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Delays in Port Wentworth Ramp-up, Concerns About Raw Sugar Costs Don’t Change the Asset Value for IPSU

February 5, 2010 – 3:43 pm
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IPSUshares are off 10%+ today following release of the company’s 1Q10 earnings results. Overall, revenues fell short of our expectations, but EPS of $14.84 (including gains from the insurance settlement and raw sugar hedges) were inline with our expectations.  We attribute the weakness in IPSU shares to two primary factors:

  1. Disappointment over the pace of expansion of capacity utilization at IPSU’s Port Wentworth refinery.  According to management, the Port Wentworth refinery operated at 60% during its fiscal first quarter.  In late October/early November, the refinery was operating at close to 50%, which implies that IPSU exited the quarter at close to 70-75% utilization.  Management indicated that utilization has increased from December to January, although there has been a “2-steps forward, one-step back” dynamic to the rate of improvement.  Heading into the quarter, we thought the  company would be close to 100% utilization by the end of January.  Clearly we were wrong.  It seems more likely that the company will finally achieve 100% utilization by the end of its second fiscal quarter, which means 2Q10 earnings will fall short of our prior expectations.
  2. Management expressed “concern” about the impact higher raw sugar costs could have on the company’s gross margins.  As we discussed in our preview, U.S. raw sugar prices have sky-rocketed in the past month and now trade between $39-$40/cwt.  Historically high raw sugar costs have been favorable for IPSU.  The company has typically been able to pass along higher input costs to its clients and as a result IPSU generates more “gross margin dollars” in a high raw sugar cost environment even if margins are unchanged.  In the most recent quarter, IPSU reported a refined/raw sugar spread of $11.00+, which normally would enable the company to achieve 10% gross margins.  Our checks with sugar brokers indicate that spot refined sugar prices have incresed at a comparable rate to that of raw sugar prices, so we don’t necessarily see why management went out of its way to cap expectations.  It appears management is concerned that vertically integrated sugar beet producers will not raise prices in response to higher raw sugar costs.  Additionally, there is a risk that IPSU’s margins on its industrial contracts could get squeezed if the company has not effectively hedged its raw sugar costs.  For now, we anticipate the company will be able to sustain a raw/refined sugar spread of $10-$12 over the course of FY10 based on our checks with sugar brokers and expectations for industrial contract pricing going forward.

Our Revised FY10 Earnings Expectations – Accounting for a Slower Ramp-up At Port Wentworth

We have revised our FY10 earnings expectations to reflect the following factors: 1) a slower ramp-up in capacity utilization at the Port Wentworth refinery, 2) Slightly higher industrial contract pricing in 2Q10 and 3Q10, and 3) Higher pricing on production sold to consumer and foodservices clients which are typically completed at spot rates.  For the second quarter we now forecast revenues of $209.0 million and EPS of $0.11.  We expect production to increase 11% sequential to approximately 5.2 million cwt.  We do not expect the company to get back to its annual run-rate of 24-27 million cwt until 3Q10.  In the table below we outline our key assumptions for 2Q10:

Source: PAA Research

Source: PAA Research

Can IPSU Still Achieve $3.00+ in CY10 EPS?

 The short answer is of course, no.  With the company company generating modest profitability in the first calendar quarter of the year it would take a number of exogenous factors for the company to achieve our prior expectations of $3.00+ in EPS in CY10.  However, we think the company could enter its third fiscal quarter on track to generate $2.50+ in annualized EPS.  More importantly, we think the company should be able to sustain structurally higher earnings over the next several years based on the following:

  1. Increased operating efficiency at Port Wentworth.  IPSU management has been somewhat coy about the financial impact of the new Port Wentworth facility. We have not been to the facility in person, but from everything else we have seen it is a tremendous leap forward for the company in terms of operating efficiency.  We anticipate the new Port Wentworth facility could enable IPSU to increase its gross margins by 1-2% on a structural basis.
  2. Strong growth at Wholesome Sweeteners.  IPSU management indicated that it will start to disclose more financial detail on Wholesome Sweeteners in its 10-Q filing for 1Q10.  Anecdotally, we know that Wholesome Sweeteners is generating double-digit revenue growth and has margins that are 3x IPSU’s company average.  We expect IPSU to purchase the remaining 50% ownership stake in Wholesome Sweeteners that it doesn’t currently own in the fourth quarter of 2010, which should increase the company’s normalized earnings profile  considerably.
  3. Secular growth in demand for refined sugar.  In the battle between high fructose corn syrup (HFCS) and refined sugar, it is increasingly clear that consumers are increasingly interested in purchasing products made without HFCS.  Gatorade, Pepsi, Dr. Pepper, and Ocean Spray have all launched refined sugar based products in the past 6-9 months. We expect the trend towards substituting refined sugar for HFCS to continue to gain momentum, which should lead to stronger revenue and earnings growth prospects for IPSU in the future.

Asset Value of IPSU Remains Unchanged Irrespective of Spot Price of Raw Sugar and the Pace of  Port Wentworth Capacity Expansion

We find IPSU shares compelling both from an earnings and asset value perspective.  As of 12/31/09, IPSU had a book value per share of $22 and that number will start to increase over the coming quarters as IPSU reports positive earnings.  At 1.0x tangible book value, IPSU shares would trade 50% higher than today’s current price.  From a sum of the parts perspective, we would argue IPSU shares are even more compelling.  We know that the company’s Port Wentworth facility is worth approximately $230 million, or $19/share alone.  We would argue that the Grammery refinery is worth approximately $100 million and the company’s ownership stakes in Santos and Wholesome Sweeteners an additional $50 million.  Even if we assume that IPSU incurs $50 million in contingent non-insured liablities related to the Port Wentworth refinery accident, we arrive at an asset value north of $27/share, 85% above current levels.

Source: PAA Research

Source: PAA Research

There has been a global surge in interest in sugar assets over the past 3-6 months due to the prospects for rising demand and tight supplies for the foreseeable future.  IPSU is well positioned to benefit from the increased use of refined sugar in beverages and other products over the coming years.  We find it highly unlikely that the stock will trade at 0.6x tangible book value and 55% of real asset value when the company’s earnings prospects are rapidly improving and global interest in sugar assets is surging.

As always, please act accordingly…

By PAA Research | Posted in Sugar | Tagged , , , | Comments (0)

IPSU’s 1Q10 Results Should Illuminate Asset Value, $3.00+ Annual Earnings Power is Still on the Come

February 4, 2010 – 2:44 pm
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IPSUwill report 1Q10 results tomorrow before the market opens.  We estimate the company could report EPS in excess of $15.00 based on the company’s settlement of its property insurance claims for the Port Wentworth refinery accident.  Additionally, we estimate the company will recognize an additional $2-$4 million in gains from its raw sugar hedges, which will be accounted for on a mark-to-market basis throughout FY10.  As of 9/30/09, the company’s FY10 raw sugar hedges were marked to $29.45.  The #16 raw sugar contract on ICE closed the year slightly above $30.  Recognition of insurance settlement gains for accounting purposes should go a long way towards illuminating the inherent value in IPSU shares.

As we have discussed in the past, we think IPSU shares are remarkably compelling at current levels based exclusively on the company’s book value after giving effect to the settlement and the implicit asset value of its refineries, joint venture arrangements, and net cash position.  Pro forma for the insurance settlement, we estimate that IPSU’s book value will be close to $22.00-$22.50/share.  The book value does not reflect any contingent liability associated with outstanding civil litigation against IPSU related to the Port Wentworth refinery accident.  We continue to expect any rulings against the company in these cases to be covered by IPSU’s worker’s comp and general liability insurance policies. On a sum of the parts basis, we estimate, IPSU could be worth as much as $25-$26/share INCLUDING an incremental $50 million in contingent, non-insured  liabilities associated with the Port Wentworth refinery accident.

Source: PAA Research

Source: PAA Research

From an operating perspective, we expect the company to generate revenues and a loss per share of $214.7 million and ($0.09).  Here are some of our key assumptions for the quarter:

  • The company’s Port Wentworth facility operated at 50% capacity utilization over the course of the quarter
  • The company produced 2,678 (cwt) for industrial clients at a price of $31.88
  • IPSU produced 1,989  (cwt) for consumer clients at a price of $40.26
  • Production of 892 (cwt) for foodservices clients at a price of $38.46
  • Gross margins of 6% (based on the low level of capacity utilization)
  • $1.0 million in other income from Wholesome Sweeteners and Santos

Key Developments During the Quarter and Questions for the Conference Call

Over the course of the quarter, here are a few key developments that could effect IPSU’s earnings prospects over the next 12-18 months (excluding ramp-up of production at the Port Wentworth facility):

  • Expansion of refined sugar use in soda’s and other beverages. Pepsi and Mountain Dew throwback received a great deal of marketing support over the course of the quarter.  Dr. Pepper, Gatorade, Snapple, and Ocean Spray are other major beverage producers that have already rolled out or plan to introduce products made with refined sugar instead of high fructose corn syrup (HFCS).  Even with the recent run-up in refined sugar prices it still appears that the shift away from HFCS towards refined sugar continues to gain momentum.  The increase in demand should enable IPSU to sustain or even expand gross margins if raw sugar shortages are addressed.
  • IPSU expands distribution to Walgreen’s.  During the quarter, IPSU began distributing refined sugar to more than 6,500 Walgreen’s locations nationwide.
  • Sugar shortages in Mexico worsen.  In the USDA’s most recent sugar market update, the government forecast that Mexico would export approximately 760 short tons of sugar to the US for the 09/10 fiscal year.  We think this could prove to be optimistic given the likelihood that the Mexico sugar crop will fall short of expectations.  The lack of imports from  Mexico could bring the sugar stocks to use ratio below 10% in the U.S. for the first time in decades.

We have a number of questions we would like answered on the company’s earnings call.  We find it amazing how many moving parts there are in the IPSU story for such a simple business (they purchase raw sugar, refine it, and sell it).  Here’s our list of questions:

  1. Are there any updates on the status of the civil litigation related to the Port Wentworth refinery accident?  We still think settlement is the most likely outcome.
  2. What are the company’s expectations for raw sugar costs for the remainder of FY10 now in light of the recent spike in prices?  According to ICE, raw sugar prices have surged to $39-40, up from $30-$31 at the end of IPSU’s 4Q09.  In the company’s 10-K filing, IPSU indicated that its raw sugar costs for the year would be $27.15 based on its remaining purchase needs for FY10.  Clearly this number has moved higher, how much will depend in part on whether or not the company increased its hedges during the quarter.
  3. What are the benefits to IPSU of sourcing its raw sugar needs for the Port Wentworth facility from the world market?  Almost all of the company’s raw sugar needs for its Port Wentworth facility are sourced under the TRQ program.  The spread between US and world raw sugar prices had widened out to $10+/cwt. Does the company’s reliance on raw sugar from world markets give it some cost advantage in this pricing environment.
  4. Now that the Port Wentworth facility is operating at full capacity, will the company have structurally higher gross margins?  We have watched videos of some of the new operations at the Port Wentworth facility.  The efficiency gains are tremendous.  Management has not yet indicated how this new facility will impact the company’s profitability on a structural basis.
  5. How will the company handle both its sugar and natural gas hedges going forward?The #16 sugar contract is in backwardation, prices for FY11 contracts are closer to $29-$30, opposed to $39-$40 for the front month. How will IPSU handle its hedging programs for sugar in light of the recent run-up in raw sugar prices.  For natural gas, prices remain relatively depressed (in a historical context) will the company be more aggressive in extending its hedges in the current environment?
  6. How does the  company plan to use its free cash flow going forward now that the large part of CAPEX related to the Port Wentworth rebuild has been completed?  IPSU should generate $30-$40 million of free cash flow over the next 12-months.  Historically, the company has issued special dividends. We think it is more likely that the  company will use free cash flow to pursue strategic acquisitions this time around.  IPSU will likely buy in the remaining 50% ownership stake in Wholesome Sweeteners in the fourth quarter of 2010.  IPSU is evolving towards a less capital intensive business and one that is likely to include more strategic joint ventures and product expansions.
  7. What percentage of IPSU’s industrial contracts are booked for FY10 and how many contracts have been booked for FY11?  Price realization for IPSU’s industrial customers typically lags the move in spot sugar prices. This can leave the company exposed to sharp increases in input costs if IPSU has not acquired and/or hedged its raw sugar needs for those customers.  Conversely, a decline in raw sugar costs following a significant run-up can be advantageous to IPSU if the company has booked a high percentage of industrial contracts (look at FY07 performance for example). It appears that IPSU had enough inventory and sugar hedges in place to fulfill the needs for its industrial customers for FY10.  We know that industrial customers have been reluctant to lock in contracts over the past 3-6 months, although that has backfired given the continued increase in prices.  We would like to know more about the company’s contract book for FY10 and FY11. 

WE anticipate IPSU’s 1Q10 results should bring investors one-step closer to focusing on the company’s fundamental earnings power and asset value.  It is important to note that settlement of the property and business interruption claims has NO bearing on the outcome of civil litigation against IPSU.  As we have determined above, the base level equity or asset value of IPSU now is $22-$26/share.  This does not include the benefits of what are likely to be strong earnings for the company over the next 12-24 months. We estimate IPSU could increase its book value by as much as 25-30% over the next two years to $27-$29, which implies shares remain grossly undervalued.

As always, please act accordingly…

By PAA Research | Posted in Sugar | Tagged , , , | Comments (0)

BCO Happily Says Goodbye to 2009; 2010 Should Be Back to Basics – Steady Organic Growth and Solid FCF Generation

February 3, 2010 – 3:54 pm
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Normally when a non-financial services company issues an earnings release that is more than 25 pages, it usually is cause for significant concern.  However in the case of BCO, the lengthy 4Q09 press release has been greeted with “open arms” given the number of changes the company has undergone in the past 3-6 months.  Overall, on an “adjusted” basis BCO’s revenues and EPS of $788 million and $0.41 exceeded expectations on the top-line ($760.8 million), but fell short of consensus EPS of $0.49.  BCO reported GAAP EPS of $2.50 which includes: 1) the benefit of a tax benefit of $117.8 million due to the release of a valuation allowance on deferred tax assets, 2) A gain on the company’s existing ownership of its Indian subsidiary of $13.9 million in which BCO acquired a majority stake during 4Q09, and 3) the negative impact of the company’s decision to repatriate cash from its Venezuela subsidiary at the parallel exchange rate (charge of $22.5 million) and to report segment operating results based on the parallel exchange rate.  Interestingly enough, the  company did not exclude $6 million in severance costs during the quarter for its insurance operations and an addtional $3 million in higher legal costs for its North America segment in its adjusted EPS calculation.  If we add back those “one-time” costs, adjusted EPS would have been $0.52 for the quarter  compared to consensus of $0.49.

BCO Happily Says Goodbye to 2009

2009 was a particularly difficult year for BCO on many fronts.  Just to review, here are the issues the company faced in the past 12-months:

  • A deeply underfunded pension following the 2008 market collapse, which caused the company to contribute $150 million to its U.S. pension plans during 3Q09.
  • Political unstability in Venezuela which led management to the decision to repatriate cash from its Venezuelan subsidiary at 5.92 bolivar/dollar compared to what used to be the stated exchange rate of 2.15 bolivar/dollar.
  • An incredibly weak demand environment for diamonds and other precious jewelry, which severely hampered financial results for the company’s higher margin value added services
  • Competitve pressures in Europe, the company’s single largest operating segment, which hurt organic growth and operating margins over the course of the year

In light of the above, it shouldn’t come as a total surprise that the stock underperformed the market and its peers, declining 10.1% for all of 2009.  As challenging as 2009 was for the company, BCO did generate roughly 1% organic growth, a reasonably impressive accomplishment in this economic environment, in our opinion.  More importantly, we think the company exited the year with a number of tailwinds that should lead to improved financial performance over the coming years, including:

  • No expected cash contributions to its U.S. pension plans in 2010 and 2011.  BCO will not be required to make a cash contribution to its U.S. pension plans until 2012 at the earliest, depending on the performance of fund assets.  This should enable the company to use more of its free cash flow to pursue strategic acquisitions.
  • Product momentum for CompuSafe, BCO’s proprietary cash management system for retailers continues to grow.  According to BCO,  the installed base of CompuSafe increased from 7,440 at the end of 2008 to 10,300 as of 12/31/09, which represents 38% YOY growth.  CompuSafe generated approximately $60 million in revenues in 2009, accounting for 2% of BCO’s total.  Management expects the installed base of CompuSafe to increase 30-40% in 2010 and has started to roll the program out internationally.  We anticipate CompuSafe could account for 4-5% of BCO’s revenues within three years.  The product increases customer traction for BCO and generates higher margins.
  • Strategic acquisitions in Brazil, Russia, India, and China should enable BCO to deliver historical growth rates over the next 3-5 years.  BCO continues to expand its global platform and has established market leadership in many countries in Latin America. In the past 12-18 months, BCO has taken steps to expand its platform in Asia through acquisition.  Demand for cash-in-transit and cash logistics services are in their nascent phase in countries such as China, India, and Russia.  We think BCO will continue to identify acquisition opportunities in those countries.  Asia only represented 3% of the company’s revenues in 2009, but should expand rapidly through a combination of organic growth and additional acquisitions.  Historically, BCO has delivered mid-to-high single digit organic revenue growth due to a general increase in cash in circulation and rising demand for cash logistics services. We expect the company to generate historical growth rates on a sustained basis as its exposure to emerging markets increases and CompuSafe gains further traction.

In 2010 BCO Should Get Back to Basics – Steady Organic Growth and Solid FCF Generation

Although it would be premature to characterize BCO’s largest end-markets as favorable, there are increasing signs that economic recovery in North America and Europe could lead to stronger cash-in-transit volumes for BCO, and perhaps more importantly greater demand for the company’s higher margin value-added services such as secure diamond and jewelry transport.  We think 2010 will be a year in which the “noise” surrounding BCO’s results diminishes and the company gets back to basics by delivering steady organic growth and strong free cash flow generation.  Management has provided initial 2010 guidance for low-to-mid single digit organic revenue growth and segment operating margins of 7.0-7.5%.  In the table below we detail management’s initial guidance range across a variety of assumptions and outline its implications for estimates relative to consensus:

Source: Company Reports, PAA Research

Source: Company Reports, PAA Research

We would characterize management’s initial revenue guidance as relatively conservative given that it does not appear to factor in any improvement in the velocity of jewelry transactions.  Overall, management’s guidance is above consensus revenue expectations, and falls slightly short of current consensus of EPS.  However, it is important to note that minority interest is a huge swing factor in the company’s EPS.  We have assumed that minority interest will increase approximately $6 million on the year based on the company’s increased ownership of its Indian subsidiary  (now consolidated) and better performance from divisions in which the company does not have complete ownership.

When we initially introduced BCO as a investment idea approximately 6-7 months ago, there were four factors that made the stock attractive in our view:

  1. Cash is a growth business. Global cash in circulation, continued retail banking branch expansion globally, proliferation of ATM’s and the CompuSafe product cycle should all drive mid-to-high single digit organic revenue growth for BCO.
  2. BCO should generate significant free cash flow even after pension contributions. The company’s financial flexibility is unmatched in its peer group.
  3. Brinks will benefit substantially from dollar weakness.
  4. BCO’s valuation is cheap.

It appears that BCO is on track to deliver strong organic growth and robust free cash flow generation in 2010, which should illuminate the value of the stock to investors.  As the table below demonstrates, BCO shares remain remarkably cheap for a company that has strong secular growth characteristics, robust free cash flow, and high returns on capital.

Source: PAA Research, Yahoo Finance

Source: PAA Research, Yahoo Finance

2009 was certainly a bumpy, if not frustrating ride for BCO shareholders.  However, the worst is now behind the company and it appears BCO is on the cusp of returning to its historical organic revenue growth and free cash flow generation profile.  We think the stock can trade to the low to mid 30’s which would represent a 16-18x multiple on our FY11 EPS estimate of $1.98 as noise surrounding the company subsides.

As always, please act accordingly….

By PAA Research | Posted in Business Services | Tagged , | Comments (0)

Quick Comments on COCO’s 2Q10 Results: Higher Retention Sparks Revenue Upside, Starts Fall Short, EPS Beat Driven by Facility Leverage, Lower Cost-per-Start – When Are We Going to Get Real Bad-Debt Expense Disclosure?

February 2, 2010 – 10:35 am
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COCO reported 1Q10 results this morning.  You can read the full press release here. Overall the company delivered upside to consensus on both the top and bottom-line, which should not come as a surprise given the strong results delivered by ESI and DV already this earnings season.  Revenues and EPS of $414.3 million and $0.44 beat consensus of $404.5 million and $0.40.  Although the company did deliver solid total enrollment growth of 22.3% YOY, we would characterize the student start growth as a disappointment in light of the robust starts witnessed at DV and ESI for the winter term and the recent results of our survey of privately held for-profit postsecondary education institutions.  The results of our survey suggested that COCO could have delivered as much as 20%+ YOY student start growth for its 2Q10.  The company’s new student start growth of 10.7% YOY was inline with management guidance of 10-12%, but fell short of our expectation of 15%.  It now appears that COCO is poised to come in at the low end of its guidance range for student starts for FY10 of 11-13% YOY growth.  Here are a few other key observations from the quarter:

  • G&A expense increased from 10.2% of revenue in 1Q10 to 11.4% of revenues in 2Q10. On a nominal basis, G&A spending increased 46.6% YOY and 20.0% Q/Q.  The company attributed the sharp increase in G&A spending to the timing of “variable compensation accruals for management”.  We wonder if some of the sharp increase relates to a large increase in spending on default management services as the company tries to lower its cohort default rates in order to maintain compliance under a 3-year calculation  regime.
  • Marketing expense continued to be a source of operating leverage for COCO. We estimate cost-per-start declined 1.4% YOY.  This is the fifth consecutive quarter in which COCO has generated a YOY decline in cost-per-start.  The advertising environment has started to normalize and we anticipate lead cost inflation could become an operating margin headwind for the company over the coming quarters.

More Bad-Debt Expense Slight of Hand

We find it remarkable that COCO continues to tout its bad-debt expense improvement.  In its earnings release the company stated that bad-debt expense had improved to 5.8% as a percentage of revenue in 2Q10, down from 6.4% in 1Q10 and 8.7% a year ago. Management also indicated that bad-debt expense was lower than the company’ guidance of 6.7%-7.1%. 

As we have stated in the past, we view the company’s bad-debt expense improvement as accounting “slight of hand”.   The manner in which COCO calculates bad-debt expense currently borders on complete irrelevance because it does not capture the reserves the company has built for its internal lending program.  In short, the company has transferred reserves on traditional accounts receivable, which it discloses quarterly to reserves on notes receivable, which it does not disclose quarterly.  Sounds like a little bit of “robbing peter to pay paul” doesn’t it? You can read more about our views on this issue here.

Just to illuminate our point, let’s take a look at what the combination of bad-debt expense on accounts receivable and reserves on notes receivable might have looked like for 1Q10 (it’s almost hard to believe, but COCO does not disclose reserve data quarterly even though the gross amount of notes receivable now approach the gross level of accounts receivable).  In 1Q10, COCO reported bad-debt expense of 6.4% as a percentage of revenue ($24.9 million), an allowance of $24 million, charge-offs of $26 million, and net accounts receivable of $61.4 million.  The company also disclosed that it had total net notes receivable of $47.0 million (both long and short-term) and an allowance against those notes receivable of $30.6 million.  The allowance against notes receivable increased $17.4 million YOY.  If we assume that the company’s provisions were equal to charge-offs, this would imply the company recognized $17.4 million in incremental expenses in 1Q10 for its notes receivable program.

If we add our estimates for the provisions on notes receivable to the company’s traditional bad-debt expense we arrive at what we call “real bad-debt expense”.  In this case the numbers are $24.9 million (bad-debt expense) + $17.4 million (estimate of notes receivable  provisions) = $42.3 million, or 10.7% as a percentage of 1Q10 revenues.  The good news for the company is that for FY09, the company’s “real-bad-debt expense” was 12.0% using a similar methodology.  It does appear that the company has made some progress in improving credit quality, although it is significantly less than COCO’s arguably useless disclosures on bad-debt expense would have you believe.  The company does not provide sufficient disclosure in its press releases for us to arrive at the “real bad-debt expense” for 2Q10.  COCO doesn’t even disclose its notes receivable balances.  We encourage the company to expand its disclosure so that investors can gain a more accurate view of the company’s true balance sheet risks.

Questions for the Conference Call:

COCO management will host a conference call today at 12PM EST.  Here are a few questions we would like answered:

  • What were the gross and net notes receivable balances as of 12/31/09.  What were the provisions for notes receivable in 2Q10?
  • Does the company expect to forge any new private lending relationships for its students in the coming quarters?
  • How will the company’s internal financing program be affected by the Heald acquisition?
  • The company’s start growth in 2Q10 was below peers and most analyst expectations.  Guidance for starts appears relatively conservative.  Has the company cut-back on marketing to ability to benefit students or other students that might have higher credit risk? (i.e. has COCO started to self-regulate as some schools in the sector have done)
  • What are the company’s expectations for lead costs going forward and how will this impact margins?
  • What steps is the company taking to ensure that its schools will remain in regulatory compliance under a 3-year cohort default rate calculation?
  • How will the company’s long-term financial objectives be impacted by the adoption of the NegReg proposals?

We continue to see significant downside to COCO shares.  It is increasingly likely that the company will face fundamental headwinds from higher lead costs, lower lead conversion rates, and lower facility cost leverage.  Additionally, we think COCO will have the greatest difficulty among publicly traded for-profit postsecondary education providers in maintaining regulatory compliance under 3-year cohort default rate standards.  As a result, we expect COCO to witness lower, if not an outright decline in enrollment growth in the coming years as it attempts to navigate the new regulatory landscape.  Investors should not confuse reasonably strong earnings today as a sign that the company’s long-term earnings prospects have changed.

As always, please act accordingly….

By PAA Research | Posted in For-profit Education | Tagged , , , | Comments (0)

PAA Research SMid Cap Portfolio Update

February 1, 2010 – 12:52 am
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We wanted to provide you with an update on the performance of our SMid Cap portfolio, which we introduced on 9/3/09. As a reminder this is a “mock” portfolio with an initial value of $100 million. We plan to manage the portfolio like a long/short equity hedge fund.

Performance Update

The PAA Research SMid Cap Portfolio is off to a solid start for 2010. A combination of a reasonably conservative configuration of the portfolio (30-40% net long through January), strong relative performance of our long ideas, and solid contribution from our short names have led to outperformance to start the year.  Here are some of the performance highlights:

  • On a year-to-date basis, the PAA Research SMid Cap Portfolio has returned 2.5% compared to a (-3.3%) and (-3.7%) decline for the S&P 400 and Russell 2000, respectively.  The table below outlines the performance of the PAA Research SMid Cap Portfolio on a year-to-date basis compared to its most relevant benchmarks: the S&P 400 and the Russell  2000.
Source: PAA Research

Source: PAA Research

  • The portfolio has generated a 9.3% return since inception, compared to a 10.4% return and 8.3% gain for the S&P 400 and Russell 2000, respectively.
  • Inception to date, long ideas have contributed 9.7% to performance, while shorts have detracted 40 bps.
  • There were no meaningful contributors to performance over the past two weeks from our long positions, although we were pleased that many of our names delivered strong relative performance and enabled returns from our short positions to preserve year-to-date gains.
  • Our top contributors to performance from our short positions over the past two-weeks were: NILE (down 10.5%), DM (down 17.0%), SCOR (down 14.5%), and SFN (down 16.5%).

Changes to the PAA Research SMid Cap Portfolio

We are making some changes to the PAA Research SMid Cap Portfolio. We have taken profits on a few short positions and added selectively to a few long positions.  The net effect of these changes is to increase our net exposure from 38.5% as of 1/19/10 to 45.8%.  Our gross exposure of $164 million, or 148.8% is a reduction from $174 million two-weeks ago.  As a reminder, we do not manage the portfolio to a specific net position, rather the portfolio weightings and net exposure are determined by our stock specific analysis. Here are the changes we are making to the portfolio for this week:

Long Positions:

Our largest long holdings after giving effect to these changes are as follows: IPSU (8.6%), BCO (7.8%), THQI (7.9%), GLG (6.4%), and GCA (6.3%).

Increased Positions: GLG, AYI, ERII, POOL, RICK, and BGG

We continue to add to GLG as it trades off despite what continues to be an increasingly compelling earnings story for 2011.  The company recently started marketing a few new funds, has received awards in Europe for some of its alternative funds, and has earned key buy recommendations from a few critical pension consultants in the US where GLG Partners has yet to achieve strong penetration (less than 5% of AUM).  The combination of enhanced marketing efforts and greater receptivity should lead to strong funds flow over the next 12-18 months for GLG.  Additionally, we estimate that more than 50% of the company’s alternative funds are now above their high water marks and another 10-20% could start to earn performance fees in 2010.  GLG shares remain overlooked relative to other alternative asset managers and we think could see significant upside as funds begin to flow and investors start to discount the earnings power of an alternative asset manager with 70% of its funds above their high water mark.

In our report Shedding Some “Light” On a New Pair Trade Idea: Long AYI/Short HUBB, we outlined our excitement about the appreciation potential for AYI shares. In general the company has delivered strong earnings result over the past several quarters given the downturn in non-residential construction spending.  Additionally, the company’s recent bond offering has left AYI well capitalized to pursue “tuck-in” acquisitions that could enhance the diversity and breadth of LED and lighting controls product offerings.  The company’s recent partnership announcement with Samsung to pursue LED products is yet another example of AYI’s efforts to expand its presence in the rapidly growing LED market.  AYI is now a 5.2% position.

We have modestly added to our positions (25-50 bps) in ERII, POOL, RICK and BGG.  The market downturn has not changed our thesis on these names.

Closed Out Positions: PCX

As consistent followers of the PAA Research SMid Cap portfolio know, we have been taking profits in PCX throughout its rapid rise. It has been one of the biggest contributors to performance since inception. However, we always had our doubts about the sustainability and longevity of a recovery in natural gas and coal prices in the US given ample supply and a relatively tepid recovery in demand.  We are closing out of our position in PCX entirely until we identify a more compelling entry point.

New Positions: AKS and LOOP

We are starting AKS and LOOP as 2.0% and 1.5% positions in the portfolio, respectively.  Materials stocks have performed the worse during the downturn in the market in the past two weeks.  We attribute the rapid selloff to concerns about global economic growth characterized in part by rising CDS spreads for sovereign debt and increased doubts about the sustainability of commodity demand in China given recent policy actions.  We think some stocks have already started to reflect a demand response beyond what policy actions from Chinese authorities imply.  We will continue to look for other materials names like AKS that are reasonably well capitalized and have overreacted to economic headlines.

In the case of LOOP, the company is the leading transaction marketplace in the commercial real estate sector.  We are by no means bullish on the prospects for price appreciation in commercial real estate over the next 12-18 months. It is our sense that bid/ask spreads are poised to narrow and we should start to see a pickup in transaction activity.  As a result, we think LOOP could witness stabilization in its subscriber base, if not an outright increase.  The company has no debt and more than 30% of its market cap in cash. We think this positions the company well to take advantage of opportunities during the downturn. We also think LOOP could be an interesting acquisition target for any number of service providers in the commercial real estate space.

Short Positions:

Our largest short positions after giving effect to these changes are: NILE (3.6%, paired against a long position in SIG), HNI Corporation (3.2%, paired against a long position in MLHR), ESI (3.5%), LINC (3.2%) and WLRD (3.1%).

Decreased Positions: COCO, NILE, JCG, SFLY, RRC, SCOR, and AM

Just as we do with our long positions, we generally like to “scale” in and out of our short positions, unless the catalysts we have targeted have been achieved.  In the case of COCO, the company will report earnings this week and the results of our recent survey of privately held for-profit postsecondary education institutions indicates COCO should deliver strong results.  We want to have “dry-powder” to add to our short positions in the event that investors misconstrue positive short term earnings results from COCO as a favorable development for the company’s longer term earnings prospects.  We still think COCO shares will trade to the $8-$10 level as the company struggles with the transition from a 2-year to a 3-year cohort default rate calculation and faces fundamental headwinds from economic stabilization.  We will look to add to our short position at any level above $15.

Increased Positions: WRLD and ZION

Shares of WRLD rallied this past week following what were strong earnings relative to consensus. We still think this payday lender is underreserved and employs some questionable business practices which otherwise mask losses from its core constituency of sub-prime borrowers.  Additionally, we think it is highly likely that the federal government will pass legislation that could effectively impair WRLD’s business model.  Several agencies within the federal government have expressed their concerns about the practices in the non-banking lending industry.  In the case of ZION, the company continues to post losses and could be woefully under-reserved if substantial declines in the commercial real estate market materialize.  ZION and WLRD are both 3.0% short positions.

Closed Out Positions: DM

We are closing our our short position in Dolan Media following a 17.0% gain.  We think the stock now reflects the negative impact mortgage modification programs such as HAMP could have on the company’s core default services business.  We will continue to look at strength in DM shares as an opportunity to initiate a short position. We are concerned about the company’s mix of assets (beyond default processing services) and the nature of its relationships with the law firms that serve as the life blood of its mortgage default processing services.

Please click on this link to view position by position detail of the PAA Research SMid Cap Portfolio.

By PAA Research | Posted in SMID Cap Portfolio, Uncategorized | Tagged | Comments (0)

ARP Raises Guidance for 4Q09 Revenues, EPS – Consensus Estimates Appear Too Low for 2010

January 27, 2010 – 7:23 pm
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After the close today, ARP issued a press release indicating that the company now expects to beat its prior revenue and EPS guidance for 4Q09.  You can read the full release here.  Management did not specifically identify the sources or magnitude of revenue upside.  The company has increased its full year guidance for EPS from $0.27-$0.33 to $0.35-$0.38.  This implies that the company generated EPS of $0.00-$0.02 for the fourth quarter compared to current consensus for a loss-per-share of ($0.06).  This is consistent with our current 4Q09 EPS estimate of $0.01.  Our EPS estimate is based on a revenue forecast of $111.7 million, compared to current consensus of $102.2 million.  We think it is reasonable to assume ARP generated revenues of $110-$115 million for 4Q09. 

Approximately one week ago we issued a report which highlighted the results of our most recent survey of independent reprographers.  In our report, we argued that current street consensus estimates for both 4Q09 and all of 2010 were too low.  Today’s press release from ARP adds further credence to our thesis that revenue trends in the reprographics industry might have found a tentative and tenuous bottom.  As a reminder, we currently forecast revenues and EPS of $479.9 million and $0.37, respectively for 2010, compared to consensus of $441.2 million and $0.10. 

The setup for ARP shares for 2010 appears to be favorable. In our view, estimates are more or less “washed out” and the stock does not yet reflect what appears to be growing signs of stability in ARP’s end-markets.  At 5.7x and 15.7%, ARP shares remain remarkably compelling on an EV/EBITDA and free-cash-flow yield basis.  In our view, we think ARP shares can trade as high as 20-25x FY10 EPS (similar to the current valuations for CBG, JLL, and ADSK) to the extent that a stabilization in the company’s revenues becomes apparent.  At 7.5x our FY10 EBITDA estimate or at a 10% yield on our FY10 free cash flow estimate of $48 million, ARP shares would trade north of $10.

By PAA Research | Posted in Business Services | Tagged , | Comments (0)

PAA Research For-Profit Education Survey Suggests Enrollment Growth for the Winter Term Remained Robust, Some Slowdown Expected in 2010, and Some Schools Have Already Introduced “Self Regulation”

January 26, 2010 – 4:39 pm
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We recently conducted a survey of privately-held for-profit postsecondary education institutions.  Our goal was to gain a better understanding of enrollment trends, identify which programs are resonating most with the education consumer, evaluate lead flow trends, learn more about cost-per-lead expectations in 2010, and to determine how institutions are preparing for the transition from a 2-year to 3-year calculation of the cohort default rates. 

The Profile of the Respondents – Feedback Most Applicable to Schools Owned by COCO, CECO, DV (Apollo College), ESI, LINC, and WPO

Senior executives from approximately 35-40 privately held for-profit institutions responded to our survey.  All of the schools captured in the survey are nationally accredited.  We think the results of the survey are most applicable to schools owned by COCO, CECO, DV (Apollo College), ESI, LINC, and WPO based on the program mix by degree level and industry and the overall size of the schools that responded.  In the table below we outline the average school size  based on total enrollments.  Overall, almost 80% of respondents work at an institution with a total student population of less than 1,000.

Source: PAA Research

Source: PAA Research

Respondents Program Offering Mix Is Heavily Weighted Towards Diploma and Associate’s Degree Programs

The schools we surveyed offer a high percentage of diploma and associate’s degree programs.  81% of respondents offer diploma programs, while more than 65% offer associate’s degree programs.

Source: PAA Research

Source: PAA Research

Most Schools Offer Allied Health, Business, and IT Programs

Among program offerings, allied health was the most common, with more than 75% of respondents indicating their school offered some allied health programs, followed by business and IT.  The mix of programs offered at the schools that responded suggests that the results of the survey would have the most relevance for COCO and WPO, beyond the companies we previously mentioned.  It is interesting to note that very few schools offer programs in a single field of study.  When we first started to follow the space a decade ago, there were many schools that were pure play allied health, business, or IT institutions.  Today, most companies have successfully introduced “cross-pollination” programs whereby a school introduces a new program at an existing institution that is currently being offered at another institution owned by the same company.  Program “cross pollination” has been an effective tool used to drive enrollment growth over the past 7-10 years, it also has substantially increased industry capacity.  Think about it this way: ESI has more than 110 ITT Tech locations nationwide and 7-8 years ago almost none of those instituions offered programs in business or criminal justice. Now almost all of them do.  We think the benefits of program “cross-pollination” have reached their peak at this stage.  Incremental growth opportunities using this strategy will be contingent upon schools identifying new programs that can be easily transplanted, target a similar student demographic, and require a low level of capital investment (is there anything cheaper than introducing a business program?).  For now, we can think of few programs that meet that criteria. 

Source: PAA Research

Source: PAA Research

Enrollment Growth, Starts, and Lead Flow for the Winter Term Remain Strong

Overall the results of our survey were very “bullish” for those focused exclusively on enrollment trends.  Based on the feedback we have received from the schools we surveyed: lead flow remains strong, conversion rates are high, and student persistence continues to increase on a YOY basis. All of these factors contributed to strong enrollment growth at the schools we surveyed for the winter term.  There has been some moderation of new student start growth, but in general  it appears that the enrollment growth momentum that started 9-12 months ago continued for the winter term. 

Winter Term Enrollment Growth Appears to be On-Par With that of the Fall Term

 For the winter term, approximately 40% of the schools we surveyed witnessed enrollment growth in excess of 20%.  For the most part, enrollment growth for the winter term was on-par with that witnessed in the fall term for the schools we surveyed.  The results of our survey corroborate the strong enrollment intake for ESI for the company’s winter term.  For now it does not appear that enrollment growth momentum has stalled in the for-profit postsecondary education sector.

Source: PAA Research

Source: PAA Research

Start Growth For Some Schools Has Moderated, but Otherwise Remains Robust

Although more than 35% of total respondents generated new student start growth in excess of 20%, a slightly surprising 33% witnessed start growth below 5%.   This suggests that enrollment growth could slow in the next several quarters, especially for those schools with a heavier mix of diploma programs. Is this the first sign that the industry is poised to witness significant mean reversion in growth or an outright enrollment decline?  Only time will tell. (Please note in the chart below where labels are missing the reader should assume that each data point is in an increment of 5%, so for example 22% of respondents witnessed start growth of 0-5%).

Source: PAA Research

Source: PAA Research

 

Lead Flow Levels Have Not Declined in the Past 3-Months

Aside from start growth, we attempt to get as many anecdotal data points on lead flow as possible (outside of COCO, no other publicly traded for-profit postsecondary education company discloses leads) to determine if a meaningful shift in enrollment trends is imminent.  Even though it appears that start growth has already started to slow for some schools, it does not appear that lead flow is the primary problem.  The majority of respondents to our survey indicated lead flow was stronger for the winter term than it was for the fall term. 

Source: PAA Research

Source: PAA Research

Increased Student Persistance Has Led to Faster Enrollment Growth for the Majority of Schools

The two primary drivers of enrollment growth are: starts and student persistence.  Historically in stronger job-markets students have dropped out of school to pursue employment opportunities.  Student retention rates have been positively correlated to the unemployment rate.  Given that state of the economy it’s safe to say that very few students are dropping out of school because they secured a new job.   While many of the schools we surveyed have not benefited from positive trends in student persistence, more than 50% have witnessed a YOY increase.  It will be interesting to see if schools can continue to improve on student persistence rates as the unemployment rate flattens out.

Source: PAA Research

Source: PAA Research

Allied Health Programs Are Currently Witnessing the Fastest Enrollment Growth

A surprising 83% of respondents indicated that allied health programs were witnessing faster enrollment growth than the average at their school.  In the past during economic downturns students have typically gravitated towards programs that are not dependent on the economic cycle for job growth or have some other secular trend that will drive employment prospects. For example, DV went through a 3-4 year period in which the company was unable to generate interest in its IT programs due to the fallout from the tech boom.  In this downturn, it does not appear that there is any one sector whose employment prospects are weaker than others, at least to the education consumer. As a result it appears students have gravitated towards allied health, which is viewed as a safe haven.  The results of our survey are bullish for the near term enrollment prospects of COCO.

Source: PAA Research

Source: PAA Research

IT, Media/Design, and Criminal Justice Are Generating Slower Enrollment Growth

The natural offset to strong demand for allied health programs as a result of the economic environment is the RELATIVE weakness in demand for business, criminal justice, media/design, and IT programs.  We were somewhat surprised to see criminal justice on this list. In theory job prospects in that field are not necessarily pro-cyclical.

Source: PAA Research

Source: PAA Research

Private Loan Availability Remains Challenging

 The dearth of private student loan availability has been and remains a significant operational challenge for the for-profit postsecondary sector.  Far too many companies in the space have increased tuition to the point where affordability has been stretched and return on educational investment has been compromised.  This model works in an environment in which student loan availability is ample and school’s are able to offload the credit risk to private players. Over the past two years, most meaningfully providers of private student loans have substantially reduced their exposure to students attending for-profit postsecondary institutions given their typical credit profile and higher default rate risk.  Based on the feedback from our survey, it does not appear that this trend has changed over the past three-months.  More than 40% of respondents indicated that the availability of private student loans had declined in the past three months.  We would not use ESI’s recent “private student loan announcement“ , as an example of improved access to credit for students attending for-profit institutions. ESI retains all of the credit risks, so the structure enables ESI to offload receivables from its balance sheet and reduce bad-debt expense in the near term.

Source: PAA Research

Source: PAA Research

Privately Held Operators Expect Enrollment Growth to Slow Over the Course of 2010

Most of the operators we spoke with are bullish on enrollment growth prospects for the remainder of 2010.  However, it appears that most of the respondents to our survey expect some slowdown in enrollment growth over the course of the year.  Based on the feedback we have received, it appears that executives at the schools we surveyed expect enrollment growth to slow to the high-single-digit/low-double-digit range by the end of 2010.  For-profit postsecondary education companies have superior enrollment and revenue visibility, so we would be surprised if actual student population trends differed materially from what the executives we surveyed expect.

Source: PAA Research

Source: PAA Research

Rising Unemployment Is the Single Largest Factor Contributing to Enrollment Growth

For a period of time, there was some debate as to whether or not postsecondary education demand trends were acyclical or counter-cyclical. It appears the most recent downturn and the commensurate explosion in demand for higher education programs has resolved that argument.  Five to ten years ago, for-profit providers of postsecondary education were in the early stages of a secular growth trend as their geographic expansion, development of new program offerings, and expansion of online offerings increased access to potential students and drove enrollment growth even during strong economic periods. We think the space has reached a level of maturity now, which makes the industry more reliant on economic cycles in our opinion.  Apparently, operators in the space agree.  75% of respondents identified rising unemployment as the strongest driver of enrollment growth at their school or campus over the past year.  The bigger question now is whether or not it is the absolute level of unemployment that serves as a driver of enrollment growth or the magnitude of change.  This could very well determine the overall demand environment for operators in this sector in the coming 6-12 months. 

Source: PAA Research

Source: PAA Research

Survey Respondents Expect Modest Lead Cost Inflation

 ESI and other publicly traded for-profit education companies have indicated that they expect the advertising environment to “normalize” which should lead to an increase in lead costs in 2010. ESI, guided to a 15% increase in advertising spending in 2010.  The respondents to our survey have indicated that they expect cost-per-lead to increase in 2010, but only a modest amount.  54% of respondents expect cost-per-lead to increase 0-5% in 2010. 

Source: PAA Research

Source: PAA Research

Operators Continue to Invest in More Capacity – Is there a Saturation Point?

Despite growing signs that enrollment growth could slow down over the next 2-3 quarters, a majority of the f0r-profit education institutions we surveyed expect new program offerings and square footage expansion to be their biggest areas of investment in 2010.  It is also interesting to note that 37% of respondents plan to increase their investment in default management services.  It’s clear that the rapid rise in cohort default rates have become a real area of regulatory concern for most operators in the sector.  Increased investment in default management services is the least costly way to address a cohort default rate issue, but it is not the only and certainly not the most effective way. 

Source: PAA Research

Source: PAA Research

Taking a step back, we ask the question: when will there be too much capacity in the higher education space?  We started to express our concerns about the overall magnitude of bricks and mortar campus expansion as far back as 2004.  Clearly, the economic downturn has masked any industry-wide issues with excess capacity.  However, all of the top 50 MSA’shave at least 7-8 for-profit education institutions located in those cities.  It appears that every school in the industry has tried to maximize the number of program offerings at each individual campus.  Capacity has been expanded from both a bricks and mortar perspective and online.  Consider the following:

  • More than 80% of schools that receive Title IV funds have some sort of online program offerings
  • ESI’s newest ITT Tech locations were opened in Akron, OH and Johnson City, TN, not exactly a list of booming metropolises.  It’s safe to say we’re past the point of low hanging fruit for ESI’s branch campus expansion strategy.
  • In 2000 there were 530 ACICS accredited institutions with 365,000 students enrolled, as of 6/30/09 there were 770 institutions with more than 700,000 students enrolled
  • Overall, the number of borrowers in repayment for all of Title IV increased from 2,399,774 as of FY00 to 3,345,534 as of FY07.  Some of the increase in enrollments has been driven by the “echo baby boom”, but it’s clear a great deal of this is capacity expansion driven.
  • 10-years ago APOL had 100,000 students enrolled, today the company has more than 400,000 students enrolled
  • 10-years ago Kaplan University Online and Bridgepoint Education, didn’t exist. Today they have more than 60,000 and 50,000 students enrolled exclusively online respectively.

Interestingly enough, the number of institutions that receive Title IV funds has actually declined in the past decade (from 6,450 to 5,776), but that number does not reflect the actual growth in physical branch campuses and online universities. For more than a decade now, the mantra of operators in the for-profit postsecondary education space has been increase and expand – increase the number of program offerings at existing locations and expand the number of branches and online offerings.  We are growing increasingly concerned that the industry has overexpanded to the point where any normalization in demand will lead to a rapid reduction in capacity utilization and compression in operating margins. 

The Transition to a 3-Year Cohort Default Rate Calculation Presents Substantial Challenges to Privately Held Operators – “Self Regulation” Is Here

There are a number of operating challenges operators in the for-profit postsecondary education sector will face over the coming years based on the current set of regulations, the most meaningful of which we think is the transition from a 2-year to a 3-year cohort default rate calculation.  The 2-year cohort default rate was a favorable regulatory construct for the for-profit postsecondary education industry because it understated actual default levels and was relatively easy to manage through forebearance/deferrment and other default management remedies.  Following the release of the unofficial 3-year cohort default rate data, we think a number of institutions have found themselves “scrambling” a bit to determine which actions to take to bring their cohort default rates into the range of regulatory compliance.  It has been our opinion that many institutions would take “self regulation” actions, which would reduce enrollment growth in the short term, but ensure effective regulatory compliance in the longer term. APOL has indicated recently that it plans to “cull the herd” over the next several quarters to reduce the number of risky students in its system.  Based on the responses to our survey, it appears APOL is not alone.  When asked what steps their institution was taking to prepare for a 3-year cohort deafult environment, 76% of respondents indicated that they were spending more on default management services and 67% expect to increase hiring of job placement professionals. This is not a surprise and those remedies seem like the most obvious and easiset to implement to help reduce cohort default rates. 

However, 24% of respondents indicated they have already reduced the number of high risk students their institution enrolls and 14% of respondents have changed their admissions policies.  This data suggests a number of schools have already introduced “self-regulation” policies in order to ensure compliance with standards under the 3-year cohort default rate calculation.  We have argued in the past that “self regulation” can have the same negative impact on enrollment trends as would explicit regulatory action from an accrediting agency or the Department of Education.  Students enrolled in any school TODAY will be captured in the first set of official 3-year cohort default rate calculations.  Schools that have particularly high cohort default rates need to implement “self regulation” policies today in order to ensure they will remain within regulatory compliance stanards. Based on the feedback from our survey it appears a large number of privately held for-profit postsecondary education institutions understand the severity of the situation.  We would speculate that the senior management teams of COCO, LINC, and WPO are having similar conversations currently.

Source: PAA Research

Source: PAA Research

In the coming days and weeks a number of publicly traded for-profit postsecondaryeducation providers will report earnings. Based on the results or our survey, the companies should report strong results.  We would use any strength in COCO, ESI, and WPO as an opportuntiy to sell shares based on the following: 1) Mounting evidence that fundemental headwinds (slwoing enrollment growth, higher lead costs) could increase over the course of the year, 2) Rapidly rising cohort default rates, which should continue to remain an overhang on the group (preliminary 2-year cohort default data will be released Feb 8th), 3) Slower enrollment growth due to “self regulation” actions taken in advance of the transition to a 3-year cohort default rate standard, 4) the potential for lower demand for those programs and schools that have violated the “more you learn, the more you earn” student covenant”, and 5) the likelihood that the Department of Education will implement new regulatory standards that significantly change marketing practices in the space, reduce the number of high risk students enrolled, and hinder programs with high tuition and low returns on educational investment.

As always, please act accordingly…

By PAA Research | Posted in For-profit Education, Uncategorized | Tagged , , , , , , , | Comments (0)

Traditional Capital Markets Activity Continues Its Recovery, TWPG Remains Well Positioned to Benefit

January 25, 2010 – 4:39 pm
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In our original report on Thomas Weisel Partners entitled “Getting Back to the Basics in the Capital Markets” we argued that TWPG shares were poised to witness considerable upside based on growing momentum in traditional capital markets activity such as equity underwriting and increasing evidence that M&A volumes were poised to rise sharply.  Thus far the investment idea has not worked. TWPG shares are now off 25% since the date we introduced the stock, even though our thesis continues to play out as we expected.  As a reminder, here is our investment thesis on TWPG shares:

  1. Even if the economy does not improve meaningfully in the next 12-months, capital markets activity will.
  2. TWPG has taken advantage of the downturn to right-size headcount and selectively enhance its human capital. The franchise remains remarkably strong and well respected.
  3. TWPG shares do not reflect the earnings power of the company in an economic recovery, which we think is $1.00+.
  4. TWPG has one of the strongest platforms to target growth companies among its peers, yet the stock trades at the lowest valuation.

Almost one-month into 2010, all signs point to a significant increase in underwriting and M&A activity for the year compared to 2009.  According to PWC, in the fourth quarter of 2009 a total of 32 IPO’s were completed in the US that raised total proceeds of $16.8 billion.  Almost half of the IPO’s completed were sponsor led (venture capital, mezzanine fund, private equity etc.), which is an important development for TWPG.  The company has long-standing relationships with many of the leading venture capital firms in silicon valley.  In addition, there were more than 69 IPO filings in the fourth quarter and another 11 in the first quarter.  In the fourth quarter of 2008, only seven companies filed to go public in the US, while there were no filings in the first quarter of 2009.  No one will confuse the current environment to 1999, but it is clear that the slow and steady normalization of traditional capital markets activity continues.

Source: PwC

Source: PwC

According to Thomson Reuters, for all of 2009 M&A transaction volume declined 28% YOY, while the number of deals decreased 7% compared to 2008.  In the US, M&A transaction volume declined 29.6% and the overall level of private equity and venture capital acquisition activity was at the lowest levels since 2002.  Trends in Canada (now a key market for TWPG), were considerably better with total M&A transaction volume increased 29.4% YOY to $154.5 billion.   We expect M&A volume to pickup substantially over the course off the year as credit tightness slowly eases and corporations look to acquire growth and put their  growing cash balances to work.  As a firm, TWPG has established itself as a leading advisor to small/mid cap growth companies in the healthcare, technology, consumer and increasingly energy and metals and mining sectors. Among these sectors, we anticipate technology could be the area with the greatest amount of deal activity over the next 9-12 months.  This should bode well for TWPG and the company’s venture capital clients.

For the fourth quarter of 2009, we estimate that TWPG was named as an underwriter on more than 20 secondaries and convertible bond offerings, completed at least three IPOs, and served as an advisor on at least three M&A transactions (including a $2.6 billion deal).  In the table below, we have outlined the company’s transaction activity in the fourth quarter and what has been announced thus far this year.  TWPG has already been named as a lead on two IPO’s that were filed this year.  Upon reviewing the table, it should become obvious that a large percentage of the company’s underwriting activity was completed by Thomas Weisel Partners Canada (aka Westwind Partners).  As we have stated in the past, the timing of TWPG’s acquisition of Westwind Partners could not have been worse, but that should not diminish its strategic importance to the company.  As the table below demonstrates, TWPG has become a well respected financial advisor to small and mid-cap companies in the energy and metals/mining sectors.  This should lead to a higher peak earnings profile for the company as transaction activity continues to improve. Perhaps most importantly, we think TWPG is poised to meet if not exceed consensus 4Q09 revenue and EPS estimates based on the information in the table below.

Source: PAA Research

Source: PAA Research

TWPG will report 4Q09 results on Tuesday after the close.  During the downturn, the company has shied away from providing explicit financial guidance, which we expect to remain the case in 2010.  For the quarter we forecast $55.8 million in revenues and a loss per share of ($0.11) compared to current consensus of $55.6 million and a loss per share of ($0.20).  We expect management to reiterate its expectations for profitability for 2010.  It appears for now that the street remains skeptical about the company’s profitability prospects in the coming year; current consensus is for a loss per share of ($0.08) compared to our estimate of EPS of $0.09.  Here are some of the key questions we would like answered on the company’s earnings call:

  • How would the company characterize the overall pipeline of deal activity compared to three months ago and does management expect traditional VC backed deals to become a bigger portion of the transaction mix in 2010?
  • What are the prospects for gains on the company’s internal venture capital portfolios?
  • Have trading volumes finally stabilized to the point where commission revenues could increase in 2010 compared to 2009?
  • What were the key hires during the fourth quarter and how much will the company invest in human capital in 2010?
  • What is the status of the shelf-filing?

TWPG currently trades at 0.8x and 1.0x book and tangible  book value, which is a sharp discount to other publicly traded boutique investment banks.   The company has a net cash position of $2.00/share and has $1.50/share in NOL’s.  At $3.72/share, the market is valuing the company’s business at close to $1.00/share, which seems egregious.  We remain confident that TWPG has earnings power of $1.00/share+ as capital markets activity recovers.  In a scenario in which capital markets continue to stabilize, corporations put cash on hand to work, and liquidity is restored to smaller growth companies, we anticipate TWPG shares could trade as high as 2.0x book value or $8.00/share.

As always, please act accordingly…

By PAA Research | Posted in Financial Services | Tagged , | Comments (0)

ESI Reports a Solid Quarter, New “Private Student Loan Program” Optically Looks Good, Economically “Kicks the Can Down the Road”

January 21, 2010 – 10:36 am
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ESI reported 4Q09 results this morning. You can read the full press release here. Overall we would characterize the results as a solid beat relative to consensus.  Here are the quick highlights:

  • Revenues of $374.4 million vs. consensus of $370.6 million (we had forecast $378 million)
  • Gross margin of 67.6% increased an astounding 400 bps YOY.  Clearly the company has benefited from an increase in the average number of students per class.  The total number of enrollments per campus for the winter term increased to 721 from 585 a year ago. Incremental margins are the single most compelling element of the for-profit postsecondary education business model.
  • ESI’s total educational spend per student (as measured by COGS/average enrollment) declined 3.6% YOY to $6,740, a record low for the company.
  • Bad-debt expense as a percentage of revenue increased to 6.9% from 6.8% in 3Q09 and 4.9% in 4Q08
  • SS&A expense excluding bad-debt expense as a percentage of revenue declined 3.2%, but on a nominal basis increased 19.2%  YOY. We expect SS&A expense excluding bad-debt expense to increase 20-25% YOY in 2010 due to higher marketing costs.

Winter Term Enrollment Intake – Demand Remains Robust

ESI generated new student start growth of 31.2% YOY against a 29.2% comp in the prior year. Very impressive.  Total enrollment increased 30.3%, which was driven in part by an 80 bps improvement in student persistence.  While these enrollment figures are impressive, we have to wonder about the quality of students the company is enrolling. If APOL, the unequivocal leader in this space has started to “cull the herd” a bit in terms of the types of students the company enrolls, we have to wonder why ESI isn’t following suit.  Based on the cost of ESI’s educational programs and the low return on educational investment, we think this could manifest itself in structurally higher default rates down the line.

ESI’s 2010 Guidance Looks Impressive, but the Delta Relative to Consensus Appears To Be Entirely Predicated on Bad-Debt Expense Improvement

ESI provide initial 2010 guidance for EPS of $10.00-$10.50/share.  This  compares to consensus heading in the quarter of $9.49.  When you factor in the enrollment upside delivered for the winter term, it appears the only meaningful difference between management’s initial guidance and current 2010 consensus EPS is bad-debt expense.  The company has guided to bad-debt expense of 4-6% as a percentage of revenue. We think that most analysts were assuming bad-debt expense for 2010 would be closer to 6.5-7.0% for the full year, perhaps slightly higher.  As a result of the company’s new private loan arrangement (and we use that term loosely), ESI will not recognize the same level of bad-debt expense in the SHORT TERM.  We estimate that the shift in bad-debt expense recognition could positively impact ESI’s 2010 EPS by as much as $0.50-$0.80, in short the difference between current consensus and management guidance.

ESI Establishes a “New Private Education Loan Program” For Its Students, Optically It Will Reduce Bad-debt expense, Economically It “Kicks the Can Down the Road”

After the close yesterday, ESI announced that it had signed a “new private education loan program” for its students with an “unaffiliated lender”.  You can read the company’s 8-K filing here.  The program entitled the PEAKS Private Student Loan program will likely become available to ESI’s students as early as the spring term.  Without finding another private loan provider for its students, ESI would be forced to use its own balance sheet to bridge the gap between the high cost of its programs and government student loan limits.  In a shrewd move, the company has created a quasi-structured finance facility that will optically reduce bad-debt expense in the SHORT-TERM, but will NOT decrease the company’s eventual credit exposure to these students.  Here are the highlights of the facility:

  • A trust was established that issued $300 million in Senior Debt to a group of investors
  • The proceeds of the Senior Debt will effectively be passed through to an unaffiliated lender that will grant loans for ESI’s students
  • The loans will be contributed to the trust as collateral against the Senior Debt
  • ESI will pay to the trust a portion of the amount of each private student loan disbursed to an ITT Tech student in exchange for Subordinated Notes.  For those familiar with structured finance parlance, this can be viewed as a form of overcollaterilization.
  • ESI will be the guarantor for all of the Senior Debt incurred by the Trust.

The chart below depicts the structure of the new private student loan arrangement and the flow of funds:

Source: Company reports, PAA Research

Source: Company reports, PAA Research

Overall, we would hardly characterize this deal as a “new private loan” arrangement.  Here are some key observations about the new private loan arrangement:

  • ESI retains all of the credit risk associated with these private loans.
  • This off-balance sheet arrangement significant reduces investor visibility about the company’s true credit exposure.
  • ESI has effectively pushed the recognition of credit losses on private loans (previously known as bad-debt expense) out a few years. Based on the typical loss curves witnessed on SLM’s private student loan program, we anticipate the company will need to make payments starting in years 2-4.
  • The unaffiliated lender is effectively a “servicer”, originating and we’re assuming servicing loans but actually has no credit exposure
  • We view the payments ESI will make to the Trust in exchange for Subordinated Notes for every loan issued to an ITT Tech as a form of “overcollaterilization”.  It’s unclear how ESI will account for the value of those subordinated notes, which could be viewed as the mezzanine tranche in a traditional ABS facility. 

Here are the questions we would like answered on the conference call about the company’s new loan arrangement:

  • Is this the best ESI could do? For almost 6-9 months now, the company has “teased” that it was on the cusp of signing an arrangement with a new lender that would provide private student loans for the company’s students.  Although this can be called a private student loan arrangement, in effect it has enabled ESI to delay bad-debt expense recognition and push receivables off its balance sheet. We have to give management credit, its a savvy move.  However, we think investors will look through this.  Additionally, what type of statement does this make about lender appetite to take on credit exposure to ESI’s students?  Not a very good one, in our opinion.
  • How quickly will the $300 million be disbursed to students?  This will impact the company’s bad-debt expense directly.
  • What will the cost of these loans be for students?
  • What percentage of total loan amount will ESI fund into the trust in exchange for Subordinated Notes (the overcollaterilization)?
  • Will the company recognize gross revenues on the tuition received through this private student loan program? An argument can be made that the company should report net revenues on that portion of tuition revenues that will be offset by payments on behalf of the company into the trust.
  • When does the company anticipate it could recognize losses on the portfolio?  As we mentioned earlier, we think within 2-4 years is a reasonable time  frame.
  • How will the company mark the subordinated notes on its balance sheet going forward?
  • Will investors be able to obtain loan performance data for the PEAKS trust?

We recognize ESI shares will likely rally today in response to solid 4Q09 results and initial investor enthusiasm about the implications of the company’s “new private student loan arrangement”.  However, we think the company’s inability to find a “real’ private loan arrangement is a damning statement on lender appetite to take on credit exposure to the typical ESI student. We would argue the new private loan arrangement reduces investor visibility without any commensurate decline in credit exposure for the company.  Overall, we view this as a yet another sign that the company is straining under the weight of its tuition policies and the low returns on educational investment for its students.  Based on recent proposals from the Dept. of Education, it appears that regulators are increasingly likely to focus on affordability and return on educational investment.  We think ESI will eventually need to drastically cut tuition in order to restore the return on educational investment for its students.  We would use any strength in the stock today as an opportunity to sell.

As always, please act accordingly….

By PAA Research | Posted in Uncategorized | Tagged , , , | Comments (0)

Feedback from Independent Reprographers Suggests the Potential for ARP to Beat Estimates is High, AIA Billings Index Could Finally Eclipse 50 in 1Q10

January 20, 2010 – 10:02 pm
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We introduced ARPas an investment idea approximately 9-months ago. At that time we thought the stock had considerable upside based in large part on the company’s market leadership position and strong free cash flow generation.  This would enable the company to weather the current economic downturn through strategic cost cutting and debt reduction.  For the most part, our investment thesis has played out.  ARP has reduced G&A spending from a 2008 annual run-rate of $166 million to $125 million in 2009.  Additionally, the company has closed approximately 30 branch locations and cut back overhead at its remaining locations. As one industry insider stated a few weeks ago: “It really is amazing how strong ARC’s (Industry parlance for ARP) EBITDA margins are considering how weak non-res (non-residential) construction has been”. 

ARP has used its solid EBITDA generation and stringent working capital management to reduce its outstanding debt. Net debt outstanding has declined from a peak of $365 million as of 3/31/08 to what we expect to be $240 million as of 12/31/09.  Over the course of 2009, we estimate ARP generated $88 million in free cash flow even with a 28% decline in revenues. Not too shabby.  Considering how well ARP  has executed over the past 9-months we are surprised the stock has only appreciated 22%. This is nothing to be ashamed of for sure, but ARP has underperformed both the  S&P 5 00 (up 32% over the same time frame) and other service oriented companies that have meaningful exposure to non-residential construction activity (CBG, JLL, ADSK etc.).

 The reprographics industry and ARP in particular are not widely followed in the investment community (we’ve asked around).  As a result, we anticipate that shares will only witness meaningful upside when there are clear signs that non-residential construction activity has bottomed and it starts to be reflected in ARP’s financial results.  For the first time since we introduced ARP as an investment idea, we think we are approaching that inflection point.

Revenue Upside for ARP for 4Q09 Appears Likely, FY10 Consensus Looks More than Achievable

 We recently conducted a survey of approximately 30-35 independent reprographic firms located across the country.  We think the results of our survey offer unique insights into fourth quarter revenue trends, strategic changes for operators in the reprographic industry, credit availability for construction firms, and the outlook for the first quarter.  Below we will discuss some of our key findings.

According to Independent Reprographers the Decline in Revenues Lessened in 4Q09, Relative to the Full Year Trend

 As we stated earlier, our initial call on ARP was not predicated on a rapid recovery in non-residential construction spending.  2009 was a brutal year for architecture, engineering, and construction (AEC) firms.  Most reprographers generate approximately 60-80% of their revenues from the AEC industry. As a result, the average reprographer witnessed at least a 20% YOY decline in revenues for the full year 2009.

Source: PAA Research

Source: PAA Research

 As difficult as 2009 overall was for the reprographic industry, it appears that 4Q09 was slightly “less bad”.  According ot the independent firms we surveyed, approximately 30% had generated a modest increase or flat YOY revenues in the fourth quarter.  This compares to only 3% of respondents that witnessed flat or an increase in revenues for all of 2009.  The median YOY revenue decline witnessed by the reprographics firms we surveyed for the fourth quarter was approximately 10-20%.  This compares to current consensus revenues for 4Q09 for ARP of  $102 million, which implies a 33.6% YOY decline. Based on the feedback from our survey it appears that consensus 4Q09 revenues for ARP could be too conservative.  We currently forecast $112 million in revenues for ARP’s 4Q09, which would represent a 6.4% Q/Q decline a 27.5% YOY decline. 

 

Source: PAA Research

Source: PAA Research

Independent Reprographers Witnessing Revenue Stability in 1Q10

 Perhaps the most surprising finding from our survey was the relative level of revenue stability that independent reprographics firms expect for the first quarter.  The magnitude of revenue visibility in the reprographics industry is not particularly high, but most firms have a sense for what projects they will be working on over any 2-3 month period.  The nature of the business is such that new projects can pop up at anytime and conversely work can be cancelled at the last minute.  In short, these results should be taken with a “grain of salt”, but they are encouraging none the less. 

Approximately 36% of independent reprographics firms that we surveyed expect to witness a YOY increase in revenues for 1Q10 compared to 1Q09, while another 39% expect revenues to be flat YOY.  We would hardly characterize these results as a clear sign that non-residential construction activity is poised to surge, but it clearly points to stabilization against what are easy comps.  This is the first time in the past year that a vast majority of independent reprographers have indicated that they expect revenues to flatten out at a minimum on a YOY basis. Based on the results of our survey, it appears that 1Q10 revenue estimates for ARP, which imply a 23.3% YOY decline, are far too conservative.  We currently forecast $122 million in revenues for 1Q10 (compared to consensus of $107 million), which would represent a 12.7% YOY decline from 1Q09 and a 35% decline from 1Q08 levels.

Source: PAA Research

Source: PAA Research

Other Key Observations from Our Survey

We wanted to share with you a few other key observations from our survey, which focus more on the state of the reprographics industry and the direction the industry could take over the coming quarters and years.  Here are a few of our key observations:

  • More and more reprographics firms are making a push to target non-AEC clients.  As we mentioned earlier, AEC (architecture, engineering, and construction) clients make up the lionshare of revenues for most reprographers.  Over the past 6-9 months, ARP management has made it clear that the company plans to make a bigger push to capture revenue opportunties from non-AEC clients in 2010.  With its national footprint and experienced sales force, we think ARC is uniquely positioned to capture revenue opportunities from non-AEC firms.  The leverage on fixed capacity that is currently being utilized at low levels, should be meaningful.  More than 85% of reprographics firms indicated they were making a bigger push to target non-AEC clients.
  • The pricing environment remains competitive, but not any different from that 3-6 months ago.  Approximately 80% of respondents indicated they had witnessed some form of pricing pressure from competitors.  Only 20% indicated they were experiencing a “great amount” of pricing pressure.  These results are consistent with our previous surveys.  ARP is better positioned than almost any other operator in the reprographics industry to weather a tighter pricing environment given the company’s operating efficiency.
  • Capacity utilization levels remain low, more reprographics firms will go out of business.  Approximately 50% of the firms we surveyed are currently operating at less than 60% capacity utilization.  Should those levels continue, we think a number of companies could be forced to close additional branch locations or shut down altogether.
Source: PAA Research

Source: PAA Research

  • Credit availability to the clients of reprographers has not improved meaningfully over the past three-months.  Better earnings prospects for banks has yet to translate into higher lending activity.  While 27% of respondents indicated that credit availability for their clients had “improved a little bit”, another 21% thought that availability had decreased over the past three months.  Vacancy rates in commercial real estate continue to surge higher, but we still believe that improved credit conditions would lead to a meaningful increase in project activity.
  • Overall sentiment among independent reprographers remains poor, although it has improved slightly in the past three months.  On a scale of 1 to 10, the respondents to our survey rated the state of the reprographics market a 3.5, which represents a slight improvement from our fall survey.  Anecdotally we know that many reprographers are struggling to keep their business afloat and are hoping that 1H10 brings revenue stability and 2H10 some revenue growth.

AIA Billings Index for December Was Another Disappointment, Could January Finally Bring Some Improvement?

The American Insitute of Architects released their Architecture Billings Index today.  The AIA billings index for December increased from November, but the results still indicated that overall activity at architecture firms declined month to month.  The ABI rating for December was 43.4 compared to 42.8 in November and 46.1 for October.  The new project inquiries index remained above 50 for the 10th consecutive month, but declined slightly from November levels to 55.3.  Credit availability remains a major impediment to project related work.  The results of our independent reprographers survey suggest that the AIA Bililngs Index is poised to increase as soon as January.  We anticipate the index could cross over 50 at some point in 1Q10, which would represent the first positive reading for the index since January 2008.

Source: AIA

Source: AIA

Revenue Stability Is the Key for Multiple Expansion for ARP -  FY10 Should Bring Potential Revenue and EPS Upside, Continued Deleveraging , and Perhaps Acquisitions

As we mentioned earlier, excellent execution, rapid deleveraging, and strong free cash flow generation for ARP over the course of 2009 has largely been overlooked by investors.  We think the appreciation prospects for shares will be increasingly tied to signs of revenue stability in 2010 (and eventually a resumption of growth).  Based on the results of our survey, it appears we are closer to revenue stability for ARP than is currently reflected in consensus estimates.  We expect 2010 to be another strong free cash flow year for ARP, although it seems unlikely that the company will be able to replicate the $85-90 million generated in 2009.  A combination of stabilizing project activity levels, the benefits of 2009 cost-cutting, expansion into non-AEC  markets, and the potential for a resumption of acquisition activity should set the stage for ARP to top consensus expectations over the course of 2010.  To arrive at our FY10 EPS estimate, we have assumed the company can generate a 60 bps improvement in gross margins compared to 2009.  In the table below we compare our current estimates for 4Q09, 1Q10, and 2010.

Source: PAA Research, Yahoo Finance

Source: PAA Research, Yahoo Finance

The setup for ARP shares for 2010 appears to be favorable. In our view, estimates are more or less “washed out” and the stock does not yet reflect what appears to be growing signs of stability in ARP’s end-markets.  From a valuation perspective, ARP shares remain remarkably cheap on an EV/EBITDA and free-cash-flow basis.  In our view, we think ARP shares can trade as high as 20-25x FY10 EPS (similar to the current valuations for CBG, JLL, and ADSK) to the extent that a stabilization in the company’s revenues becomes apparent.  At 7.5x our FY10 EBITDA estimate or at a 10% yield on our FY10 free cash flow estimate of $48 million, ARP shares would trade north of $10.

As always, please act accordingly…

By PAA Research | Posted in Business Services | Tagged , , | Comments (0)