In the for-profit postsecondary education sector, controversy never dies and it seems like trading opportunities are omnipresent. After a one-month period during which news flow within the industry slowed to a lull and stocks remained range bound, we expect the next 4-8 weeks to be characterized by much higher volatility as companies within the sector report earnings and investors gain more clarity on the final Department of Education 2009 NegReg proposals.   If the past 24 hours are any indicator there certainly could be some fireworks.  We have held a bearish view on the appreciation prospects for a few stocks in the sector for the past 9-12 months, specifically COCO, ESI, and WPO.  Each of these companies faces either: structural issues due to overly aggressive tuition price policies that have eroded the return on education investment for students (ESI), difficulties in maintaining compliance with CURRENT regulatory standards under a 3-year cohort default rate construct (COCO, WPO), significant regulatory scrutiny (WPO, as far as we know), and potential earnings headwinds as the job market stabilizes and advertising costs increase (COCO, ESI, WPO).

Although investors have been emboldened by a recent Credit Suisse report which suggested that the Dept. of Education’s gainful employment regulation proposal could be less onerous than originally thought, we still think the sector is hardly out of the woods from a regulatory perspective (more on this later).  We recently conducted a survey of approximately 30 privately held for-profit education institutions to gain a better understanding of the following:

• Lead flow, student starts, persistence rate, and enrollment trends for the spring term
• Which programs are witnessing stronger demand than others
• Capital allocation priorities for 2010
• How institutions are combating higher cohort default rates
• Operator views on existing 2009 NegReg proposals and how they would prefer them to be altered
• New strategic initiatives in the sector that could impact enrollment growth going forward

Overall, the results of our survey have not altered our views on stock price appreciation prospect for COCO, ESI, and WPO, although based on the feedback we received sector-wide enrollment growth for the spring term remained strong.  Operators are highly concerned about the outcome of 2009 NegReg and are in the process of implementing a variety of initiatives to prepare for what is likely to be a more stringent regulatory environment going forward.  The 30+ schools we surveyed offer primarily diploma and associate’s degree programs and have an aggregate student population of close to 30,000.  We think the results of our survey are highly applicable to COCO, ESI, and WPO as well as several other publicly traded for-profit education providers.  Below we discuss the key observations from our survey.  As a reminder, gold and institutional subscribers can download the full survey on the “Surveys” page.

Counter-Cyclical Cracks? Total YOY Enrollment Growth for the Spring Term Remained Strong Although Moderated from the Winter Term

Given the state of the labor markets, it should come as no surprise that enrollment growth remained solid for most operators during the spring term.  One or two operators that responded to our survey indicated that they were at peak enrollment capacity at their particular campus or institution.  Although more than 85% of respondents witnessed an increase in total enrollments for the spring term, it appears that the rate of growth moderated slightly from the winter term.  Based on the feedback from our survey it seems likely that most publicly traded companies in the sector should be able to achieve high-single digit, if not low double-digit enrollment growth for the first quarter.

However, it appears that enrollment growth has moderated somewhat from the winter term. Are we starting to see the counter-cyclicality of demand for higher education start to manifest itself?

YOY Student Start Growth Remained Solid, but Also Slowed from the Winter Term

A combination of more difficult comparisons and a moderation in job losses in the US could be starting to reduce student start growth across the for-profit postsecondary education sector.  The trends could hardly be characterized as weak, but there has been a noted slowdown in start growth from the winter to spring term based on the feedback from our survey.  We also think that more stringent admissions standards could start to play a role in the student start and enrollment growth prospects for operators in the sector.  A number of institutions have indicated that they have altered admissions standards to prepare for 3-year cohort default rate regulatory compliance and in anticipation of potentially greater oversight from the Department of Education.  We do not see this as a huge fundamental shift that will drive enrollment trends…… yet.  For the spring term, just over 50% of respondents generated start growth of 10% or less, that’s an increase from 40% in our winter term survey.

Gains in Student Persistence Have Also Started to Moderate

Both student start growth and improvements in student persistence should decline in an improving or stabilizing labor market.  Historically outside of personal “issues”, the biggest factor impacting student persistence has been the state of the labor market. In the late 1990’s and even between 2004-2006, many students dropped out of school to pursue job opportunities. This dynamic was particularly acute for operators such as ESI and DV in the late 1990’s.  We are a long way from those halcyon days, but any incremental shift in employment prospects for the target student demographic of for-profit education institutions could impact persistence rates on the margin.  No schools we surveyed for the winter term witnessed a YOY decline in student persistence, while a number of schools had a decrease in student persistence on a YOY basis for the spring term.

We don’t want to sound overly pessimistic.  The general feedback we received on enrollment trends is supportive of solid earnings growth for most operators in the space. However, the slowdown in student start growth and persistence rate historically have been early indicators of the emergence of counter-cyclical headwinds.  We think these headwinds could accelerate in the next several quarters if economic growth continues and the labor markets continue to stabilize.  This is particularly problematic for COCO, and to a lesser extent WPO and ESI.

Allied Health Programs Continue to Generate the Strongest Demand, Business and IT Remain Relatively Weak

Consistent with the results of our winter term survey, allied health programs continue to witness the strongest demand, while those for business and IT are the weakest.  In theory these results should be favorable for COCO and less so for companies with a stronger focus in business and IT such as ESI and DV. However, for the winter term both DV and ESI generated stronger YOY start growth than did COCO.  We attribute the strength in allied health programs to the perception that end-market demand for graduates of those programs is acyclical.  As one sell-side analyst has described it, the heatlhcare overhaul will create huge incremental demand for allied health workers.  We certainly hope so, ACICS accredited schools alone are enrolling more than 100,000 students into medical assisting programs ANNUALLY.

Lead Flow Trends Remain Favorable, Lead Cost Inflation Starting to Bubble Up

Lead flow trends remained favorable over the past three months. More than 65% of respondents witnessed an increase in lead flow from the winter term.  In addition, it appears that the lead flow conversion rate improved slightly for the spring term.

The Last Days of Margin Expansion? Lead Cost Trends Starting to Present Headwinds

The combination of stronger lead flow and slightly higher conversion rates should help mitigate the impact of rising lead costs and enable most operators to deliver another quarter of solid margin expansion for 1Q10.  However, we anticipate we could be in the last innings of the margin expansion game.  For-profit education institutions have benefited immensely from the economic downturn.  Lead flow and conversion rates surged, while advertising rates and lead costs collapsed.  It appears that lead costs at the very least have started to show clear signs of increasing. This could become a significant headwind for companies such as COCO that have a higher mix of shorter term program offerings.  COCO needs to refill seats every year, which can make margin expansion particularly challenging in a rising lead cost environment.  Incremental margins in the for-profit education sector are enormous, so in the short term most companies should be able to fully offset higher lead costs with larger class sizes and better campus utilization.  As we get into the second half of 2010, it might become increasingly difficult for companies in the sector to deliver margin expansion.  As far as we can tell street estimates do not yet reflect a decremental margin scenario – stay tuned.  According to our survey, more than 85% of respondents witnessed a YOY increase in lead costs for the spring term.

Tuition Price Increases No Longer Appear to Be a Major Source of Growth

Historically the 20-25% EPS growth recipe for publicly traded for-profit education providers has been 1) 10-15% enrollment growth + 2) 3-5% tuition price increase + 3) 50-100 bps margin expansion = 25%+ EPS growth.  In the last recession, tuition price increases averaged 6.8% annually at public institutions and 4.8% annually at private institutions from 2001 to 2003.  In an economic downturn public colleges and universities are forced to raise tuition to meet funding needs created by lower state budget levels.  Private colleges typically feel the funding squeeze from lower endowment levels. This has created a “tuition price increase umbrella” for for-profit postsecondary education providers.  Things have changed in the past 12-18 months as investors, regulators, and consumers increasingly focus on affordability and outcomes.  Overly aggressive tuition price increases in the past 5-7 years have resulted in program costs that have eroded the return on educational investment for the student, in some cases.   The Department of Education through its gainful employment proposal and other initiatives has made it clear that it will no longer tolerate high priced programs that yield questionable outcomes for its students.  As a result, it appears that many for-profit institutions have significantly reeled in the rate at which they increase tuition, even though public universities and non-profit colleges continue to raise program costs at typical recession levels.  According to our survey, 80% of respondents have raised tuition 5% or less and a surprising 40% did not increase tuition at all.  This is yet another example of how the threat of regulatory action has resulted in meaningful change to operating behavior in the for-profit education sector.

Demand for Default Management Services Continues to Boom, How Effective Can it Be?

For-profit education institutions continue to invest in cohort default management services in order to combat higher default rates caused by a combination of lax admission standards (in some cases) and the economic downturn.  In addition, a number of institutions will face considerable difficulty complying with 3-year cohort default rate standards.  COCO and WPO are at the top of that list among publicly traded for-profit education companies.  According to the results of our survey, investment in default management services will be on par with that in new program offerings and square footage growth in 2010.

As a side note, we just wanted to point out that the number of institutions that plan to invest significantly in square footage growth this year has declined considerably in our spring survey compared to our winter survey.  Is this a sign that operators are growing cautious about growth prospects beyond this year?  Five to six years ago we started to voice concerns about saturation of capacity in the for-profit education sector.  During this economic downturn those concerns have been washed away in a tidal wave of lead flow, yet more and more bricks and mortar campuses continue to open and online programs continue to expand. Things could get very interesting in a tighter lead flow environment.

How Effective Can Default Management Be?

Approximately 70% of the respondents to our survey witnessed an increase in their 2-year cohort default rate from FY07 to FY08 (based on preliminary data).  In addition, more than 70% of survey respondents indicated that they plan to increase their investment in default management services to prepare for the transition to a 3-year cohort default rate regulatory construct.  One of the biggest questions we have had over the past 3-6 months is: how much can CDR’s be reduced through increased investment in default management services?

We have always maintained the view that the best way to reduce student loan default rates is through better admissions practices, lower program costs (amazingly people still try to deny the role that student debt burdens play in defaults, it’s as if the principles of credit don’t exist in the student loan market), increased investment in student retention/services programs, enhanced academic quality, and expansion of job placement efforts.  The term “default management services” includes some investment in student services and education about the implications of borrowing, but it is not the type of wholesale change that can structurally alter an institution’s regulatory compliance risk profile in our view.  Overall, it appears that the institutions we surveyed anticipate their investment can reduce 2-year cohort default rates by as much as 0-6%.  While this is encouraging, both COCO and WPO have a number of schools whose informational 3-year cohort default rates from FY05-FY07 were well above 30%.  This implies that simply increasing investment in default management services could leave those institutions precariously close to the boundaries of regulatory compliance.  The results of our survey suggest that institutions who have structurally high cohort default rates need to consider more significant “self regulation” actions such as changing admissions policies and potentially lowering tuition in order to more effectively mitigate the risk of violating 3-year cohort default rate standards in the next 2-3 years.

Gainful Employment Has Become the Hot-Button Issue for NegReg 2009

As the trading action in past 24 hours indicates, the Department of Education’s proposal on gainful employment is the most important issue for investors in the for-profit education sector.  It shouldn’t come as a surprise that operators are equally concerned about the eventual resolution of the Duncan/Shireman gainful employment regulation.  Interestingly enough, three months ago the for-profit postsecondary institutions we surveyed were not nearly as concerned about gainful employment as they are now.  Strange.  The proposal didn’t change. Perhaps the CCA did a better job of educating people in the space on its potential implications.  Either way, it is the one issue operators are most focused on.

How Would Institutions Structure a Gainful Employment Provision

Given the magnitude and breadth of concern about the gainful employment proposal, we thought it might be interesting to solicit feedback from operators in the space to determine what they would want/accept/tolerate from a gainful employment regulation in the event the department of education is 100% committed to implementing something.  In general, the feedback fell into three camps:

• The Dept. of Ed. shouldn’t and does not have the authority to implement a gainful employment regulation
• Gainful employment regulations should be applied to all higher education institutions
• We don’t have any specific recommendations

None of the responses we received came close in spirit to what Credit Suisse has indicated could be the eventual outcome for the gainful employment provision.

The Credit Suisse Gainful Employment Structure Raises More Questions than Answers

Publicly traded for-profit education providers rallied sharply yesterday following Credit Suisse’s upgrade of ESI and DV.  Credit Suisse now believes that the Dept. of Education’s gainful employment provision will now include completion and job placement rateexemptions, whereby a school with a completion rate above 50% and a job placement rate above 70% would be exempt from the gainful employment provision (expected to cap debt-service to income ratio at 8% and 10% repayment period).  A gainful employment provision without some exemptions would have been crippling to the earnings prospects of ESI, WPO, EDMC, DV, and several others in the for-profit education sector.  At this stage we anticipate we will get final details on the Dept. of Education’s proposals within the next 4-6 weeks.  For many investors Credit Suisse’s insights into the potential outcome of gainful employment resolved a lot of issues, we still have a host of questions, including:

• How will completion rates be calculated? Many for-profit institutions have completion rates well below 50% using the Dept. of Ed’s methodology. We find it hard to believe that the Dept. of Ed. won’t use its own data for completion rates, but there are several problems with the current methodology.
• How will the job placement rate be calculated?  Currently only national accrediting bodies specifically include job placement rates as part of their accreditation criteria and require schools to report them annually.  Regionally accredited for-profit institutions are not required to report job placement rates.  Would this rule only apply to national accredited schools (highly unlikely given the Dept.’s recent scrutiny of regional bodies)?  Whose data will the Dept. use?  How will job placement be defined? As we’ve indicated in the past, the definition of “job placement” is controversial and easily manipulated.
• Are default rates or the change in default rates not going to be considered as a condition of gainful employment? In spirit, we thought the Dept. of Ed. was trying to reduce the number of students that are saddled with excessive student debt and then default as a result, yet it does not appear that CDR’s play any role in the gainful employment provision.  We think a gainful employment provision that includes exemptions for schools with low default rates makes sense and accomplishes some of the Dept. of Education’s goals.  Schools that offer shorter programs with structurally high default rates (think COCO) actually are not impacted by the current gainful employment construct either way. Go figure.

Even If the Gainful Employment Proposal Has Less Teeth than Originally Feared, This Isn’t W’s Department of Education

Based on the level of regulatory activity over the past year, it is pretty obvious to most investors that the current administration is focused on exercising more oversight on the for-profit education sector.  It’s interesting to us that many investors overlooked an article published today on insidehighered.com, which can be found here.  In effect the head of the Higher Learning Commission sounded the alarm bell (for those that hadn’t already heard it) that this Department is focused on access, affordability, and accountability, above all else.  Based on the tenor of the NegReg process and the willingness of the Department to play “hard ball” with accrediting agencies, we think it is safe to say that regulatory oversight on this space will remain strict at least through 2012.   Apparently most operators agree, more than 80% of respondents indicated that they think this Department is more active in its oversight of the sector.  Candidly we should have phrased the question differently to exclude NegReg from the equation, which would have given us a better sense of whether more program reviews and other regulatory inquries are ongoing. That is our sense and it appears that operators are preparing themselves for a stricter operating environment.

Could APOL’s University Orientation Program Become Industry Standard?

APOL’s efforts to “cull the herd” through its University Orientation program have created a level of confusion about the company’s enrollment growth and earnings prospects among investors, in our opinion:

• Will the University Orientation program curb start growth? Yes
• Will the University Orientation Program result in higher matriculation rates? Possibly yes, but matriculation rates are also heavily impacted by economic factors in our view
• Will the University Orientation program result in better student outcomes? Yes
• Is the full negative impact of slower growth as a result of the University Orientation program reflected in earnings estimates? No, which is a problem for APOL shareholders

More importantly, we think APOL’s University Orientation program could be a sign of things to come in the for-profit education sector.  25% of the institutions we surveyed have adopted or plan to adopt a program similar to APOL’s University Orientation in the near future.  An additional 40% are watching the results of APOL’s program closely and would consider adopting something similar in the future.  As an industry leader, APOL has set a precedent.  Whether it be perceived or real, the threat of regulatory action from the Department of Education combined with rapidly rising cohort default rates has caused many institutions to reconsider their admissions policies and student retention programs. In an environment in which subpar outcomes have recourse the status quo will not suffice.  There has been a distinct change in tenor among many for-profit education institutions we speak to.  As we have argued many times in the past the threat of regulatory action sometimes can be as powerful as actual judgement.

Over the next several quarters we anticipate more and more institutions will consider adopting programs similar to the University Orientation program. In the short term, this will result in slower enrollment growth (if not negative), higher lead costs, suppressed operating margins, but higher retention rates and completion rates.  Over the long term, we think tighter management of the admissions process will yield better student outcomes and lower default rates.  In short, exactly what the Dept. of Education and taxpayers want.

Our Investment Theses On COCO, ESI, and WPO Remain Intact Despite Reduced Concerns About Gainful Employment

On a day when for-profit education stocks gapped higher, we are reminded that the principle tenets of our short thesis on COCO, ESI, and WPO were never predicated on a change in the regulatory landscape.  The findings from our survey suggest that enrollment growth momentum continued for the spring term, but started to show early signs of cyclical pressure.  In addition, lead costs have now gone from a margin tailwind to a margin headwind.  Perhaps most importantly, the feedback from our survey suggests that many institutions have responded to stricter oversight from the Department of Education by modifying their approach to enrollment growth in the form of tighter admissions standards, investment in default management services, lower tuition price increases, and potential modifications to retention based programs.  Are these factors reflected in consensus estimates? No.

Gainful employment as previously contemplated would have decimated ESI’s earnings prospects, if Credit Suisse is correct, for now it appears that risk might have been mitigated somewhat. However, gainful employment in its current form could still negatively impact ESI where the return on educational student for students is questionable and debt burdens are high.  In addition, gainful employment will have no bearing on COCO and WPO’s ability to navigate a 3-year cohort default rate environment.  Not to mention the cyclical headwinds the group now faces….

As always, please act accordingly….