This report was originally published on 7/23/09.

ESI reported 2Q09 results this morning. You can get all of the details here. Overall the company reported bigger upside to consensus estimates than we expected ($317.1MM and $1.87 actual vs. $306.1MM and $1.73). As we stated yesterday, we thought the company would beat estimates, but the upside was stronger than we expected. YOY new student start growth of 33.5% was better than our expectation of 20% and what we think was consensus expectations of 20-25% growth. Persistence increased 140 bps YOY, which reversed a trend over the past year when student persistence had been flat or down on a YOY basis. ESI also raised its EPS guidance for 2009 from $7.00-$7.25 to $7.55-$7.85.

Everything on the surface sounds great, so why is the stock trading down 6% this morning? It’s pretty simple, bad-debt. Bad-debt as a percentage of revenue increased from 4.9% in 1Q09 to 5.9% in 2Q09. A year ago bad-debt expense was 3.9%. Historically, higher student persistence has lead to a decline in bad-debt expense for the publicly traded for-profit postsecondary education providers. Companies typically reserve at much higher levels for students that dropout or withdraw, so if more students are staying in school bad-debt expense levels should have a natural downward bias. However, in the case of ESI the difference between the tuition the company charges and government student loan limits has grown so large that bad-debt expense is more a function of whether or not the company can find third party financing for its students. Otherwise, the company is forced to use its own balance sheet to finance the cost of tuition. ESI reserves at very high rates on any tuition that is funded from the company’s balance sheet, so any increase in enrollments that is not offset by an increase in third party lending sources will lead to naturally higher bad-debt expense.

For the second half, ESI is guiding for bad-debt expense as a percentage of revenue to range from 5.5-7.5% and DSO’s to increase to 25-35 days. ESI has a significant conundrum. The likelihood of finding other third party lenders to finance loans for its students is low given the ongoing difficulties in the credit markets. We would argue that the likelihood will decrease substantially within the next 6-9 months once cohort default data for FY08 is released (expected early Feb. 2010). ESI did add a consortium of credit unions to its list of private lenders earlier in the year, but it is important to note that loans originated under this program have recourse to ESI if defaults exceed certain thresholds.

Overall, even though ESI delivered more enrollment, revenue and earnings upside than we expected, the company’s 2Q09 results and 2H09 outlook confirmed our thesis on the company. Tuition prices are simply to high. The company will have great difficulty finding third party lenders to bridge the gap between the cost of its programs and government student loan limits. This will lead to greater bad-debt expense, greater working capital use, lower free cash flow generation and lower returns on capital for ESI.

Questions We Would Like Answered On ESI’s 2Q09 Conf. Call

• How large is the company’s lending arrangement with Student CU Connect CUSO ( the third party lender the company partnered with in the first quarter of 2009)?
• What are the default level thresholds for recourse in the company’s arrangement with Student CU Connect CUSO? What are they for the company’s prior risk sharing arrangement with Sallie Mae?
• Are there any active ongoing discussions with other potential third party lenders?
• If the company is unable to find other third party lenders, what does the company’s free cash flow generation profile look like on a going forward basis?
• How sustainable is the current level of marketing spend? Marketing expenditures increased 1% YOY, which helped the company keep reduce SS&A expenses excluding bad-debt by 350 bps.
• What are the company’s growth plans for Daniel Webster College?
• Was the upside to new student starts in 2Q09 driven more by increased lead flow or increased conversion rates?
• Are there any updates to the current qui tam surrounding alleged violations of incentive compensation provisions?

The call starts at 11AM. You can listen in here.

As always, please act accordingly….