ESI reported 2Q10 earnings results this morning. Overall we think the precipitous slow down in new student start growth for the summer term should start to raise significant questions about the ability of ESI and other for-profit postsecondary education providers to deliver enrollment growth going forward given signs of stabilization in the labor market.  As we discussed in our report “A View from Privately Held For-Profit Postsecondary Institutions” and our ESI quarterly preview, there are growing signs that enrollment growth could slow precipitously over the back half of 2010 and into 2011. We think a round of negative earnings revisions could follow in the coming months and quarters.

Here are some of the quick highlights from the quarter:

• Revenues and EPS of $401.8MM and $2.78 fell short of our estimates of $412.7 million and $2.83. Consensus heading into the quarter called for revenues of $403.9 million and EPS of $2.68.
• Gross margin improved 390 bps YOY to an eye-opening 69.0%.  Cost of educational services spend per student declined 6.8% YOY to $1,618 and 3.7% from first quarter levels.  As we discussed in our preview, we think this could become a hot-button issue in coming weeks and months as Congress more closely evaluates the space.
• Bad-debt expense declined 20 bps sequentially to 5.7% and was down 20 bps YOY as well.  DSO’s actually increased sequentially from 21 days in 1Q10 to 22.3 days in 2Q10. We think this could come as a surprise to some people as many investors expected utilization of the PEAKS loan program would reduce the company’s accounts receivable exposure relatively quickly.
• SS&A excluding bad-debt expense increased 25.0% YOY to $88.0 million. SS&A expense excluding bad-debt expense increased at the fastest rate of growth in the last decade on a YOY basis.  Lead costs have started to increase and the company will likely be required to invest more in job placement professionals, retention programs, and other areas of regulatory compliance in coming years. We anticipate SS&A expense excluding bad-debt expense could revert to historical norms of 25-27% as a percentage of revenues in the next 2-3 years, which would be at least a $1.25-$1.75 drag on the company’s EPS.
• ESI repurchased 1.0MM shares during the quarter, which helped to reduce the share count from 35.5 million in 1Q10 to 34.5 million in 2Q10.  We estimate the share count reduction added $0.08 to ESI’s EPS for the quarter.  Without the benefit of share buybacks the company would have topped consensus EPS expectations by a more meager $0.02.

The table below compares ESI’s 2Q10 results relative to our estimates and consensus:

Considerations for the Conference Call:

In light of the relatively lackluster earnings beat, the sharp deceleration in student start growth for the summer term, and the unrelenting regulatory concerns surrounding the sector, we think this earnings conference call could take on a different tone than prior ESI hosted events. At least we can hope that some more relevant questions are posed on the conference call.  The company has yet to release its 10Q, which we are hopeful will include more disclosure on PEAKS.  We’re not holding our breathe.

ere 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.
• Have operating margins peaked? In light of the rapid growth in SS&A spending and what we perceive to be maximum capacity utilization at many of their schools. As we pointed out in our preview, mean reversion in operating margins combined with an enrollment growth slow down would put EPS in the $6.50-$7.00 range without any impact from proposed regulatory measures.

There are two primary elements of our short thesis on ESI, regulatory and fundamental.  We think ESI’s 2Q10 earnings results and summer term enrollment intake added further credence to our fundamental short thesis on the company.  We anticipate ESI could witness a decline in new student starts as early as the Winter term of 2011, which should result in a sharp reduction in operating margins.  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….