On Thursday, July 22nd ESI will report 2Q10 earnings results and its Summer 2010 enrollment figures.  This quarter’s earnings season for the for-profit postsecondary education sector should be unique.  We would not go as far as to say that earnings will not matter, but clearly investor attention remains focused on the eventual outcome of the Department of Education’s “gainful employment” proposal and the possibility that Congress could introduce new legislation in the coming months to implement tighter restrictions on the sector.  We encourage investors not to lose sight of what might prove to be a critical inflection point for the growth trajectory and profitability of many operators in this sector.  Based on our checks with privately held for-profit postsecondary education institutions new student start growth slowed precipitously for the Summer term and expectations for the Fall term are relatively muted in response to current lead flow trends (more on this later).

Although we expect ESI to once again beat consensus revenue and EPS estimates for 2Q10, we think the company’s summer term enrollment intake could signify the first meaningful deceleration in student start growth.  Overall demand for higher education remains robust in light of current unemployment levels, but the magnitude of payroll reductions is more important than the absolute level of unemployment.  Initial jobless claims have stabilized at elevated levels, which portends solid lead flow for companies like ESI. However, the Challenger Gray mass layoff data indicates overall lead flow trends could moderate sharply in coming months if not decline altogether.

Our original short thesis was never predicated specifically on “gainful employment”.  For the past 15-18 months we have argued that ESI’s business model was structurally broken.  The “more you learn, more you earn” student covenant has been broken and the return on educational investment is now highly questionable.  As a result, we expect student loan default rates to ratchet higher just as operating margins for ESI reach record levels.  As we predicted, increased regulatory oversight became the natural outcome.

The remedy to the structural flaw in ESI’s business model has always been fairly obvious and easy to accomplish – CUT TUITION.  Contrary to what industry operators and lobbyists would have you believe restoring the return on educational investment equation for students will not lead to reduced access, just lower profitability.  Based on the recent decision by APOL’s management to institute another 5% tuition price increase this year, it still sounds like operators in the for-profit postsecondary education space are “tone deaf”.  Companies may view tuition price increases as sacrosanct, the Dept. of Education does not.  The Dept. of Education’s gainful employment proposal hangs like an anvil over the heads of many companies in the for-profit postsecondary education sector.  ESI stands to be impacted the most based on current conjecture surrounding the Department’s gainful employment.

As ESI’s management prepares to discuss its 2Q10 results and outlook with investors we can’t help but wonder if we’ll continue to hear the same absurdities about the company’s multi-factor model supporting tuition increases (why does the multi-factor model always return a 5% tuition price increase) and our favorite “We don’t want to get into that kind of detail” in response to any question about reserve policies on internal lending or the PEAKS program.  Might ESI management finally recognize that with the stock at 8x 2010 EPS the street isn’t exactly rewarding the company for its current disclosure policy?  Here’s to hoping we hear some probing questions and some detailed answers on Thursday.

How Cheap are ESI Shares?

The most common refrain we hear from bulls in the sector about ESI is that the impact of “gainful employment”, any other potential regulatory action or change in legislation, and a potential slowdown in enrollment trends is “priced in”.  Our response is: we’ll believe it when we see these stocks rally on negative estimate revisions. The only problem is there have been no negative estimate revisions yet.  We’re at a loss as to why we haven’t seen negative estimate revisions in the sector given what has already been proposed as part of NegReg 2009 and clear evidence that enrollment trends are decelerating.  The buy-side has not been fooled. We think current valuations reflect the risk of legislative action from Congress and the likely implications of the Department of Education’s gainful employment proposal, but perhaps not the repercussions of slowing enrollment and margin pressures.  Our estimates do not include any impact from gainful employment. They do reflect the impact of what has already been proposed by the Department of Education as part of NegReg 2009. More importantly, our estimates reflect a simple concept called “mean reversion”.

ESI’s Gross Margin “Miracle” Explained

Every year for the past 10-years, gross margins for ESI have increaed on a YOY basis, a truly impressive accomplishment.  In the aggregate, ESI’s gross margins have increased from 39.1% in 2000 to what we estimate will be 66.0% in 2010.  We doubt there are many other publicly traded companies that can boast similar gross margin expansion over the same time frame.  While people are quick to point out the positive benefits of the company’s transition to a “2+1″ educational delivery format (2-days on campus one day online) in our view there are two more important factors that have contributed to ESI’s gross margin miracle:

• Tuition prices increases (100% incremental margin)
• Increased campus utilization (80%+ incremental margins)

It is well known that the incremental margin on adding students to existing classes and campuses is one of the most compelling elements of the for-profit postsecondary education business model.  ESI’s operating results over the past decade prove this out. In the chart below we compare the company’s average number of enrollments per campus to gross margins from 1997 to 2010.

From 1997-2002, ESI’s average enrollment per campus ranged between 415-455 students and as a result gross margins remained in a relatively tight range of 37-43%. One could argue that the primary factor that enabled the company to improve gross margins from 38% to 43% over that time frame was simply an increase in tuition.  In 2003, ESI introduced its “2+1″ delivery format which resulted in structurally higher gross margins and also improved the marketability of the company’s programs. As a result, average enrollment per school increased to 550 students and gross margins expanded rapidly.  The 8-9% increase in gross margins from 2002-2005 can be attribute to the benefits of the “2+1″ delivery model, better capacity utilization, and of course tuition price increases.  In 2005 and 2006, gross margins remained relatively constant (up 70 bps YOY) because the average enrollment per campus remained flat. The only source of gross margin expansion was a 5% tuition price increase (quelle surprise).  Then between 2007-2010 gross margins expanded an additional 13% as the average number of students per campus increased from 559 in 2007 to what we expect to be 704 in 2010.

In the chart below we examine ESI’s operating efficiency in another way. Over the past 13-years ESI’s average cost of educational services spend per student has actually declined 3.5% on a NOMINAL BASIS – not on an inflation adjusted basis, but on a nominal basis.  We think this is a function of two factors:

• ESI generally has not reinvested in its students.  We think the anemic growth in average starting salaries for its graduates over the past 12-years is a good barometer for the investment ESI has made in educational quality.
• Campus utilization has improved dramatically.  As discussed above, the average campus will have 300 more students enrolled at the end of 2010 than it did in 1997.  Absolute COGS spending has increased at a 9.9% CAGR over the past 12-13 years as the number of campuses increased from approximately 60 to more than 120 nationwide.

When we compare the ESI’s revenue-per-student to the company’s educational services spend per student it paints a rather damning picture. Even adjusting for the benefits of better campus utilization on educational services spend per student, it’s hard to make the argument that ESI runs a student centric business model.

To summarize, ESI’s gross margin miracle over the past decade for the most part has been driven by tuition price increases and better campus utilization.  We know that ESI’s tuition levels have reached untenable levels. The best case going forward is that revenue-per-student will remain at current levels for a few years, although we continue to think that a tuition price reduction is the more likely outcome.  Our checks with privately held for-profit education institutions and our analysis of the historical correlation between trends in non-farm payrolls in the US and enrollments indicate that student start and population growth could decelerate.   In light of these factors, it appears to be a natural conclusion that ESI’s gross margins could revert to 2007 levels if not worse in the next few years.

SS&A Spending Also Appears Poised for Mean Reversion

From 1997 to 2007, SS&A spending excluding bad-debt expense increased at a CAGR of 13.3% and averaged 26.7% as a percentage of revenue. The collapse in advertising rates in 2008, 2009, and to a lesser extent in 2010 enabled ESI to reduce its SS&A expense dramatically.  Based on our checks with lead generators and privately held institutions, lead costs have increased in the high single digit low double digit range in the past few months. We expect this trend to continue as automotive advertisers come back into the marketplace and political spending for the November election ramps up. The days of cheap remnant inventory on cable networks has probably passed.  Over the past several years, ESI continued to expand the number of enrollment counselors it employs at double-digit rates annually.  We think SS&A expense (ex-bad-debt expense) could return to historical rates as a percentage of revenue over the next several years as advertising rates increase and enrollment counselor productivity declines. We estimate this could impact operating margins by as much as 4-5% and EPS by $1.25-$1.75.

Maybe the Short Thesis Isn’t Just “Gainful Employment”

As we have outlined above, ESI’s 35%+ operating margins are largely a function of tuition price increases, improved campus utilization caused by labor market weakness, and favorable lead cost trends due to depressed advertising spending.  While many investors continue to “fall over themselves” to figure out the latest rumor on “gainful employment” we continue to focus on the bigger picture.  From that perspective, there are growing signs that enrollment trends could deteriorate rapidly and operating margins could revert to historical levels.

In the table below we outline some of our key earnings assumptions for ESI.  In general, we have assumed that revenue-per-student stays flat at 2010 levels.  For 2Q10, we expect ESI to deliver another quarter of upside, although we can’t rule out that the company could have pulled back the reins a little bit in light of all of the congressional scrutiny.   For 2011 and 2012, we expect slowing enrollment trends and lead cost inflation to take their toll on ESI’s topline and operating margins.  For FY12 we forecast $1.4 billion in revenues and EPS of $6.85.  To put this in perspective, our FY12 estimates imply an average number of students per school and operating margins inline with 2007 levels.  That seems reasonable to us.  If “gainful employment” is enacted as currently rumored our estimates would be lower.  ESI shares currently trade at 13.2x our FY12 EPS estimates, which seems fairly lofty for a cyclical company facing potential regulatory headwinds that generates a significant portion of revenues from consumer finance.  Is the market discounting a $6.50-$7.00/share earnings scenario for ESI before the potential impact of “gainful employment”? We think not.

Other Considerations for ESI’s Earnings Conference Call?

We are hopeful that sell-side analysts will ask more probing questions of ESI management in light of all of the regulatory scrutiny surrounding the sector.  Here are a few questions we would like more detail on:

• How much does ESI reserve on internal loans?  This has become a hot-button issue for some members of the HELP committee.  DV recently disclosed that it reserves 36-37% on its internal loans extended to students.  We found this surprising given the relative quality of DV’s student population and educational outcomes.  We have analyzed ESI’s account receivable trends over the past 2-3 years with the help of one of our subscribers, which suggests that ESI reserves as much as 45% on its internal loans.  Certain members of Congress do not find it palatable that companies reserve at extraordinarily high levels for loans initiated from their own balance sheet but are more than happy to have tax payers foot close to 90% of the bill for the same student.
• How much was originated under the PEAKS program and how much subordinated debt did ESI purchase from the trust? The PEAKS program reduces investor transparency and obfuscates ESI’s true student loan risk. We think it is possible that ESI could have to bring it “back on balance sheet” in the next several years given that the company is the ultimate guarantor of all loans extended under the program.
• What now for Daniel Webster? The HLC’s decision to allow Dana College to fail rather than have the institution sold to a group of investors is a seminal event in the higher education space. Clearly the accrediting agencies are taking a more aggressive tact in oversight given the public embarrassment they faced on the credit hour issue and increased oversight from the Department of Education.  ”Accreditation shopping” is over.  The good news for ESI is that the company was able to purchase its regionally accredited platform, Daniel Webster before the door was slammed shut. What isn’t clear is how NEASC will view any change in the strategic direction of the institution.  It should be interesting.

There are two primary elements of our short thesis on ESI, regulatory and fundamental.  There is no question that ESI shares could rally if the eventual outcome of gainful employment is not as bad as feared. However, we would use any strength in ESI shares to establish or add-to short positions.  We still think ESI shares could trade as low as 10x our FY12 EPS estimate, or $65-&70 share.

As always, please act accordingly….