We wanted to highlight a few details from Sallie Mae’s earnings release last night and subsequent conference call that we think are important to followers of ITT Educational Services, Inc., Career Education Corp. and Corinthian Colleges, Inc. As we have discussed previously, we are closely watching the performance of Sallie Mae’s “non-traditional” loan portfolio, which is primarily comprised of loans made to students attending for-profit postsecondary education institutions. In the past students attending schools owned by ESI, CECO and COCO have all participated in the Sallie Mae private loan program. We think the performance data from Sallie Mae’s non-traditional loan portfolio is the best real-time proxy for the repayment status of students that have attended these schools. As you might expect, the charge-off and delinquency data for the second quarter was not pretty. Here are the highlights:

• The percentage of loans that were more than 90 days delinquent increased from 19.1% in the first quarter to 20.6% in the second quarter. A year ago 90-day+ delinquencies were 9.8%.
• Charge-offs JUMPED from 14.5% in 1Q09 to 24.0% in 2Q09! Charge-offs were 11.5% a year ago.
• Sallie Mae still had allowances of 32.7% for losses in its non-traditional loan portfolio

The chart below outlines 90-day+ delinquencies and charge-offs for Sallie Mae’s non-traditional loan portfolio over the past 10-quarters (click on chart for full image view).

Source: Sallie Mae

As we’ve stated in the past, the Sallie Mae non-traditional loan performance data is not a perfect proxy for what cohort default data will eventually look like, but we think it is the best gauge available. Defaults and delinquencies captured in the Sallie Mae data in some cases 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. Also, 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. We expect a very large number of for-profit postsecondary education institutions and some schools owned by ESI in particular to have cohort default rates in excess of 20%, if not 25% for the 2008 calculation. In the past, this has resulted in significant regulatory scrutiny and often changes to the operating landscape.

A Quick Look at Our Expectations for ESI’s 2Q09, Will ESI Recognize Any Losses Related to Recourse Loans Made Under the Sallie Mae Program?

ESI will report 2Q09 results before the market opens tomorrow. Based on our channel checks on lead flow and conversion rates, we expect ESI to have another strong enrollment intake and potentially deliver upside to revenues and EPS. Following “blow-out” results in the first quarter, we think the sell-side has finally raised estimates to more reasonable levels. As a result, we expect any upside to estimates for the remainder of 2009 to be marginal. The street is now forecasting significant enrollment growth and operating margin expansion. We continue to believe that 2009 will represent peak earnings for ESI. Here are some of our key assumptions for the summer term enrollment intake and 2Q09 revenue and earnings:

• Total YOY growth in new student starts of 20%
• Flat student persistence YOY, 73.9%
• Total enrollment growth YOY of 20.8% to 66,185 students
• Revenues of $313.5 million and EPS of $1.79 (compared to consensus of $307 million and $1.73)

One of the things we will be watching for is any commentary related to potential charges related to recourse loans made with Sallie Mae. We do not think these concerns are reflected in expectations currently and it appears more and more likely that default thresholds could be breached (the company has never disclosed what the recourse default levels are).

Some will ask us: How can you recommend going short a stock when you think there’s the potential for upside to earnings? Overall, we continue to focus on the bigger picture with ESI and the other for-profit postsecondary education providers who have higher priced tuition. While some might get excited about strong enrollment trends and new student starts, we think this will only exacerbate ESI’s impending student loan default problem. In our view, students enrolling today, in an environment with poor prospects for employment (we’ve assumed the job market will remain challenged for at least two years) are likely to default at a remarkably high rate if the cost to complete an associate’s degree at ITT Tech continues to remain above $45,000. We continue to argue that the company’s default rates are likely to remain structurally high as a result of the company’s tuition policies. Also, we anticipate that the postsecondary education consumer will become increasingly sensitive to price given the widespread publicity about student debt burdens and defaults. We think the company needs to lower tuition, substantially, in order to remedy the structural problems with its business model.

As always, please act accordingly….