Even though we are only 24 hours away from the first earnings report of the season from a publicly traded for-profit education provider, investor focus remains firmly on the eventual outcome of the Department of Education’s “gainful employment” proposal.  Trading these stocks over the past few weeks has been almost entirely about conjecture and innuendo coming from Capitol Hill.  While we don’t want to dismiss the potential implications of gainful employment on the fundamental earnings prospects of many for-profit postsecondary education operators, we recognize that we have no unique insights to offer on the potential outcome of the proposal.  As we discussed in our recent preview of ESI’s 2Q10 earnings, our short theses on COCO, ESI, and WPO  have never been contingent upon gainful employment.  The regulatory element of our short thesis on these stocks has been that certain operating practices would result in poor student outcomes and soaring cohort default rates, which would eventually lead to greater scrutiny from the Dept. of Education, accrediting agencies, and potentially Congress.  This element of our short thesis has started to play out as an increasing number of regulators and legislators are asking more detailed questions about the return on educational investment for students and tax payers at some institutions in the for-profit postsecondary education sector.  We expect the debate on Capitol Hill to rage on for months and think it’s more likely than not that new regulations will be drafted at the very least at the sub-committee level.

The second component of our short theses on COCO, ESI, and WPO relates to the fundamental earnings prospects for these companies, irrespective of any changes to the regulatory landscape.  As we outlined in excruciating detail in our ESI earnings preview, for-profit postsecondary education companies have benefited enormously from the economic downturn: lead flow surged, lead costs collapsed, conversion rates improved, and capacity utilization rates reached peak levels. Is it any wonder operators in the space have witnessed jaw-dropping revenue growth and margin expansion?  While the for-profit education sector has benefited from secular growth and market share gains over the past 10-15 years, the results from the past two and a half years provide ample confirmation that enrollment growth and earnings prospects are inherently counter-cyclical.

The for-profit postsecondary education sector sits at a critical impasse both from a regulatory and fundamental perspective.  The unemployment rate in the US appears to have stabilized, albeit at lofty levels.  Based on our analysis of historical enrollment data and our conversations with operators in the space we have concluded that the incremental change in non-farm payrolls is the key driver of demand in the higher education space, not the absolute level of unemployment.  The (-2.4%) student start growth posted by DeVry’s US Education Corp. in the spring term served as “the canary in the coal mine”, in our view.  DeVry management indicated that demand for the type of diploma and associate’s degree programs offered at US Education was inherently counter-cyclical.  We are still surprised we did not see a round of negative estimate revisions following these comments.

In advance of earnings seasons, we wanted to gain a stronger understanding of how broader economic trends over the past three months might have impacted for-profit postsecondary education providers. We recently conducted a survey of approximately 25 privately held for-profit education institutions across the country.  The purpose of our survey was to learn more about the following:

• Lead flow, student starts, persistence rate, and enrollment trends for the summer term
• Which programs are witnessing stronger demand than others
• How institutions are combating higher cohort default rates
• How institutions will make changes to comply with the final NegReg 2009 proposals (excluding gainful employment)
• New strategic initiatives in the sector that could impact enrollment growth going forward
• How the negative publicity surrounding the sector has impacted enrollment trends

The 25 schools we surveyed offer primarily diploma and associate’s degree programs and have an aggregate student population of close to 20,000.  The majority of schools that participated offer diploma and associate’s degree programs.  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.

Here Comes the Enrollment Growth Deceleration

Although overall enrollment trends remained favorable for the majority of the for-profit postsecondary institutions we surveyed, there is no question that significant deceleration in growth occurred from the spring to the summer term.  For the spring term, a greater percentage of institutions that responded witnessed total enrollment growth in excess of 10%.

For the summer term, approximately one-third of respondents witnessed a decline or flat enrollments, while another third generated enrollment growth between 0-10%.  We do not want to overstate the rate of deceleration here, it appears that some institutions maintained the rate of growth witnessed in the spring term.  However a significant percentage of schools witnessed a deceleration in enrollment growth of 5-10%.  We attribute the slowdown in enrollment growth to a combination of difficult comps and counter-cyclical factors.

Student Start Growth Decelerating More Quickly Than Total Enrollment Growth

The minor enrollment deceleration would not be be as damning if student start growth also didn’t show signs of deteriorating.  In our Spring 2010 survey approximately 81% of respondents generated student start growth, with approximately 40% of respondents witnessing start growth in excess of 20%.  The overlap in respondents to our Spring and Summer surveys is quite high.  For the Summer term, more than 40% of respondents generated flat starts YOY or actually witnessed a decline in new students.  Additionally, less than 10% of respondents generated student start growth of more than 20%.  Counter-cyclical factors certainly have impacted student start growth in the past three months.  A number of schools also indicated that they have started to modify admissions standards to better position their institution for a 3-year cohort default rate environment.  Overall average new student start growth for the institutions we surveyed was in the mid-to-high single digit range.  Based on this data, we think it is possible that publicly traded companies that have greater exposure to diploma and associate’s degree programs and also face potential regulatory scrutiny could witness flat start growth, or perhaps even a decline for the summer term.

Gains in Student Persistence Appear to Have Peaked

Improved student persistence, or the percentage of students that continue in a program from one quarter to the next, has been a big driver of enrollment growth over the past two years. Outside of company specific efforts to improve student retention, persistence rates historically have been positively correlated to rising unemployment. Students are more likely to stay in school when job opportunities are scarce. Conversely, tight labor markets often lead to higher student dropouts as job offers become plentiful.  For example, DV’s and ESI’s student persistence rates were negatively impacted by the tech bubble in the late 1990’s which enabled many students to obtain employment without completing their degree program.

It is also important to remember that increased student retention leads to higher revenue-per-student gains and operating margin expansion.  There is no more profitable revenue stream to a for-profit postsecondary education institution than a retained student.  For the summer term it appears student persistence rates remained consistent with year ago levels.  In our spring survey, approximately 50% of institutions that responded indicated that persistence rates had increased YOY.  For our summer term survey only 30% have witnessed a YOY increase in student persistence.  A reversal in student persistence would lead to rapid margin degradation.  It is still too early to raise a warning flag on student persistence, but it appears that rates have stabilized at high levels…. for now.

Lead Flow Trends Looking “Toppy”, Costs Are Increasing

In our spring term survey, more than 65% of respondents indicated they witnessed an increase in lead flow over the prior three months. For our summer term survey, approximately 42% of institutions indicated that lead flow had increased in the past three month.  Additionally, nearly 30% of the schools we surveyed actually witnessed a sequential decline in lead flow. Some of this can be attributed to seasonal factors, but lead flow typically starts to pick up meaningfully in July in anticipation of what is traditionally the largest intake of the year in the Fall.

Lead Costs Have Started to Increase

Based on the modest recovery in advertising revenues reported by most media companies over the past 3-6 months, it should come as no surprise that lead costs have started to increase.  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. Over the next 6-9 months, it might become increasingly difficult for companies in the sector to deliver margin expansion. Amazingly street estimates do not yet reflect margin stabilization, let alone a decremental margin scenario – stay tuned. For our spring term survey, more than 85% of respondents witnessed a YOY increase in lead costs.  In our summer term survey the percentage of respondents that witnessed a YOY increase in lead costs remained relatively similar but the magnitude of change was larger.  It appears that lead costs for most institutions increased in the high single digit to low double digit range for the summer term.

Approach to Cohort Default Rates Remains Too “Back-End” Centric

In our survey we asked a number of questions about cohort default rates and how institutions plan to manage the transition from a 2-year to a 3-year calculation.  As one would expect, most institutions expect to witness an increase in their FY09 cohort default rates as compared to FY08 given the time period captured (10/1/08-9/30/10).  Most respondents expect their 2-year cohort default rate to increase in a range of 0-3%.  While several of the institutions we surveyed have 2-year cohort default rates of less than 10% and are less concerned about how to comply with regulatory standards, the majority of schools that responded target a lower socio-economic demographic and face greater default risk as a result.  In our view there are five major ways to effectively lower cohort default rates (our views on the effectiveness of the cohort default rate as a barometer of student and lender outcomes is a conversation for another time):

• Increased admissions standards
• Lower tuition (yes absolute debt burdens have implications on the rate of default, the rules of credit do apply to the higher education space)
• Enhanced investment in student retention programs
• Increased hiring of job placement professionals
• Investment in default management services

The latter two options are more palatable to higher education institutions, but are less likely to actually structurally lower default rate risk.  The “back end” approach of trying to chase down students once they’re outside the confines of the institution is difficult work and less likely to lead to long term improvement in a school’s cohort default rates.  As ineffective as back-end management of default rates can be, it still is far more profitable to the institution than narrowing the pipeline of incoming students.  It is important to remember that a student that completes more than 60% of a single term is still profitable to the institution, in some cases sooner.  Over the next several years, we think an increasing number of institutions will start to adopt admissions policies and programs that effectively manage default risk.  The transition to a 3-year cohort default rate definition will make it more difficult for schools to push students into deferment and forebearance programs, which have generally had the effect of “kicking” the student’s repayment issues “down the road”.  Additionally, we anticipate the labor market could remain depressed for several years to come.  Many of the schools owned by COCO and WPO could face incredible difficulty in complying with three year cohort default rate standards unless they change their approach to mitigation.  The eventual resolution of COCO’s and WPO”s cohort default rate issues will come in the form of slower enrollment growth and increased costs related to retention programs and default management or worse yet, loss of access to Title IV if the companies choose not to change their approach.

APOL’s University Orientation Program Rapidly Becoming Industry Standard

As we discussed in our report on our spring term survey of privately held institutions, an increasing number of schools are contemplating following APOL’s lead with its University orientation program. We know that Kaplan University has already adopted a similar program. When the two single largest providers in the industry adopt an initiative, it’s not unreasonable to think that most institutions will eventually follow.  The implementation of a “University Orientation”-like program at a particular institution would have the following impact in our view:

• Lower new student start growth for at least one year
• Lower enrollment growth for 12-18 months
• Eventually higher retention rates
• Higher student matriculation rates over the long term
• Lower cohort default rates

While APOL management has pointed to the longer term benefits on the company’s retention and matriculation rates, we think the impact the University Orientation program could have on default rates was the primary reason the program has been implemented on a wholesale basis. We think it is possible that APOL’s FY09 2-year cohort default rate could approach the mid to high teens.  Clearly management recognized that things were getting out of control after more than five years of moving “downstream” to achieve growth.  The University Orientation program should structurally lower APOL’s cohort default rates, it just might take some time.

Adopting a “University Orientation”-like program for an institution is not a simple decision. It requires significant upfront costs and will lead to slower student start growth in the short term. The long term benefits appear clear…. in theory. Realistically only time will tell how much the University Orientation program improves retention rates and lowers default rate risk for APOL.  That hasn’t stopped a significant percentage of the schools we surveyed from adopting similar programs.  30% of respondents have adopted or plan to adopt a similar program to University Orientation.  We think it will only be a matter of time before it becomes standard. We view this as a positive development, even if it results in lower enrollment growth for several years.

Not a Surprise – Negative Publicity Surrounding the Sector Has Hurt Lead Flow and Conversion Rates

There has been no shortage of publicity surrounding the for-profit education sector over the past 2-3 months.  It seems every week another member of Congress attempts to pile-on the “sabre rattling” band wagon.  The media loves controversy and stories about wrongdoings to the under-privileged, this sector has plenty of both.  One of these things we were interested in hearing about is how the negative publicity has impacted lead flow and conversion rates. It should come as no surprise that the majority of schools have witnessed some impact on student start trends.  According to our survey, 61% of schools have witnessed some detrimental impact on their lead flow or conversion rates. In some respects, the ability of the sector to continue to flourish (relatively speaking) in the face of this negative publicity is an incredible testament to the acute shortage of higher education supply in the US.

Other Key Observations from Our Survey

Our survey includes over thirty questions, so rather than delving into each one in depth, we wanted to provide you with a few more key observations. As a reminder you can download the full survey results on the “Surveys” tab on our website.

• Demand for allied health programs remains the strongest. More than 90% of respondents indicated that allied health programs were witnessing enrollment growth above the average for their institution.  We can only conclude that students are increasingly looking for programs that position them to pursue jobs in relatively acyclical fields.
• Demand for business programs remains relatively weak.  56% of respondents indicated that business programs were witnessing weaker enrollment trends than average.
• 80% of respondents expect lead costs to increase in the mid-to-high single digits for the rest of 2010
• About one-third of the institutions we surveyed plan to increase base salaries for enrollment counselors once the safe harbors for incentive comp are removed.  25% of the institutions we surveyed also expect enrollment counselor turnover to increase as a result of the changes.
• Respondents expect to generate low to mid single digit start growth for the fall term, despite the slowdown in lead flow and starts in the summer term.
• For the remainder of 2010, the majority of respondents expect to generate enrollment growth of 0-10%.  In our spring survey, more than 50% of institutions expected total enrollment growth to increase in excess of 10% for the remainder of 2010.  Expectations have been dialed down.

Deceleration Signs Are Mounting As Are Potential Cost Pressures

Our survey of privately held for-profit postsecondary education institutions provides further credence to our view that enrollment, revenue, and earnings growth could be poised to decelerate quickly.  To be clear, enrollment trends have not fallen off a cliff, but we think it is possible that many of the more cyclically levered schools, such as those owned by COCO and WPO, could witness a decline in student start growth as early as the fall term.  We’re not sure what’s priced into these stocks from a fundamental perspective.  Clearly the sell-side has it all wrong. In our view, we think it is possible that we could see “mean reversion” in enrollment growth and operating margins over the next two years. The number of FAFSA applications to for-profit institutions has increased more than 50% since 2007, some publicly traded companies have witnessed growth higher than that.  As the higher education bubble starts to deflate in the face of more stable employment trends we encourage investors to asses these stocks off of 2007 earnings and then decide if they’re attractively valued given the regulatory risks.

As always, please act accordingly…