This report was originally published on 2/2/10.

COCO reported 1Q10 results this morning.  You can read the full press releasehere. Overall the company delivered upside to consensus on both the top and bottom-line, which should not come as a surprise given the strong results delivered by ESI (109.74 ↑0.21%)and DV (65.73 ↓1.54%) already this earnings season.  Revenues and EPS of $414.3 million and $0.44 beat consensus of $404.5 million and $0.40.  Although the company did deliver solid total enrollment growth of 22.3% YOY, we would characterize the student start growth as a disappointment in light of the robust starts witnessed at DV and ESI for the winter term and the recent results of our survey of privately held for-profit postsecondary education institutions.  The results of our survey suggested that COCO could have delivered as much as 20%+ YOY student start growth for its 2Q10.  The company’s new student start growth of 10.7% YOY was inline with management guidance of 10-12%, but fell short of our expectation of 15%.  It now appears that COCO is poised to come in at the low end of its guidance range for student starts for FY10 of 11-13% YOY growth.  Here are a few other key observations from the quarter:

• G&A expense increased from 10.2% of revenue in 1Q10 to 11.4% of revenues in 2Q10. On a nominal basis, G&A spending increased 46.6% YOY and 20.0% Q/Q.  The company attributed the sharp increase in G&A spending to the timing of “variable compensation accruals for management”.  We wonder if some of the sharp increase relates to a large increase in spending on default management services as the company tries to lower its cohort default rates in order to maintain compliance under a 3-year calculation  regime.
• Marketing expense continued to be a source of operating leverage for COCO. We estimate cost-per-start declined 1.4% YOY.  This is the fifth consecutive quarter in which COCO has generated a YOY decline in cost-per-start.  The advertising environment has started to normalize and we anticipate lead cost inflation could become an operating margin headwind for the company over the coming quarters.

More Bad-Debt Expense Slight of Hand

We find it remarkable that COCO continues to tout its bad-debt expense improvement.  In its earnings release the company stated that bad-debt expense had improved to 5.8% as a percentage of revenue in 2Q10, down from 6.4% in 1Q10 and 8.7% a year ago. Management also indicated that bad-debt expense was lower than the company’ guidance of 6.7%-7.1%.

As we have stated in the past, we view the company’s bad-debt expense improvement as accounting “slight of hand”.   The manner in which COCO calculates bad-debt expense currently borders on complete irrelevance because it does not capture the reserves the company has built for its internal lending program.  In short, the company has transferred reserves on traditional accounts receivable, which it discloses quarterly to reserves on notes receivable, which it does not disclose quarterly.  Sounds like a little bit of “robbing peter to pay paul” doesn’t it? You can read more about our views on this issue here.

Just to illuminate our point, let’s take a look at what the combination of bad-debt expense on accounts receivable and reserves on notes receivable might have looked like for 1Q10 (it’s almost hard to believe, but COCO does not disclose reserve data quarterly even though the gross amount of notes receivable now approach the gross level of accounts receivable).  In 1Q10, COCO reported bad-debt expense of 6.4% as a percentage of revenue ($24.9 million), an allowance of $24 million, charge-offs of $26 million, and net accounts receivable of $61.4 million.  The company also disclosed that it had total net notes receivable of $47.0 million (both long and short-term) and an allowance against those notes receivable of $30.6 million.  The allowance against notes receivable increased $17.4 million YOY.  If we assume that the company’s provisions were equal to charge-offs, this would imply the company recognized $17.4 million in incremental expenses in 1Q10 for its notes receivable program.

If we add our estimates for the provisions on notes receivable to the company’s traditional bad-debt expense we arrive at what we call “real bad-debt expense”.  In this case the numbers are $24.9 million (bad-debt expense) + $17.4 million (estimate of notes receivable  provisions) = $42.3 million, or 10.7% as a percentage of 1Q10 revenues.  The good news for the company is that for FY09, the company’s “real-bad-debt expense” was 12.0% using a similar methodology.  It does appear that the company has made some progress in improving credit quality, although it is significantly less than COCO’s arguably useless disclosures on bad-debt expense would have you believe.  The company does not provide sufficient disclosure in its press releases for us to arrive at the “real bad-debt expense” for 2Q10.  COCO doesn’t even disclose its notes receivable balances.  We encourage the company to expand its disclosure so that investors can gain a more accurate view of the company’s true balance sheet risks.

Questions for the Conference Call:

COCO management will host a conference call today at 12PM EST.  Here are a few questions we would like answered:

• What were the gross and net notes receivable balances as of 12/31/09.  What were the provisions for notes receivable in 2Q10?
• Does the company expect to forge any new private lending relationships for its students in the coming quarters?
• How will the company’s internal financing program be affected by the Heald acquisition?
• The company’s start growth in 2Q10 was below peers and most analyst expectations.  Guidance for starts appears relatively conservative.  Has the company cut-back on marketing to ability to benefit students or other students that might have higher credit risk? (i.e. has COCO started to self-regulate as some schools in the sector have done)
• What are the company’s expectations for lead costs going forward and how will this impact margins?
• What steps is the company taking to ensure that its schools will remain in regulatory compliance under a 3-year cohort default rate calculation?
• How will the company’s long-term financial objectives be impacted by the adoption of the NegReg proposals?

We continue to see significant downside to COCO shares.  It is increasingly likely that the company will face fundamental headwinds from higher lead costs, lower lead conversion rates, and lower facility cost leverage.  Additionally, we think COCO will have the greatest difficulty among publicly traded for-profit postsecondary education providers in maintaining regulatory compliance under 3-year cohort default rate standards.  As a result, we expect COCO to witness lower, if not an outright decline in enrollment growth in the coming years as it attempts to navigate the new regulatory landscape.  Investors should not confuse reasonably strong earnings today as a sign that the company’s long-term earnings prospects have changed.

As always, please act accordingly….