We have written extensively about our concerns about the for-profit postsecondary education space and ITT Educational Services, Inc. in particular.  Our primary thesis is that overly aggressive tuition policies have significantly reduced the return on educational investment to the point where for some programs it is outright negative.  This is a SECULAR issue, which will be exacerbated by the current economic environment.  You can read about our thesis in detail here.  With that in mind, we have been somewhat surprised by the market’s reaction to Corinthian Colleges, Inc.’s recent earnings report.  It’s true that the company beat street estimates for the quarter and provided guidance that was above street consensus.  You can get all of the details here.  The stock has increased 9.4% over the past two days of trading.  We caution investors to focus on the bigger picture here.  Although fundamentals are robust currently, we think COCO’s results in many respects confirmed our short thesis on ESI.  Specifically, 1) we think COCO’s bad-debt expense improvement was a bit of a mirage, 2) the company is now subject to a lawsuit brought by former students, and 3) COCO management indicated that several (if not many) of the companies schools could have cohort default rates in excess of 25% for the FY08 measurement period.

COCO’s Bad-Debt Expense Slight of Hand

Corinthian Colleges, Inc. primarily offers diploma and associate’s degree programs.  Historically, the company has targeted students from lower soci0-economic backgrounds. As a result, the company typically has witnessed higher bad-debt expense and student loan defaults than its peers.  In the for-profit postsecondary education space, bad-debt expense is driven principally by two factors: student loan availability and student persistence.  Companies reserve as much as 50% (more on this later) against tuition that students are paying directly out of pocket.  Obtaining financial aid for a student is the single fastest way to lower the amount of bad-debt reserves.  Aside from student loan packaging, student persistence is the other big factor in bad-debt expense.  Companies in the for-profit postsecondary education space typically reserve at higher levels for tuition owed from students that have dropped out of school  Collection rates on these receivables can be as little as 25%, if not lower.

COCO’s bad-debt expense reached a high of 9.1% as a percentage of revenue in the company’s fiscal fourth quarter of 2008.  In the most recent quarter, the company reported bad-debt expense as a percentage of revenue of 7.1%, seemingly a huge improvement.  Here is what COCO’s CFO, Kenneth Ord said about the bad-debt expense improvement on the company’s earnings conference call (thanks to Seeking Alpha):

“Our bad debt in the fourth quarter was 7.1% which was below guidance of 7.58% [7.5-8.0%] and a substantial decrease from the 9.1% reported in the fourth quarter of last year. The improvement is primarily the result of improved efficiencies in financial aid packaging for students and more efficient internal lending processes. In addition, the continued phase out of our legacy loan inventory also helped to reduce bad debt in the fourth quarter.

In terms of bad debt guidance we expect continued improvements in bad debt in fiscal 2010 and remain comfortable with bad debt in a range of 6.5-7% for the year. We expect bad debt in the first quarter to range from 6.7-7.1% of revenue.“

The chart below depicts the progress that COCO has made in reducing bad-debt expense over the past 12-months.  On the surface it looks very encouraging, but overall bad-debt levels still remain high compared to historical levels.

Source: Company reports

Similar to ESI, COCO has elected to extend its own balance sheet to finance student tuition to bridge the gap created once Sallie Mae halted its private loan programs to traditional proprietary schools.  The student financing gap is simply the difference between the annual cost of tuition and government student loan limits.  As we have discussed in the past, it has widened dramatically over the past few years due to tuition price increases that have doubled the rate of inflation.  In its fiscal fourth quarter of 2008, COCO introduced the Genesis Lending Service program.  In fiscal 2009, the company provided approximately $120 million of tuition financing to its students under this program and management indicated that it plans to provide an additional  $130 million in  FY10.  As one might expect, COCO’s student notes receivable balances have increased rapidly.  Total net student notes receivable  increased from $17 million to $41.5 million.  The loss profile of these loans is quite high given the socio-economic background of the typical COCO student.  To COCO’s credit, the company is reserving at high levels on the loans it extends. As of year end, the allowance for students notes receivables stood at 41.3% of total gross student notes receivable.  This compares favorably to the typical allowance maintained by the company for its gross accounts receivable of 25-30%. 

Of course, reserves created for the company’s Genesis Loan Program are not included in the bad-debt expense calculation that COCO management has touted for investors.  In fiscal 2009, COCO incurred $45.8 million in reserve expenses for its student notes receivable under the Genesis Loan Program.  We don’t know how you think about it, but to us this strikes us as a little bit of “robbing Peter to pay Paul”.  It’s true the company has done a better job “packaging” students, but then again it’s COCO’s own balance sheet that is being used for the packaging.  We are introducing a metric which we call “real bad-debt expense”.  This is the sum of COCO”s bad-debt reserves for its traditional accounts receivable and those for its student notes receivable.  In theory, if COCO were not using its own balance sheet the company would incur much higher bad-debt expense levels.  Effectively bad-debt expense has been shifted from accounts receivable to student notes receivable.  The chart below compares COCO’s reported bad-debt expenes to our “real bad-debt expense” metric.   Based on our calculation “real bad-debt expense” was 12.0% of revenue in FY09.

Source: Company Reports, PAA Research

One other interesting aspect to examine is COCO’s bad-debt reserves relative to charge-offs.  For the most part over the past decade, COCO has established reserves that exceeded charge-offs on an annual basis.  Although it is not yet a screaming warning sign, it is interesting that FY09 was the first year in which bad-debt reserves were substantially lower than charge-offs.  In addition, in two of the last three quarters bad-debt reserves were meaningfully lower than charge-offs.  The company did build excess reserves in FY08, so perhaps it is more comfortable with its allowance levels.  The allowance level still represented 27.8% of total gross receivables at the end of FY09, which was actually up from 25.5% at the end of FY08.  We also think the lower level of bad-debt reserves relative to charge-offs could be a function of “the robbing peter to pay paul” syndrome we mentioned earlier.  The company is establishing high levels of reserves for its student notes receivable, which in effect have replaced traditional accounts receivable.

Source: Company reports, PAA Research

We also have not addressed the changes to the company’s revenue recognition policies surrounding loans originated under the Genesis program.  Initially, the company indicated that it would establish a 50% reserve for loans originated under the program, which would be accounted for as a discount to revenues instead of bad-debt expense.  As a result of the current economic environment and having a full year of loan performance data, management has elected to increase the discount rate from 50% to 56-58%.  There are two points we would like to address.  First, management identified lower FICO scores for its students as a primary reason why the company elected to increase the discount rate applied to loans COCO originates.  Demand for higher education has never been stronger.   Mounting job losses have created a surge in lead flow and higher conversion rates.  Shouldn’t COCO take this opportunity to enroll students with stronger credit backgrounds knowing how difficult it will be to obtain employment upon graduation and service student loans?  Second, as tax payers we’re not sure how we can be satisfied with a system whereby a company generates 81.3% of its revenues from tax payer supported federal financial aid, but thinks its prudent to reserve as much as 58% against loans originated from its own balance sheet to a similar (in some cases the same) student that is securing the Title IV funds. COCO’s Genesis Loans have a higher interest rate (12%+) than the typical Title IV loan, so one can make an argument the company should establish higher reserves than it normally would. However, the discount rate applied to these loans is simply extraordinary.  What are COCO’s accounting policies on loans the company originates telling us about the credit quality of their students and their ability to pay?  We get the sense this could become a major issue in the coming months and years.

Former Student Lawsuit May or May Not Have Merit, but It Could Signal a Change in the Political Landscape

In their review of COCO’s 4Q09 earnings results, our friends at the Student Lending Analytics Blog highlighted a new lawsuit that has been brought against COCO by former Everest College students.  In short the former students allege that the company misrepresented job placement rates, the quality of education and the ability to transfer credits.  In sprit, this lawsuit appears very similar to the much ballyhooed Monroe College lawsuit, which has been in the press of late.  Former student lawsuits are very common in the for-profit education sector.  Companies like COCO and ESI have established binding arbitration agreements to reduce their exposure to former student lawsuits, which in many cases have proven to be frivolous.  Under the binding arbitration agreement, the student agrees to settle any dispute with the school through an arbitrator provided by the American Arbitration Association.  In addition, the arbitration clause provides that aspects of the arbitration proceeding  (i.e. ruling or awards) will be kept confiential.  It appears the students involved in this particular lawsuit are trying to circumvent the arbitration process by forming a class. ESI has also been exposed to former student lawsuits, although to our knowledge the plaintiffs have all been forced into the arbitration process.

It is difficult to determine whether or not any of these lawsuits will gain traction.  We’re not interested in evaluating the merits of the allegations.  We do think the sudden increase in this type of lawsuit is further sign that students are becoming increasingly disenfranchised with the economic hardship placed on them by high tuition prices.  Currently, there’s a group entitled “Cancel Student Loan Debt to Stimulate the Economy” on Facebook that has more than 220,000 fans. More and more media coverage has been dedicated towards student debt burdens.  We think the release of the preliminary FY08 cohort default data in February 2010 could be the catalyst that turns the student debt burden discussion into a full-fledged political issue. 

25%+ Cohort Default Rates Are On Their Way, How Many Schools Will Be On The List?

We were surprised the market shrugged off COCO’s management admission that some of its schools are likely to have cohort default rates in excess of 25% for FY08.  Here is what management stated about where they think cohort default rates for FY08 could shake out (again thanks to Seeking Alpha):

“Although we won’t receive draft rates for the 2008 cohort of students until February 2010, we have reviewed the preliminary data from our Guaranty agencies from the defaults that have already occurred.

This preliminary data indicates that some of our institutions will have a 2008 cohort default rate above 25%. Under current rules, institutions exceeding a cohort default threshold of 25% for three consecutive years could become ineligible to receive Title IV funding. We want to emphasize we do not expect any of our schools to exceed the 25% threshold for three consecutive years.”

Management then stated later that it thought that those schools whose preliminary FY07 cohort default rate exceeded 20% were at risk of eclipsing 25% for the FY08 cohort.  According to the preliminary FY07 cohort default data, the default rate increased 2.4% from FY06 to FY07 company-wide for COCO.  However,  at its more troubled schools (from a cohort default rate perspective), the cohort default rate increased 4.6% YOY on average.  We think it is likely that the YOY increase in cohort default rates from FY07 to FY08 will exceed that from FY06 to FY07.  As a result we think it is possible more than 5 schools could have cohort default rates in excess of 25%.  Remember, the FY07 cohort default rate measurement period ended September 30, 2008, before the world really changed.  In the table below, we outline the 11 schools owned by COCO, which we think could have a cohort default rate in excess of 25% in FY08.  Our cutoff was any school with a  FY07 cohort  default rate of 18%.  It is important to note that for Title IV eligibility purposes one school can capture more than one campus.  For example, COCO’s Everest College in Gardena, CA has one other campus whose default rate data is included in the calculation.  In the table below we identify those schools that are main campuses for other COCO locations with the number of branches in parenthesis.  The eleven schools we have identified as possibly troubled represent 26 total campuses out of 106 company-wide.

Source: Company Reports

We think investors should start to brush up on what transpired in the for-profit education sector in the early to mid 1990’s to try to understand the worst case scenario. At that time, 6 schools that eventually became part of COCO lost their eligibilty to Title IV loan programs.  Those schools did not re-obtain Title IV eligiblity until the year 2000.  We think the companies are generally better run and have more sophisticated collection and regulatory compliance practices than they did in the 1990’s.  However, the student debt burdens are higher and the economy is in much worse shape.  This suggests that cohort default rates for some schools could eclipse the levels witnessed in the early 1990’s.  We think we are on the brink of entering a period of intense regulatory scrutiny for the for-profit postsecondary education sector. 

Adding COCO to Our List of Short Recommendations

For a few months we have recommend that investors sell or short ESI, we are now adding COCO to our list of short recommendations.  We think companies with higher priced degree programs and consequently high levels of bad-debt expense and cohort default rates will fare the worse in a shakeout in the group.  As we have discussed in the context of ESI, we think the easiest way for COCO to diminish its regulatory risks and rebalance the return on educational investment equation for its students would be to cut tuition.  Surging default rates could become the impetus for regulators to take a closer look at tuition policies among for-profit postsecondary education providers.  COCO shares currently trade at approximately 16x FY10 EPS estimates, on the surface the stock does not appear to be egregiously expensive.  However, we know that COCO’s earnings have been highly counter-cyclical.  We do not expect the job market to improve substantially anytime soon, but that doesn’t mean that the company won’t face fundamental head winds in the next 12-months such as slower lead flow and higher advertising costs in addition to increased regulatory scrutiny.   We think downside to COCO shares is in the $14-$15 range, which would imply a return of 20%+ from current levels.

As always, please act accordingly…