Please make sure to click on the link at the end of the post to read our full write-up on ESI.

We have followed the for-profit education sector for almost a decade now. Companies such as Apollo Group, DeVry, Inc. and ITT Educational Services, Inc., among others, have generated fantastic enrollment, revenue and EPS as they gained significant market share from the traditional academic sector. Over the past 12-18 months, most stocks in the space have outperformed the market by a substantial amount due in large part to a significant uptick in demand for higher education caused by rising unemployment. Lead costs have plummeted, conversion rates have improved and demand remains robust, in many respects it is the best time to be a for-profit provider of postsecondary education. However, we think have recently witnessed the early signs of what could be a meaningful inflection point for the revenue and earnings growth prospects for the group.

Over the past 2-3 years, we have grown increasingly concerned that some companies in the space were beginning to price themselves out of the market; that is tuition levels were approaching, if not exceeding the level at which a graduate could consistently service their student debt burden. In many respects, this is an indictment of the higher education system in the US at large. Simply stated, tuition has become too expensive. If existing shareholders in the space have not started to focus on the importance of student debt burdens, then investor reaction to APOL’s recent earnings report and ESI’s 10-K disclosure about its preliminary 2007 cohort default rates should have served as an alarm bell. Some companies in the sector will weather the pending cohort default rate storm better than others. It is our view that ITT Educational Services, Inc. (ESI) could fair the worst – their programs are some of the most expensive and it is no longer clear that graduates earn a strong return on their educational investment. We anticipate, shares could witness substantial downside in the near-term as the prospect of higher cohort default rates at its schools becomes an “anvil” hanging over the head of shareholder sentiment. Our thesis is based on the following:

1. Over the next few quarters, ESI will continue to benefit from strong demand for its programs caused by the economic downturn. This is already reflected in consensus – strength should be sold or shorted.
2. ESI has broken “the more you learn, the more you earn” student covenant.
3. Student debt burden to attend ITT Tech now rivals mortgage debt burden at the peak of the housing bubble – cohort default rates should continue to surge higher.
4. Our proprietary survey suggests that students are finding it increasingly difficult to make student loan payments.
5. ESI has not disclosed that it is subject to a qui tam lawsuit based on alleged violations of the incentive compensation provisions of the Higher Education Act.
6. ESI is over-earning at the expense of its students – tuition price cuts will become a necessary remedy for the company to fix its business model, in our view. We estimate that restoring the affordability of ESI’s programs could negatively impact EPS by $2.50-$3.00 in 2010, if not more.

Please click on this link to read our full report on ESI.

As always, please act accordingly…..

Disclaimer: The author owns puts in ESI, positions can change at any time without notice.