In our original post on ITT Educational Services, Inc., we argued that the company’s business model was structurally broken because it was no longer clear that students earned a positive return on their educational investment. After more than a decade of increasing tuition at an annual rate twice that of inflation, the affordability equation for a student pursuing an associate’s or bachelor’s degree at the ITT Technical Institute has become problematic. As a reminder, the average cost of an associate’s degree for a student enrolling at ITT Tech this year is approximately $45,000 and the average starting salary for the 75% of graduates placed in their field of study in 2008 was $33,370. Historically, organizations such as the Project on Student Debt and FinAid have recommended that students do not take on more student debt than their expected starting salary upon graduation. Anything beyond that level typically places undue financial strain on the student and makes them more likely to default. Based on our proprietary analysis in our original post on ESI, we argued that student debt burdens for the company’s graduates were now approaching levels similar to that for mortgage debt during the peak of the housing bubble. Stated another way, graduates from ESI’s associate’s degree programs in 2008 will allocate approximately 20% of their GROSS income to servicing student loans. Clearly this is unsustainable. In our view, this is a secular issue – tuition has increased beyond the student’s ability to consistently pay. The current economic downturn will only exacerbate this trend.

There is some good news, the Income Based Repayment (IBR) plan could substantially reduce student debt burdens nationally and for ESI grads in particular. However, it is not a panacea and we still think ESI is more likely than not to see a higher level of regulatory scrutiny over the coming years as cohort default rates for their students surge.

Income Based Repayment Lowers Payments in the Short Term, but Will Not Make a Huge Difference for ESI’s grads

The Income Based Repayment (IBR) Plan was introduced as part of the College Cost Reduction and Access Act of 2007 and became available July 1st of this year. IBR is a new repayment plan for the major types of federal student loans. Under the plan, the monthly payment is capped at an amount that is intended to be affordable based on the income and family size of the borrower. Stafford, Grad PLUS, and Consolidation Loans made under the Direct Loan or Federal Family Education Loan Program (FFEL) are all eligible for repayment under IBR. The amount of repayment under IBR is determined based on a formula that evaluates a student’s/graduate’s discretionary income, where discretionary income is the difference between adjusted gross income and the federal poverty line (approximately $16,000). Payments are limited to 15% of monthly discretionary income. Here are a few other key provisions of Income Based Repayment:

• The maximum repayment period is extended to 25 years and the difference between the original interest payments owed and interest payments made under IBR are capitalized and added to the principal of the loan
• Students must be current on student loans in order to apply for IBR
• Plus loans and private loans are not eligible for IBR

How significant are the reductions in student loan payments? For many students this could be a “game changer”. However, looking at the profile for the typical ESI graduate, the reductions appear to be helpful, but not as much as one would think. It is important to remember that the maximum federal loan limit for an independent student only covers approximately half the cost of obtaining an associate’s degree at ITT Tech. Assuming every student that graduates from ITT Tech obtains the maximum federal loan limit of $21,000 for the first two years of an undergraduate degree program we estimate the monthly debt servicing cost to be approximately $240. According to the Department of Education’s own calculations, independent students that are not married would pay $172-$234 in monthly debt servicing costs if their adjusted gross income is between $30-$35,000. The savings become more material if the student is married or has children. Overall, IBR does not appear to be a game changer for the vast majority of ESI students who are typically single and between the ages of 22-30. The Institute for College Access and Success has estimated that as many as one million students will take advantage of IBR. It will help dampen the coming surge in cohort default rates, but for ESI in particular it does not appear like it will have a dramatic effect.

Revisiting ESI’s Revenue Sources

Over the past two-years, ESI’s revenue sources have shifted substantially as private lenders have backed away from the student loan market. At the start of the decade, ESI only generated 5% of its revenues from private student loans. However, private loans increased to as much as 34% of revenues in 2006 as the company’s tuition price increases widened the gap between the overall cost of education at ITT Tech and federal student loan limits. Sallie Mae was the single largest provider of private loans to ESI’s students from 2002-2007. In February 2008, Sallie Mae elected to terminate its private loan relationship with ESI due to rising delinquency and defaults. As a result, private loans for ESI plummeted to only 8% of total revenues in 2008 and the company’s internal financing program increased to 10% of total revenues. The chart below outlines ESI’s revenues sources by category so far this decade (click on chart for full image view):

Source: Company reports

Outside of using their own balance sheet, ESI has been a direct beneficiary of higher federal student loan limits and expansion of the size of the maximum Pell Grant. As the chart below demonstrates, from 2007 to 2008 the percentage of revenues coming from FFEL loan programs increased from 51% to 59%, while the average amount of funding per student increased from $9,183 to $11,439 annually.

Source: Company reports

The average Pell Grant per student was $2,501 in 2008, up substantially from $1,805 in 2005. Although its impact will be modest relative to the overall student debt burden, we expect ESI’s students to benefit from increased Pell Grant limits and overall funding in the next year.

Source: Company reports

ESI has been pursuing other private lending relationships to help bridge the gap between the cost of its programs and federal loan limits. Recently the Eli Lilly Credit Union expanded its relationship with ESI and its students. We do not have details on the size of their program with ESI, nor whether or not these loans are recourse to the company. We still find it remarkable that ESI management commented at in investor presentation that they planned to increase tuition over the next several years at rates commensurate to the past few years. That begs two questions: 1) How will the company fund those tuition price increases (more from its balance sheet)? and 2) How will students be able to service that debt upon graduation when starting salaries are likely to remain in the $30-$35,000 range?

A Review of Recent Sallie Mae Data Suggests “The Horse Has Left the Barn” For Defaults in FY08 and FY09 – Will ESI Take Any Charges for Recourse Loans Under the Sallie Mae Program

As we have mentioned in the past, the “cohort default rate” used by the Department of Education to measure educational outcomes is a poor barometer of real-time trends in how students are keeping up with loan payments. As a reminder, under the Higher Education Act a postsecondary institution can lose eligibility to participate in certain Title IV loan programs if the rate at which students default on their federal student loans exceed certain percentages. The rates are calculated per institution and are based on the number of students that default (not the dollar amount). An institution whose cohort default rate exceeds 25% for three consecutive years loses eligibility to participate in the vast majority of Title IV programs.

The methodology used to calculate the cohort default rate dramatically understates credit risk for a particular group of student loans. The data is calculated based on a fiscal year that begins October 1st and ends September 30thand is structured to capture student defaults within a 24-month period. Students that enter repayment after October 1st are captured in that particular years cohort. For example a student that enters repayment on October 10, 2006 and defaulted in June of 2008 would have been captured in the cohort default data for FY07 (the most recent data set available). However, a student entering repayment on October 10, 2006 and that defaulted in December 2008 was not captured in the cohort default rate for FY07. In fact, that student under the current metholdogy is not captured in the cohort default data at all. Any student that defaults 24-months after the initial repayment period will not be captured in the cohort default data. In order to address the inadequacies of the cohort default data, the time period was recently expanded to three years, which will begin with the FY09 cohort. Unfortunately preliminary cohort default data for FY09 will not be released until early in calendar 2012. We think the cohort default data for FY08 will be terrible and that for FY09 even worse. How can an investor get real time data on what cohort default rates might look like? Let’s take a look at data from Sallie Mae’s “non-traditional” loan portfolio.

Sallie Mae is the largest servicer of student loans in the US. In the late 1990’s in an effort to boost profitablity, the company introduced a private loan program. As part of this initiative, in the early part of this decade Sallie Mae expanded their private loan program to what they called “non-traditional schools”, which was primarily made up of for-profit postsecondary education providers. ESI, Career Education Corp. and Corinthian Colleges, Inc. all had significant relationships with Sallie Mae. ESI has never disclosed exactly how much of its revenues were attributed to private loans offered to its students through Sallie Mae, but it is important to note that private loans were 30% of revenues for ESI up until Sallie Mae terminated the program in February 2008. Overall Sallie Mae’s non-traditional loan portfolio was approximately $5.1 billion as of 3/31/09.

Default rates and delinquencies have sky-rocketed in the past 6-months, as one might expect given the economic environment and the high cost of completing some of the degree programs offered by ESI and Career Education Corp. According to Sallie Mae, the number of charge-offs in the portfolio has increased from 10.0% as of 9/30/08 (remember the last measurement date of the FY07 cohort default data) to 14.5% as of 3/31/08. Perhaps even more unsettling is that the percentage of loans that were more than 90 days delinquent has increased from 11.9% as of 9/30/08 to 19.1% as of 3/31/08. Stated another way, approximately 34% of loans Sallie Mae made to non-traditional schools are delinquent or in default!

Source: Sallie Mae

It is important to note that defaults and delinquencies are not a perfect proxy for what cohort default rates might look like for companies like ESI. First, defaults and delinquencies captured in the Sallie Mae data could go back to loans originated beyond the scope of the cohort default calculation (i.e. prior to September 30, 2007). We know there are loans in that portfolio that are 3-5 years old that could now be in delinquency or default. Second, the interest rates charged on many of these loans were higher than the typical loan under Title IV. Finally, there could be substantial variances in the quality of the schools in Sallie Mae’s “non-traditional” loan portfolio.

That being said, the data from Sallie Mae suggests that cohort default rates are poised to surge. In the past, this has resulted in significant regulatory scrutiny and often changes to the operating landscape.

One thing which we have not heard much discussion about is ESI’s potential liability from loans originated by Sallie Mae to its students in 2007. Here is what ESI stated in its 2006 10-K stemming from its relationships with private lenders:

“In 2006, we also indirectly derived approximately 34% of our revenue from unaffiliated private student loan programs. We have no financial responsibility with respect to any loans made to students or their parents under the unaffiliated private loan programs, except for an immaterial amount of loans with respect to which our obligations are fully reserved.”

Here is what the company stated in its 2007 10-K related to its relationship with Sallie Mae:

“In addition, we are financially responsible for certain loans made to students or their parents under an unaffiliated private education loan program. This program was terminated effective February 22, 2008 [Sallie Mae]. We do not believe that our financial responsibility with respect to those loans will have a material adverse affect on our financial condition, results of operations or cash flows.”

ESI has never disclosed exactly what the trigger might be for potential liability with respect to its relationship with Sallie Mae. Based on the changes in the company’s disclosure, it would seem ESI’s only liability relates to originations made in 2007. Assuming that loans made by Sallie Mae accounted for 20% of ESI’s revenues in 2007, that would imply the total loan portfolio for that year amounted to $170 million. We think investors should pay close attention to the performance of Sallie Mae’s non-traditional loan portfolio going forward to gauge whether or not ESI will take any charges related to defaults.

Department of Education Clearly Is Focused On Affordability

There is no discernible difference between educational outcome for students attending the ITT Technical Institute and other career oriented schools as measured by placement rates and average starting salaries. However, ESI has some of the highest operating margins in the for-profit education sector. Even if you wanted to give the company credit for more cost efficient marketing and educational delivery, we think that higher tuition costs are the biggest single factor in ESI’s superior operating margins. The administration has made it clear they are focused on access and affordability. During a period of rising default rates, we think it is highly likely that ESI will become subject to greater regulatory scrutiny due to the high cost of its programs and elevated operating margins. We continue to believe the only remedy is for the company to restore the affordability of its programs such that “the more you learn, the more you earn” student covenant is re-established. We estimate that restoring affordability of ESI’s programs could negatively impact EPS by $2.50-$3.00, perhaps more.

As always, please act accordingly…