This report was originally published on 2/9/10.

In an 8-K filing this morning, COCO (17.72 ↑1.72%) disclosed its draft 2-year cohort default rate (CDR) data for FY08, which was released to schools yesterday.   Under the 2-year definition cohort default rates must not exceed 25% for any school for three consecutive years, or 40% in any single year, or that institution will lose access to federal financial aid.  Starting in FY09, for-profit poststecondary institutions will be measured by a 3-year cohort default rate definition.  Institutions must not exceed 30% cohort default rates for three consecutive years or 40% in any given year under the 3-year definition, or that school will lose access to Title IV.  As a reminder, here are the measurement periods for the 2-year cohort default rate data.  Note that the FY08 data only captures those students that were delinquent as of 1/3/09.

Source: Department of Education

Highlights from COCO’s FY08 Draft 2-Year Cohort Default Rates

In COCO’s 10-Q filing for the quarter ended 9/30/09, the company indicated that it expected as many as 10-12 of its institutions to exceed the 25% cohort default rate threshold when the draft FY08 data was released.  Clearly, the company was trying to manage expectations for what was likely to be a series of concerning data for any shareholder in the company. The number of schools that exceeded the 25% threshold in FY08 actually came in below the company’s initial expectations, although we would hardly characterize the data as a positive for COCO.  Here are the highlights:

• Overall COCO had a consolidated average cohort default rate of 19.2% for FY08, compared to 15.2% for FY07. Keep in mind the FY08 consolidated average includes the 9 Heald schools recently acquired whose FY08 cohort default rates ranged from 7.4% to 15.3%.  A 4% YOY increase in cohort default rates is alarming enough, but without the contribution of Heald that number would have been materially higher.
• A total of 9 schools (out of 49) had a cohort default rate in excess of 25%.  A few individual schools stand out.  The company’s Everest Institute location in San Antonio, TX had a cohort default rate of 35.2%.  It is almost certain that this school would lose access to Title IV funds under a 3-year calculation of cohort default rate.  COCO’s WyoTech location in Daytona Beach, FL had a FY08 cohort default rate of 29.0%, compared to 6.9% in FY07.  That type of increase is highly unusual. We are wondering if the actual cohort is incredibly small, otherwise it points to a significant reduction in regulatory standards at that particular institution.
• 20 of the company’s schools witnessed an increase in their cohort default rate of 5% or greater.

COCO’s Compliance With 3-Year Cohort Default Rate Standards Looks Dire – Extensive Self Regulation Is a Necessary Remedy

In its 8-K filing, COCO identified the following programs the company has implemented to help lower cohort default rates at its schools:

1. A new contact management system to assist in reaching students who are no longer in school
2. An internal department focused primarily on early stage delinquencies
3. An expanded program of entrance and exit counseling and financial literacy training for current students
4. The use of outside firms to help reach and inform borrowers about alternatives to default, including income-based repayment, forbearance and deferral

These are all necessary steps to help lower the company’s cohort default rates and can move the needle a little bit.  However, none of these actions address the primary drivers of cohort default rates which are: who you enroll and the educational outcome they receive (graduation rate and starting salaries).  Student drop-outs are the single highest source of student loan defaults. COCO has witnessed improved student retention over the past 12-18 months, which in theory should help to lower cohort default rates.  The company should continue to invest in student retention programs to help mitigate the impact of student dropouts.  Otherwise, we doubt the company can do much else to improve educational outcomes for its graduates given the state of the labor markets.  As a result, the most impactful and effective remedy will be for COCO to reduce the number of at risk students it admits into its schools, in our opinion.  Although management did not state it explicitly on the company’s most recent earnings conference call, we think the sharp slowdown in student starts in the most recent quarter and that implied by guidance, was driven by a conscious attempt to reduce the number of high-risk students COCO enrolls.

COCO’s 3-Year Cohort Default Rate Compliance Looks Increasingly Dire

As we have stated in the past, the introduction of a 3-year cohort default rate standard was a “game changer” for many for-profit postsecondary education companies.  The introduction of a 3-year cohort default rate brings us one-step closer to true lifetime student loan defaults.  More importantly, the extension of the measurement period has the effect of doubling the cohort default rate for most for-profit postsecondary institutions.  A report from GAO confirms the impact of expanding the measurement period based on FY99-FY01 data, as did the release of “unofficial” 3-year cohort default rate data from the Department of Education.  For a company like COCO, the switch from a 2-year to 3-year definition has the impact of increasing the default rate by 90-100%.

As we mentioned above, the regulatory compliance standards under the 3-year cohort default rate calculation are 30% and 40%. That is any school whose cohort default rate eclipses 30% for three consecutive years will lose access to Title IV and any institution whose cohort default rate exceeds 40% in a SINGLE year will lose access to the government student loan program.  In our view we would characterize any school whose cohort default rate eclipses 15% on a 2-year definition as “problematic” given that that school will likely have a cohort default rate close to, if not above 30% on a 3-year calculation.  We view any institution whose cohort default rate under a 2-year definition that exceeds 20% as “at risk”.  Using the same 90-100% multiplier, the cohort default rate for that institution could exceed 40% in a single year under a 3-year calculation.  In our view, any school whose cohort default rate exceeds 25% in a single year needs to make significant changes to its enrollment practices in order to ensure that it will meet regulatory standards under a 3-year cohort default rate calculation.  With that in mind, let’s take another look at COCO’s FY08 cohort default rate data for FY08:

• Based on the draft FY08 cohort default rate data, more than 70% of COCO’s institutions had a cohort default rate in excess of 15%.  Excluding the schools purchased in the Heald College acquisition, 35 out of 40 legacy COCO institutions had a cohort default rate in excess of 15% for FY08.  Perhaps most worrisome, nine of these schools have had a cohort default rate in excess of 15% for three consecutive years. This indicates that these schools could be at significant risk of exceeding the 30% cohort default rate standard for three consecutive years under the 3-year calculation.
• 21 of the company’s schools had a FY08 cohort default rate in excess of 20% under a 2-year calcuation.  If the 3-year cohort default rate standards were in place today, we estimate that a high percentage of these schools could potentially lose access to Title IV.

The measurement period for the first 3-year cohort default rate calculation begins in FY09, which is right now.  It is hard for us to quantify what the impact of COCO’s established default management programs could be, but our sense is that it will not be sufficient to mitigate all of the company’s risks associated with the 3-year cohort default rate standards.  Here are the actions we think the company needs to implement:

1. Further expand student retention programs
2. Invest in facilities, faculty, and programs to improve academic quality
3. Hire additional job placement professionals and forge more corporate alliances/partnerships for graduates
4. “Cull the herd”.  Dramatically reduce the number of at risk students the company enrolls.

The introduction of the 3-year cohort default rate standards created a higher level of recourse for for-profit postsecondary education institutions.  For a long period of time, institutions could enroll low quality/high risk students without fear of recourse if they eventually defaulted because of the mechanics of the 2-year cohort default rate calculation.  Deferrment, forebearance, and other tools were implemented to reduce 2-year cohort default rates, although in most cases lifetime student default rates remained astonishingly high.  We think the 3-year cohort default rate standard will usher in a new era for operators such as COCO characterized by a reduction in the total student population and an increase in costs related to student services and default management.  We are surprised that consensus estimates for COCO continue to forecast higher enrollments, revenue, and EPS.  The writing is on the wall and COCO needs to take significant action to reduce the number of high risk students it enrolls or the consequences could be damaging.

As always, please act accordingly….