ESI will report 1Q10 results on Thursday, 4/22 before the market opens.  Based on the feedback from our recent survey of privately held for-profit education institutions, we think enrollment momentum across ESI’s network of campuses likely remained strong during for the spring term.    Here are some of the key issues and questions that we will be focused on when the company reports 1Q10 earnings and management hosts its subsequent conference call:

• Are there any signs of more significant lead cost inflation?
• What was the company’s final job placement rate for 2009 graduates?
• Expansion plans for Daniel Webster
• Has the company modified its operating strategy or  tuition pricing at all due to the threat of greater regulatory oversight from the Dept. of Education generally for proprietary institutions?
• Any new thoughts on the “gainful employment” proposal for NegReg 2009? What are management’s views on the rumored exemption provisions based on completion and job placement rates?
• How much does the company expect to reduce cohort default rates through its investment in default management services?

Spring Term Enrollment Growth/Starts

• Are there any signs that new student start growth is poised to slow due to an improving economy?
• Have conversion rates moderated at all due to economic  stabilization?
• At what point does ESI achieve saturation in the US with its primary education concept, ITT Tech?
• How much has start growth been boosted by an increase in the matriculation rate between associate’s and bachelor’s degree programs?

Student Financing

• How quickly is the PEAKS loan program ramping up?
• Will the company provide disclosure on reserves against the subordinated notes that will be issued as a form of overcollateralization for the trust?
• How much of the company’s notes receivable were refinanced through PEAKS in the first quarter?
• How would a change in the treatment of private student loans in bankruptcy alter the company’s reserve policies on its internally financed loans and the issuance of subordinated notes for the PEAKS loan program?
• Does the company have any other active conversations with other potential private student loan providers?

Overall, we expect the company to report revenues and EPS of $374.4 million and $2.28, which is more or less inline with consensus.  Over the next several quarters, we expect operating margin expansion to moderate and eventually turn to degradation due to slower enrollment growth combined with a rapid increase in lead costs.  We expect ESI to become increasingly judicious in its tuition pricing policies given the mounting scrutiny surrounding affordability, return on educational investment, and student debt burdens.  As a result, we only expect revenue-per-student gains of 1% for FY10.  ESI will offset published tuition price increases with greater discounting and expansion of scholarship programs. Historically, tuition price increases have been a stable, high margin source of revenue growth for companies like ESI.  As we have argued for a long time, the student debt burden placed on ESI’s graduates is unsustainable.  Whether or not gainful employment is instituted in its current form, it should be clear to everyone that ESI has little room to increase its tuition unless it dramatically improves student outcomes.  As a result, one major source of revenue growth and margin expansion has been removed from ESI’s earnings story.  In the table below, we outline our estimates for 1Q10, FY10, and FY11. As you can see, we expect FY10 earnings to represent a peak for the company.

Source: PAA Research

New Lawsuit Raises More Questions About ESI’s Regulatory Compliance Practices

A new lawsuit was filed against ESI in the US District Court Southern District of Indiana last week, which we think could cause investors to question many of the company’s regulatory compliance practices.  We cannot speak to the veracity of the lawsuit, but the nature of the allegations and source of the claims should raise a few eyebrows among investors and potentially even regulators.  Dr. Jason Halasa filed a wrongful termination suit again ESI.  Dr. Halasa served as the Director of ESI’s ITT Tech location in Lathrop, CA in 2009.  Dr. Halasa has a strong background in IT and an extensive track record in higher education.  You can learn more about his background here.  Dr. Halasa alleges the followings:

• Staff members altered the results to admissions tests for students that failed so that they could be enrolled
• Grade were falsified to meet minimum GPA benchmarks for federal financial aid
• Attendance records were modified to ensure ESI could collect federal financial aid
• Job placement statistics were inflated and misrepresented to potential students and the ACICS
• Incentive compensation violations

Dr. Halasa did not last long at ESI, he was terminated after only 6-months as a Director.  The plaintiff claims he was fired because he raised concerns about these issues and refused to look the other way.  This is not the first time we have heard these types of allegations against ESI in particular or other operators in the for-profit education sector.  Typically lawsuits of this nature are filed by former admissions reps, enrollment counselors, or someone working in the financial aid office.  It is somewhat unusual for a Director of a school (in charge of running the school) to make these allegations.  At a time when the Department of Education appears to be increasingly less tolerant of lax regulatory compliance practices and questionable enrollment techniques, we anticipate these allegations could subject ESI to additional scrutiny, in our opinion.

As always, please act accordingly…