This report was originally published on 2/21/10.

Our entry for chart of the week is sure to send a painful reminder to shareholders of APOL(63.11 ↓0.52%) about Friday’s sell-off.  APOL provided initial guidance for its 2Q10 earnings which were well below consensus expectations.  The primary culprit – bad debt expense.  APOL management expects bad-debt expense as a percentage of revenue to be 6.8-7.1% for 2Q10 and remain at those levels for the remainder of 2010. This is the highest level of bad-debt expense APOL has experienced as a public company and serves as another indicator that APOL’s days of primarily serving high quality working adult students have long since passed.  Approximately 5-6 years ago the strategic decision was made to move “downstream” in terms of target student demographic (age and income) in order to sustain growth.  Consider the following: University of Phoenix entered the prior decade generating 49% of its revenues from Title IV Funds. In 2009, University of Phoenix received 85% of its revenues from federal financial aid.  Wow.

To the company’s credit, the initiative has worked – financially.  APOL now has over 200,000 associate’s degree students and revenues have more than doubled over the past five years.  The move has not worked for shareholders. APOL shares are down 24.6% over the past 5-years.  The transition away from older, higher-quality working adult students has resulted in a host of regulatory issues and concerns for APOL, leading to dramatic multiple compression in the stock.  We can’t help but wonder if APOL shareholders would have been better off if  the company “stuck to its knitting” and expanded internationally in the working adult market, instead of moving “downstream” in the U.S.

Now here comes the “holy #$@^!” moment for longtime followers of the for-profit education sector: APOL’s bad-debt expense is now higher than COCO (17.71 ↑1.67%)’s.  Truly astonishing.

Source: PAA Research

A few observations we would like to make:

• The chart above should not be misconstrued as an indicator of improved student quality at COCO.  The chart above compares APOL’s bad-debt expense to that of COCO’s on a reported basis.  As we have been arguing for sometime,  COCO dramatically understates its true bad-debt expense by excluding reserves on notes receivable for its internal lending program.  We estimate “real bad-debt expense” for COCO in FY09 was closer to 12.0%, not the 8.5% the company reported.
• APOL continues to make it clear that they plan to “cull the herd” and reduce the number of higher risk associate’s degree students the company enrolls.  This should reduce APOL’s regulatory risk-profile over time and result in lower bad-debt expense.

We think Friday’s announcement from APOL should serve as a warning to all investor in the for-profit education sector.  Enrollment growth can be seductive, but it is incumbent upon senior executives in the space to consistently monitor the manner in which it is achieved.  We call this the “enrollment growth paradox” – it looks great in the short term, but often leads to significant negative regulatory repercussions in the long term.  APOL is the first company to dial-back on growth and implement extensive “self-regulation”, we are almost certain it won’t be the last.

As always, please act accordingly….