This report was originally published on 1/19/10.

ESI will report 4Q09 results on Thursday, before the market opens.  Here are the issues which we expect to be at the forefront of investor concerns heading into and subsequent to the company’s earnings release:

• Sustainability of enrollment growth – On the heels of APOL (63.08 ↓0.57%)’s 1Q10 results, we think investors are increasingly concerned about the implications of economic stabilization on enrollment growth prospects for operators in the for-profit postsecondary education sector. Additionally, APOL management made it clear that the company planned to take additional steps to “cull the herd” and improve the overall quality of its student population.  Will ESI follow suit?  We think self-regulation will become one of the major themes in the for-profit postsecondary education sector in 2010 as companies attempt to prepare for the transition to a 3-year cohort default rate calculation and face greater regulatory scrutiny from the Department of Education and potentially Congress.
• Operating margin leverage – A thing of the past?: We have argued for some time that operating margin trends for ESI are unsustainable.  As we highlightedin our 3Q09 preview, the company’s investment in its students as measured by cost-of-goods sold per student has actually DECLINED on an absolute basis over the past 12-years.  For 2009, we estimate the company is on pace to spend approximately $7,000 per student, which is well below ESI’s historical averages of $7,700-$8,200. In addition, the company’s SS&A spending excluding bad-debt expense has declined from a normal range of 25-27% as a percentage of revenues to 22% in 2009.  There is no question that ESI has been the direct beneficiary of a decline in advertising rates and an explosion in remnant inventory on cable networks.  Based on our checks with several large lead generation companies, it now appears that lead-costs are poised to increase.  We anticipate SS&A excluding bad-debt expnese could increase as much as 20% YOY for ESI in 2010 based on the company’s investment in enrollment counselors and increased lead costs. As a result of these two factors, we anticipate operating margins could DECLINE by as much as 150-200 bps in 2010.
• Where is the new private student loan relationship?For several quarters now, ESI’s management has teased that the company was on the brink of striking a relationship with another financial services company that would offer private loans to its students.  Based on our review of the company’s student catalogs for the winter term, it appears that JPMorgan and Student CU Connect remain the only providers of private loans for ESI students.  As the table below demonstrates, JPMorgan continues to cut back on student loan originations.  The company does not provide disclosure detail on loans extended to students attending for-profit institutions, but overall student loan originations declined 40% in 4Q09 to approximately $0.6 billion.  The most obvious implication of the decline in student loan origination volume by JPMorgan and the lack of a new lending partnership is that ESI will be forced to use its balance sheet to fund student tuition.  As a result we estimate bad-debt expense will remain between 6.5-7.0% as a percentage of revenue for the foreseeable future.

Source: JPMorgan

• Management thoughts on Neg Reg 2009 – ESI shares sold off today in large part due to investor concerns about the implications of the “gainful employment” language proposed by the Department of Education in advance of the latest round of Negotiated Rulemaking. As we have argued for some time, ESI has broken “the more you learn, the more you earn” student covenant as a result of the company’s tuition policies and low starting salaries for its graduates.  We would argue that ESI could be impacted the most among publicly traded for-profit postsecondary education providers if the Dept. of Ed. enacts provisions which tie tuition policies to income levels for students upon graduation.
• Deferred Revenue vs. Revenue Growth- One of the major “red flags” for ESI from an accounting perspective  over the past 18-months has been the sizeable divergence between the company’s revenue and deferred revenue growth.  Historically, deferred revenue growth has matched, if not exceeded ESI’s revenue growth.  However, starting in 2Q08 revenue growth began to eclipse deferred revenue growth by more than 30%.  Management has attributed this to a shift in funding sources for its students (ESI’s balance sheet), but the trend has yet to normalize, which has some forensic accountants on watch.

PAA Research’s 4Q09 and 2010 Estimates vs. Consensus

In the table below, we outline our primary estimates for 4Q09 and 2010 vs. consensus expectations. For the fourth quarter, we anticipate the company could beat slightly on both the top and bottom line based on improving student persistence and a continuation of operating margin leverage on both COGS and SS&A expense.  For 2010, our EPS estimate of $9.00 is below current consensus of $9.49.  It is clear that the street has yet to factor in any negative operating leverage stemming from higher lead flow costs and slowing enrollment growth.

Source: PAA Research, Yahoo Finance

We anticipate FY09 will represent a peak in operating margins for ESI.  We are stunned by the company’s decision to increase tuition another 5% at almost all of its ITT Technical locations starting with the spring term.  The Department of Education has made it clear that it is focused on improving access, affordability, and outcomes. In light of the increased regulatory scrutiny and the diminishing returns for ESI’s graduates on their educational investment, how can the company justify a tuition price increase? We continue to believe that the necessary remedy for ESI will be to drastically reduce its tuition in order to restore the return on educational investment equation for its students.  Based on recent proposals from Department of Education officials, it appears we are not the only ones focused on the return on educational investment.

As always, please act accordingly…