COCO reported 3Q10 earnings results this morning.  You can read the full release here.  Overall, we would characterize the results as more or less inline, but they will likely be viewed as a disappointment in light of the strong earnings delivered by other for-profit postsecondary education companies over the past few weeks.  More importantly, the company guided down for 4Q10, new student start growth slowed, and the company witnessed a large increase in cost per start.  We view these as worrisome signs for COCO shareholders and they likely represent the first signals that economic improvement will hamper the company’s earnings growth prospects going forward.  Here are some key observations from the quarter:

• Revenues and EPS of $478.3 million and $0.48 (ex-acquisition related charges) topped consensus of $472.9 million and $0.46.  Revenues slightly exceeded our estimate, but EPS fell short of expectations by $0.02.
• Operating margin (ex-acquisition related costs) increased 290 bps YOY, but declined 10 bps sequentially.  Incremental operating margins decelerated from 38.7% in 2Q10 to 17.4% in 3Q10.
• We think the quarter was notable for the rapid increase in marketing expenditures.  Overall marketing spend increased more than 33% YOY and cost per start increased 13.4%.  Existing COCO shareholders should be worried about the sudden acceleration in marketing costs given that the company has yet to be impacted by higher ad rates.  Based on feedback from other publicly traded for-profit education operators (both public and private) we anticipate COCO could experience a 15% YOY increase in advertising costs as soon as 4Q10.
• Organic student start growth increased 7.1%, which was inline with our expectations.  Total organic enrollment growth of 18.4% was slightly better than our expectation of 17.0%.  It appears that enrollments at Heald declined by almost 700 student sequentially from the end of 2Q10, when COCO management indicated the acquired property had 12,900 students.

The Questions that Should Be Asked on the Conference Call, but Probably Won’t

We are hopeful that COCO management will entertain our queries on their conference call. Our guess is they probably won’t so here’s a list of questions we would pose given the opportunity:

1) How much did the company reserve against notes receivable during the quarter? In our original report on COCO, we argued that the company’s bad-debt expense improvements over the past several quarters have been nothing more than “accounting slight of hand”.  A significant portion of COCO’s bad-debt expense has been transferred from reserves on accounts receivable to reserves on notes receivable as a result of the company’s decision to use its own balance sheet to finance student tuition.  Reserve levels on these notes receivable approach 54-56% of principal.  The company chooses not to disclose its reserve levels on notes receivable on a quarterly basis even though reserves on notes receivable increased by $40 million in FY09 alone.  We are surprised this has not become an area of greater investor attention.  Management lauds its bad-debt expense improvement as reserves on notes receivable ratchet higher.  We consider “real bad debt expense” the sum of the company’s reserves on accounts receivable and those on notes receivable.  On this basis, COCO’s bad-debt expense actually increased from 5.1% in FY07 to 12.0% in FY09.

2) Has COCO altered its reserve policies on its internal lending program? As we stated earlier, management has indicated in the past that its reserves levels on internally financed student loans were as high as 54-56% of the principal balance. However, over the past several quarters the allowance as a percentage of gross notes receivable has been declining.   Is this a function of better collections performance causing the company to release reserves or has COCO been reserving at lower levels?

3) How would a change in the treatment of private student loans in bankruptcy alter the company’s reserve methodology on private student loans? Would the company need to increase reserves on existing notes receivable? There are currently two separate bills that contemplate allowing students to discharge private student loans in bankruptcy.  Given the growing size of COCO’s internal lending program ($85.8 million gross as of 6/30/09), a change in the bankruptcy laws could cause the company to boost reserves on existing and future internally financed student loans.

4) Has the company witnessed any sequential deterioration in lead flow or conversion rates over the past two months? A number of schools in our Spring 2010 survey of privately held for-profit postsecondary education institutions indicated that enrollment growth and lead flow had slowed somewhat from the winter term.  More importantly for COCO, DV management on its conference call indicated its Apollo College division had witnessed a precipitous decline in lead flow as a result of “counter-cyclical” factors.  The overlap in program offerings and target student demographic between DV’s Apollo College and COCO’s Everest Institute is high.  Although it is not yet factored in consensus estimates, it should not come as surprise if the labor market continues to improve and COCO starts to generate negative comps for student start growth given the nature of its program offerings.

5) Has the company modified its recruitment or enrollment practices for ability to benefit students?  More than 25% of COCO’s student population has been enrolled through the “ability to benefit” program, whereby a student that does not have a high school diploma or GED equivalent can enroll in a higher education program if they pass an admissions exam.  A recent OIG report commissioned by Congress raised a number of questions about the integrity of the administration of these exams and called into question whether or not schools have employed aggressive practices to boost enrollment growth. Based on comments made during congressional hearings and proposals included as part of NegReg 2009, it is clear that the Dept. of Education would like to implement stricter regulatory oversight on ability to benefit programs.  Of all publicly traded companies in the for-profit education sector, this would have the most negative impact on COCO.

6) The company is investing heavily in cohort default management services.  How much does management think it can improve its 2-year and 3-year CDR’s? COCO continues to struggle with higher cohort default rates for FY09 and we anticipate there are a number of the company’s schools that could have a 2-year CDR in excess of 25% for at least one, if not two consecutive years.  As part of our survey of privately held for-profit postsecondary education institutions, we wanted to determine how much they thought they could improve their 2-year cohort default rates through greater investment in default management services.  The majority of respondents indicated that they though they could improve their 2-year cohort default rates by 0-6%.  While this is a significant level of improvement, it might not be sufficient for many schools as regulatory standard switches from a 2-year to a 3-year calculation.  COCO bulls will argue that the company’s CDR’s should improve if the labor market improves. However, we think many shareholders over estimate the level of improvement that could results from job growth and underestimate the structural issues with COCO’s enrollment practices and target student demographic.  Consider the following: for FY07 COCO’s company-wide 2-year cohort default rate was 15.2%.  During the measurement period for the FY07 cohort default rate calculation (ends January 2008) the unemployment rate in the US was in a range of 4.5-5.0%.  Using COCO’s school by school cohort default rate data from FY05-FY07, we estimate that 11 of its 49 schools (excluding Heald) would have difficulty meeting the 30% 3-year cohort default rate threshold.  We doubt that we will see that type of job market for sometime. COCO management should have concrete views on the level of improvement in its cohort defaults rates that can be generated by greater investment in default management services. We think the company needs to improve cohort default rates by 5%+ at all of its schools to ensure the company can sustain regulatory compliance with 3-year CDR standards.

7) Has the company altered its recruitment or admissions practices in order to ensure better compliance with 3-year cohort default rate regulatory standards? Based on our analysis of the company’s school by school cohort default rates, we estimate as much as 25% of COCO’s legacy school network could have difficulty maintaining compliance with a 3-year cohort default rate standard.  The natural response from management, in our view should be too alter its recruiting, enrollment, tuition, and retention practices to improve outcomes.  Thus far we have heard little from COCO management that would indicate that the company is making wholesale changes to its enrollment practices.  Hope is not an operating strategy and we increasingly get the sense that management has taken the view that the Department of Education might offer schools an extension on compliance with key regulatory standards such as 90/10 and the 3-year cohort default rate.  We think this is a dangerous strategy and would like to see COCO management take a proactive approach towards ensuring its regulatory compliance. We think this could come in the form of higher admissions standards, reduced tuition, greater investment in student services and job placement professionals.  The stakes could not be higher for COCO shareholders.

Establishing a Realistic Set of Estimates for COCO

It is well known among investors in the for-profit education sector that COCO is the most cyclically levered publicly traded company in the space. Their programs are the shortest in duration and it places a lot of pressure on the company to refill seats every year.  As a result, any modest deterioration in lead flow, conversion rates, or marketing costs can have a disproportionate impact on the company’s earnings prospects. We are surprised that up until now there has not been one negative estimate revision from the sell-side analysts who follow the stock.  Certainly DV management provided a script on how earnings could be negatively impacted for certain programs in allied health if the economy continues to improve. The refrain we most often here from bulls is that COCO is simply to cheap – not on our estimates.  It appears investors have started to treat COCO as a cyclical, which we think is appropriate.  The stock trades at a seemingly implausible 8.1x consensus EPS estimates for FY11. Of course, most analyst on the buyside recognize how the company’s earnings could be negatively impacted by better employment trends, higher marketing costs, and regulatory factors.

On our estimates, COCO shares do not look nearly as attractive. In the table below, we outline our estimates for COCO for FY11 and FY12.  We think the company could witness rapid margin deterioration as student starts decline and marketing costs increase.  It is important to note that we have not assumed that the company alters its admissions practices to better positions itself for compliance with 3-year cohort default rate standards, nor do we factor in any impact from NegReg 2009.  If either of those two things occur, our current estimates could look optimistic.

At 15x and 38x our FY11 and FY12 EPS estimates, we would hardly characterize COCO’s valuation as compelling.  In addition, the company’s earnings prospects could be negatively impacted by the outcome of NegReg 2009 and senior management has yet to provide us with an answer as to how COCO will meet 3-year cohort rate standards.  COCO is a cyclical stock trading on peak earnings estimates that faces significant regulatory headwinds in the next 2-3 years.  On that basis, it’s not hard to see how shares could see further downside.

As always, please act accordingly….