This report was originally published on 3/4/10.

We recently discussed WPO (446.15 ↓1.20%)’s 4Q09 results, which have prompted a 5.8% rally in shares.  In our review, we highlighted how we were eagerly anticipating the release of WPO’s 10-K, which we hoped would include more extensive disclosure on regulatory compliance and operating metrics at Kaplan Higher Education, the company’s largest division.  WPO recently issued its 2009 10-K filing.  The company did include some additional detail on Kaplan Higher Education (KHE), but we still think the company’s disclosure standards are insufficient to effectively measure the profitability prospects of KHE.  We are surprised the 10-K hasn’t received more attention from investors given some of the new disclosures that were unveiled for the first time.  Below we discuss some of the highlights of WPO’s 10-K related to Kaplan Higher Education.

The Department of Education Commences Program Review at Kaplan University

In its 10-K, WPO disclosed that the Department of Education commenced a program review at Kaplan University in September 2009.   To our knowledge this is the first time that WPO has disclosed the matter.  We are not sure why this was not disclosed in the company’s 3Q09 10-Q filing given that in WPO’s own words: “No assurance can be given that the Department of Education’s final report will not have a significant adverse effect on Kaplan’s ability to continue to operate this school.“.  No details were given as to the scope or potential target of the Department of Education’s program review, except that it is being conducted at the Kaplan University offices in Fort Lauderdale, FL.

According to the company, Kaplan University had 65,500 students enrolled at the end of 2009 (60,400 online, 5,100 onsite), which means the school represented 62.4% of Kaplan Higher Education’s total student population.  Kaplan University has been a huge area of investment for WPO over the past decade. The company launched a massive, multi-million dollar national advertising campaign in 2009. We think the company’s increased investment in marketing was a primary driver behind the 38.5% YOY enrollment growth achieved by Kaplan University Online in 4Q09.  Any regulatory issue that could potentially impair consumer perception of the quality of Kaplan University would have a large impact on WPO’s profitability prospects.

A Quick Overview of the Department of Education Program Review Process

It has come to our attention that the relative knowledge gap between the typical WPO investor about the intricacies of the regulatory landscape in the for-profit postsecondary education sector compared to let’s say, the average COCO (17.73 ↑1.78%) shareholder is fairly wide.  We thought it might be helpful to quickly cover what the Program Review process entails.   For those that are interested in learning more, we would encourage you to read this document published by the Department of Education.  Program reviews are not conducted with the same frequency as an audit, but are also not completely uncommon.  Typically a program review is prompted by concerns about a school’s regulatory compliance.  The Department of Education and Congress (through the Higher Education Act) have identified the following criteria to serve as impetus for conducting a program review:

1. High cohort default rates (over 25 percent)
2. Significant fluctuation in FFEL volume or Pell awards between years;
3. Serious deficiencies as reported by state licensing agencies or accrediting agencies;
4. High withdrawal rates; and
5. A significant risk of noncompliance with administrative capability or financial responsibility provisions of student financial aid programs, as determined by the Secretary

A program review can also be prompted from feedback received from other channels beyond the traditional operating metrics the Department of Education would receive from a postsecondary institution in normal course. These factors include:

1. Reports from agency partners, such as state licensing agencies, guaranty agencies and accrediting agencies;
2. Referrals from OIG; and/or
3. Student and/or institutional employee complaints.

When a program review is launched, a case-management team is sent to the school to collect information and inquire about some of the Department’s concerns on a face-to-face basis.  Typically, the Department of Education will issue a findings report to the institution, after which the school will have the opportunity to respond. A program review can be limited in scope to a few specific issues (think University of Phoenix incentive compensation) or include a complete analysis of a school’s regulatory compliance practices.  The Department of Education describes the purpose of the program review process as to:

1. Strengthen administrative capability and financial responsibility under Title IV statutes and regulations through on-site assessments of and technical assistance on institutional administration of the student financial aid programs.
2. Address financial harm to the taxpayer through liability assessments.
3. Tend to those institutions that are seriously mismanaging or abusing the student financial aid programs through referral for administrative action, including emergency action, and referrals to the Inspector General – Investigative Services when appropriate.

In the case of Kaplan University, we cannot point to any specific catalyst for the Department of Education to launch a program review based on publicly available information.  At the very least, we know that it was not prompted by Kaplan University Online’s cohort default rate for F07, which was 13.3%.  The program review could result in changes to Kaplan University’s enrollment, administrative, and regulatory compliance practices, a significant fine, or nothing at all.  We anticipate this could become an overhang on WPO shares given Kaplan University’s overall contribution to the company’s revenues and earnings.  The longer the program review lasts, the more likely it will result in material changes to Kaplan University’s practices, or potentially material fines, in our opinion.  Overall, we have argued for sometime that lax regulatory compliance at Kaplan Higher Education could become a material issue for the company and shareholders.  The combination of four outstanding false claim actions (qui tams) against Kaplan Higher Education and program review at Kaplan University adds further credence to our thesis.

A Few Kaplan Higher Education Schools Appear to Have Avoided a CDR Bullet

In our review of WPO’s 4Q09 results we wondered if the company would provide disclosure on preliminary cohort default rate data for FY08, which was released to postsecondary education institutions in early February. To the company’s credit they did provide some color on preliminary FY08 cohort default rates for Kaplan Higher Education.  Overall, the company expects the cohort default rate for Kaplan Higher Education to be in a range of 16-18%, which would be consistent with FY07 levels.  However, trends at Kaplan University continue to be worrisome. The company indicated that it expects the FY08 cohort default rate for Kaplan University to range between 15-17%, up from 13.3% in FY07 and 5.9% in FY05. The rapid rise in cohort default rates at Kaplan University cannot be attributed to the economy alone, in our opinion.  The data suggests that the company has been aggressive in its enrollment and admissions practices, which could lead to additional regulatory scrutiny down the line.  Perhaps most importantly, the overall Kaplan Higher Education 2-year cohort default rate data suggests the company will have difficulty maintaining regulatory compliance standards under a 3-year cohort default rate standard.

On a school by school basis, Kaplan Higher Education only had one institution whose cohort default rate exceeded 25% in FY08, which was down from four in FY07.  It appears that the company’s investments in default management have yielded positive results, particularly at TESST College – Baltimore, Texas Careers, TESST College – Townson, and the Texas School of Business, all of which had 2-year cohort default rates in excess of 25%.  WPO stated that no school had a cohort default rate in excess of 25% for two consecutive years.  This is particularly noteworthy for the company’s TESST College – Townson, which was at risk of losing access to Title IV if its cohort default rate exceed 25% in FY08.

Other Highlights from WPO’s 10-K:

• Kaplan University generated 87.5% of its revenue in 2009  from Title IV Funds, up from 85% in 2008.  The “90/10 Rule” could pose a significant challenge for Kaplan University when the grace period for the 2008 increase in student loan limits expires.
• 60.6% of Kaplan Higher Education students were enrolled in diploma or associate’s degree programs at the end of 2009.  For the first-time WPO disclosed the company’s enrollment mix by degree level.  The total percentage of students enrolled in bachelor’s or master’s degree programs increased from 33% in 2007 to 39% in 2009.
• Bad-debt expense as a percentage of total COMPANY-WIDE revenues increased from 3.5% in 2008 to 3.7% in 2009.  WPO does not disclose bad-debt expense as a percentage of revenue for Kaplan Higher Education on a stand-alone basis.  Given the nature of its other divisions, we think the bad-debt expense for those businesses is negligible. If all of the company’s allowances for doubtful accounts were attributed to Kaplan, bad-debt expense as a percentage of revenue would have been 6.4% in 2009.

Kaplan Higher Education continues to “fly under the radar” for most for-profit education investors, even though the company has more than 100,000 students enrolled and would be one of the largest players in the sector on a stand-alone basis.  We maintain the view that the company will need to dramatically alter its enrollment policies at many of its schools in order to maintain compliance with regulatory standards under a 3-year cohort default rate calculation. We anticipate this could be a significant headwind for the company over the next several years. Should the company choose to continue on its current path, it is our opinion that a number of the company’s schools could run the risk of losing access to Title IV funds in the next 3-4 years. In a scenario in which some of the regulatory issues are not addressed we anticipate the intrinsic of value of Kaplan could be impaired by as much as 30-40%, which would imply WPO shares would be worth as little as $275-$300. Conversely, we anticipate the neccesary remedies we proposed in the past could reduce the growth profile of Kaplan for 3-5 years, but perhaps only impair the intrinsic value of the company by 10-20%. Stated another way, should these regulatory issues go unchecked we estimate peak cycle earnings for WPO of $18-20 per share, assuming earnings recover for the company’s newspaper, magazine and broadcasting divisions. As WPO’s 10-K filing demonstrates, the regulatory and litigation issues continue to mount against Kaplan Higher Education.  The stakes are incredibly high for WPO shareholders.

As always, please act accordingly…