threat of action served as a catalyst for the company to change its approach to enrollment growth.  Five years later, the company is still mired in a long-restructuring process and the stock is more than 60% below its 2004 highs.  We anticipate that a number of operators in the for-profit education space including WPO and COCO could be forced to meaningfully alter enrollment practices in order to prepare for compliance with a 3-year cohort default rate calculation.  The alternative is to continue on the current tact and potentially face significant regulatory scrutiny in a few years.  Neither scenario is factored into consensus estimates and we anticipate the negative operating leverage in a period of slower enrollment growth, if not an outright decline in student population could be significant.

Affordability Is Part of the Educational Access Equation Isn’t It?

In its press release, it appears LINC wants to make the argument that compliance with 3-year cohort default rate standards could reduce the company’s ability to target a specific student demographic and as a result reduce access to higher education.  The company (similar to other for-profit providers of postsecondary education) continues to tout its efforts to expand educational access to the underprivleged and economically disadvantaged.

As we have stated in the past, we are big proponents of expanding access to higher education.  However, for leading for-profit education companies to make veiled threats about how they will reduce access for certain types of students because of their higher risk profile without acknowledging their role in determining the likelihood of default seems disingenuous to us.  We think educational quality and tuition play a huge role in default rates.  It seems in every single public policy discussion about the regulatory framework in the for-profit postsecondary education sector, industry operators and lobbyists argue that tighter compliance standards will equate to reduced access to higher education.  It is true that for-profit postsecondary educationa providers offer an invaluable opportunity to a segment of the population whose educational needs are unlikely to be addressed by the traditional academic sector.  The argument from for-profit providers of postsecondary education is: our default rates are higher because of the student population we serve.

We think this argument completely ignores the unnecessary financial burden that high-priced tuition policies have placed on graduates of many for-profit postsecondary institutions.  If operators acknowledge that they address a different student demographic than the traditional academic sector, why do they use price points from private colleges to establish tuition levels?  There is no question that the magnitude of student debt burdens is a large factor in default risk.  We think the tuition levels charged to students at institutions like ESI (109.51 ↑0.02%)’s ITT Technical Institute are unsustainable and have eroded the return on educational investment for the student.  We think it is increasingly likely that the progression of expanding educational access to students will include reduced tuition prices either through explicit Dept. of Education regulation or through an increasingly price sensitive educational consumer.

We continue to get questions about COCO, ESI, and WPO and whether or not we think that current valuation levels fully reflect our concerns about the sector.  The short answer is no.  As far as we know, there have been no negative estimate revisions in the space.  We think companies such as COCO, ESI, and WPO could represent “value traps” as investors increasingly realize the financial implications of “self regulation”, increasing consumer sensitivity to higher tuition prices, and maintaining compliance with 3-year cohort default rate regulatory standards.

As always, please act accordingly…