WPO reported 1Q10 results on 5/7.  Overall, the results did little to alter our short thesis on the stock.  The company beat our estimates on the topline but fell short of our EPS forecast due to lower than expected profitability at the company’s newspaper division and wider than expected losses from its paper company affiliate.  Excluding one-time charges in WPO’s  test prep and newspaper divisions, EPS of $5.48 missed our estimate of $5.68.  In short, WPO’s results were more of the same: growth and margin expansion at Kaplan Higher Education effectively offset lackluster results from the company’s other operating divisions.

1Q10 Results Overview:

We wanted to highlight a few key observations from WPO’s 1Q10 operating results from each of the company’s major operating divisions.

Education:

We commend the company for providing additional disclosures about Kaplan Higher Education.  Given its relative importance to the company’s overall earnings, it’s amazing that the company hasn’t provided investors with the necessary metrics to gauge the profitability prospects of Kaplan Higher Education sooner.  Overall, Kaplan University reported another strong quarter of enrollment growth, but there are no shortage of issues that the company will need to address over the next 6-9 months both from a fundamental and regulatory perspective.  They include:

• Slowing campus based student start growth.  For the first quarter, new student starts at Kaplan Higher Education (KHE) campuses decelerated to 5% YOY.  We don’t know how difficult the comp was, nor do we know what type of start growth KHE campuses generated in the fourth quarter. However, based on the operating results of other publicly traded for-profit postsecondary education companies and the results of our survey of privately held institutions, KHE’s campus based enrollment growth has been below the industry average.  WPO’s campus network is largely comprised of the legacy assets of Quest Education, who at one-time was viewed as a “kissing cousin” to COCO in terms of the target student demographic and the types of programs the company’s schools offered.  In this context, it shouldn’t come as a surprise that KHE”s campus based student starts slowed precipitously as COCO’s student starts in its most recently reported quarter decelerated substantially. WPO management offers investors few insights into its higher education division, but we can only assume that the deceleration in student starts is a function of counter-cyclical demand factors.  As of yet, we have not heard from any of our industry sources that KHE has made the wholesale changes needed to its recruitment, admissions, and program delivery practices in order to structurally lower the company’s cohort default rate and regulatory risk profile. Eventually, we think some form of “self regulation will be the outcome at KHE, which will likely lead to declines in student population and much lower operating margins.
• Rising lead costs. Approximately 60% of KHE’s student population is enrolled in diploma or associate’s degree programs. Similar to other for-profit postsecondary education providers that have a heavy mix of shorter term programs, KHE’s operating margins are highly sensitive to lead costs, conversion rates, and total student start costs.  Over the course of the past few weeks, several leading operators in the sector have indicated that lead costs increased in the first quarter and are likely to increase over the course of the next several quarters. Up until the last 12-18 months, KHE’s operating margins were well below its peer group. The recent surge in margins can be directly attributed to the availability of lower cost leads and robust enrollment growth.  We think both of these factors could become headwinds for the company in the second half of this year.
• Impact of Gainful Employment Proposal – How do KHE students finance their education? Kaplan’s programs are some of the most expensive in the for-profit education industry.  Annual student tuition for the company’s program offerings ranges from $16,000-$20,000. The company does not offer any detail on job placement rates are average starting salaries, so it is difficult for us to evaluate the return on educational investment for students.  Certainly, the cohort default rates for KHE’s schools are fairly damning.  Additionally, WPO provides little disclosure on bad-debt expense at KHE or how students finance their education. We can only assume that WPO has introduced an “internal financing” student lending program similar to other operators in the space to help students bridge the gap between government student loan limits and the cost of their programs.  WPO was the only publicly traded for-profit education company to include a discussion of the Dept. of Education’s gainful employment proposal in its press release. It is difficult for us to determine its potential impact, but based on KHE’s program costs we think it could be significant.
• Update on or resolution of the program review of Kaplan University.  In its 1Q10 earnings release, WPO did not provide any additional detail on the Dept. of Education’s program review of Kaplan University, which was launched Sept. 2009, but first disclosed in the company’s 10-K filing 5-6 months later.  It still appears that investors have not discounted any possibility that the outcome of the program review could be negative.  Based on our conversations with former KHE employees, review of legal filings, and analysis of publicly available data, we think there are a host of issues that could be the Dept. of Ed’s focus in the program review.  Thus far the program review has been largely ignored by shareholders (the stock actually traded higher on the day the program review was first disclosed).  Given the lack of attention to some of the regulatory issues KHE now faces, we think any negative outcome for the program review could cause WPO shares to trade lower.
• Resolution of Qui Tam actions against KHE.  KHE currently has four separate qui tam actions outstanding against the company. In the 10+ years we have been following the sector, this is the largest number of qui tam actions outstanding against a publicly traded for-profit postsecondary education company. We think investors should be alarmed by the number of qui tam actions, the nature of the claims, and who the relators (plaintiffs) are.  You can read more about the qui tam actions here. Based on our conversations with individuals closely following the legal process, it appears that a decision on WPO’s motion to dismiss the broadest reaching qui tam could be reached within the next few weeks.  In the opinion of our sources the motion to dismiss will be denied.  At current valuation levels, it does not appear that WPO shares discount any negative impact (brand/reputation or financial) from the outstanding qui tam actions.

Newspaper

WPO has yet to demonstrate that it can consistently generate operating profits from its flagship newspaper division.  For 1Q10, both revenues and EBITDA from the company’s newspaper division fell short of our estimates.  In the first quarter, operating profitability from WPO’s newspaper division lagged the results of both NYT and GCI.  The secular decline in readership, cicrulation, and profitability of newspapers has been well documented.  It still remains unclear whether or not the Washington Post (the newspaper) will play a meaningful role in the media landscape over the next ten years.

Cable

CableOne, WPO’s cable division generated revenues and EBITDA that were more or less inline with our estimates.  Despite a sequential increase in the number of high speed data and telephony subscribers, we think investors should be increasingly concerned about video RGU trends. For six consecutive quarters now, CableOne has witnessed a YOY decline in video RGU’s.  There is no question that overall economic weakness and the downturn in housing has had a negative impact on RGU growth at CableOne. However, the company’s peers have witnessed more favorable RGU trends, which leads to questions about the nature of the markets CableOne serves and whether or not growth has been impaired by competitive threats from new market entrants like Verizon.  The long term earnings prospects for this division could become increasingly cloudy as competitive headwinds mount.  In the chart below we outline video RGU growth at CableOne over the last four years.

Broadcasting

WPO’s broadcasting assets (6 television stations) benefited from a broad recovery in advertising spending in the first quarters as well as the Winter Olympics (WPO owns 2 NBC affiliates).  Revenues of $73.5 million and EBITDA of $24 million beat our estimates of $58.1 million and $17.4 million.

Magazine

Last week, WPO announced it was putting Newsweek up for sale. In the company’s press release, Don Graham stated:

“Newsweek is a lively, important magazine and website, and in the current climate, it might be a better fit elsewhere.“

When one of the largest and most well established operators in the traditional print media sector decides to jettison a flagship brand investors should take notice.  Mr. Graham’s commentary seemed to imply that WPO management could not figure out a profitable business model in the new media landscape for Newsweek.  McGraw Hill’s recent sale of Businessweek to Bloomberg is the most recent transaction comp, and it’s not a particularly good one for WPO shareholders. Bloomberg acquired Businessweek for approximately $10 million.  Based on Newsweek’s limited profitability prospects, we think it will be difficult for WPO to generate meaningful proceeds from the sale.  We have questioned why Newsweek exists in the past.  It appears we could be approaching an answer to that question imminently.

In the table below we compare WPO’s 1Q10 results from each of the company’s major operating divisions to our estimates:

Our Revised Estimates for WPO

We have revised our revenue and EPS estimates for WPO.  We now forecast $4.75 billion and $26.58 in revenues and EPS in FY10, respectively.  For FY11, we forecast $4.83 billion and $21.30 in revenues and EPS.  Over the next several quarters we anticipate operating profitability from KHE could decline sharply due to the impact of “self-regulation”, reduced lead flow from an improving economy, and higher advertising costs.  It is important to note that our estimates do not reflect any impact from NegReg 2009, including gainful employment, which we anticipate could dramatically reduce KHE’s earnings prospects.

WPO’s 1Q10 results did little to change our short thesis on the stock.  The company has yet to demonstrate that its traditional print media assets will be sources of shareholder value creation over the next 3-5 years. This leaves the company (and by proxy shareholders) increasingly dependent on operating results from the company’s higher education division.  At KHE, operating headwinds are growing while regulatory headwinds pile up. At 18x and 22x our FY10 and FY11 EPS estimates, it does not appear these issues are reflected in the stock price.  We continue to believe the true “intrinsic value” value of WPO is closer to $300.

As always, please act accordingly….