ESI reports 3Q09 earnings and fall term enrollments Thursday morning.  In general, we have discussedat great length our concerns about what we view as structural issues with the company’s tuition policies and the return on educational investment students now receive.  We think this will eventually cause the company to reduce tuition, which could severely alter the company’s earnings growth prospects.  In the near term, we think it will be increasingly difficult for ESI to deliver the type of earnings upside the company has generated over the past several quarters. The bar has been raised considerably and street estimates no longer seem like a “layup”.

Thoughts on 3Q09 and Fall Term Enrollments – Can Lower Lead Costs and Campus Level Efficiencies Offset Higher Bad-Debt Expense?

We currently forecast revenues of $337 million and EPS of $1.97, which is more or less inline with consensus of $335 million and $1.97.  Here are some of the key assumptions in our estimates:

• A 5% YOY increase in revenue per-student (ESI is on track to generate revenue-per-student of $19,100 in FY09)
• Gross margin of 65.1%, flat sequentially but up 250 bps YOY
• SS&A expense of 28.5% as a percentage of revenue.  Excluding bad-debt expense we forecast SS&A spending to increase 13.0 % YOY, but decline 380 bps as a % of revenue
• Bad-debt expense of 6.5% as a % of revenue

For the fall term enrollment intake, we expect new student start growth of 25.0% to 27, 300 students, which will include the contribution of Daniel Webster College. We anticipate management could tighten the range of its annual EPS guidance from a range of $7.55-$7.85 to something along the lines of $7.70-$7.85 based on solid 3Q09 results and a strong enrollment intake. 

Bad-Debt Expense Should Increase Based on Reduce Private Loan Funding, So Should Notes Receivable, Sizing Up CU Connect

 ESI’s “margin for error” is growing increasingly tight due to the company’s rapidly increasing bad-debt expense.  As a reminder, in the for-profit education sector bad-debt expense is largely a function of a company’s ability to secure federal or private student financing for its students.   Bad-debt expense has been ratcheting up due to an ever-widening tuition gap between government student loan limits and a dearth of private student loan options for students enrolled at many for-profit education institutions.  In the case of ESI, we expect bad-debt expense to increase 150 bps as a percentage of revenue from 2Q09 levels.  We have heard from industry sources that JPMorgancut back funding for its Chase Select Private Loan Program to for-profit educational institutions, including ESI at some point in the second quarter.  The Chase Select Private Loan Progam is one of two private lending relationships ESI features in its student catalogs.  Student CU Connect is the other.  The chart below outlines JPMorgan’s student loan origination volume over the past 7-quarters. Clearly the company has cut back funding to the student loan market considerably. Overall originations for the third quarter were down 42% YOY to $1.5 billion.  JPMorgan does not disclose origination volumes between FFEL and private student loans.

Source: JPMorgan

 ESI’s other significant private student loan relationship is with Student CU Connect, a consortium of seven credit unions that provide private student loans for ITT Tech students. Student CU Connect was launched in March of this year.  In addition to providing traditional private student loans to ITT Tech students, Student CU Connect has also borrowed money from ESI directly to provide loans for ESI students.  During the second quarter, ESI lent Student CU Connect $13.9 million.  We wanted to take a closer look at the members of Student CU Connect to see if the lending consortium could help reduce ESI’s need to use its own balance sheet to fund student tuition.  As the table below demonstrates, the credit unions that comprise Student CU Connect are relatively small and have little experience in student loans. 

Source: Credit Union Annual Reports

In 2006, private student loans (primarily Sallie Mae) represented 34% of ESI’s revenues. We do not think that Student CU Connect will become anything greater than 5-7% of total revenues for ESI (including what ESI lends to Student CU Connect).  This leaves a sizeable gap for ESI to finance on its own which will likely lead to higher bad-debt expense levels for the foreseeable future.

Sallie Mae Non-Traditional Loan Charge-Offs Continue to Spike Higher, Delinquencies Appear To Be Stabilizing – Will ESI Recognize Any Charges for Contingent Liabilities From Its Sallie Mae Program?

 We have discussed the importance of Sallie Mae’s non-traditional loan portfolio performance in the past.  Sallie Mae became an increasingly important lender to ITT Tech students from 2005-2007.  SLM has not disclosed exactly what the non-traditional loan portfolio is composed of, but suffice to say loans to students attending for-profit higher education institutions are a big part of the book.  We are surprised that Sallie Mae’s non-traditional loan portfolio performance has not become a more closely watched data point for investors in the space. The company reported results last night, here are some of the highlights about the performance of the company’s non-traditional loan portfolio:

• The percentage of loans that were more than 90 days delinquent DECREASED from 20.6% in the second quarter to 17.8% in the third quarter. A year ago 90-day+ delinquencies were 11.9%.   SLM management stated that it thinks delinquency trends may have finally reached a peak.
• Charge-offs JUMPED from 24.0% in 2Q09 to 28.5% in 3Q09! Charge-offs were 10.0% a year ago.
• Sallie Mae still had allowances of 32.9% for losses in loans that were in repayment in its non-traditional loan portfolio

In our opinion, the charge-off data for SLM’s non-traditonal loan portfolio is the best proxy for REAL default rates in the for-profit education sector, not the cohort default rate.  The loans Sallie Mae originated for students attending ITT Tech have recourse beyond specific default levels. Neither ESI, nor SLM have ever disclosed the default threshold.  Based on the progression of charge-offs we wonder if ESI will take any charges in the next few quarters for defaults associated with its recourse lending relationship with SLM.

Backing Into FY10 Consensus – Margins Don’t Grow to the Sky Do They?

ESI will not provide FY10 guidance until it reports 4Q09 results in all likelihood.  We thought it might be interesting to try to “back into” what current consensus implies for enrollment growth, revenue growth, and operating margins.  Current consensus revenues for FY10 for revenues and EPS are $1.55 billion and $9.25, here is our best guess for the underlying assumptions:

• Total enrollment growth of 15.0% YOY
• Revenue per-student gains of 3.0% YOY
• Gross margin expansion of 60 bps YOY to 66.0% as  a percentage of revenue
• Bad-debt expense of 6.5% as a percentage of revenue
• Flat SS&A spending as a percentage of revenue excluding bad-debt (22.2%)

We think enrollment growth expectations could be particularly difficult to achieve given the difficult comps the company will face throughout the year and the likelihood that student demand will decline as the economy stabilizes.  As difficult as enrollment expectations might be to achieve, we actually think the company could have the most difficulty sustaining current operating margins.

ESI’s Operating Margin Miracle – Time for Mean Reversion

Assuming ESI achieves something close to consensus estimates in the next two quarters, operating margins will eclipse 37% for the full year in 2009.  Considering the company had 24.3% operating margins in 2006, this is truly an amazing achievement. So how has ESI delivered such strong margin expansion? First let’s examine trends in the cost of goods sold.  One of the most compelling financial aspects of the higher education business model is the profitability of students added to an existing class or campus.  Incremental margins on students added to an existing class or campus are extraordinarily high, maybe as high as 80-90%.  In periods of strong demand gross margins can expand rapidly. For the past 10 quarters ESI has generated incremental operating margins in excess of 50% in large part due to leverage on the cost of goods sold.  There is something else at play here.  Over the past 12-years, ESI’s cost of goods sold per student has actually DECLINED.  The compound annual growth rate from 1997 to 2009 is -0.2%.  This compares to a 4.2% CAGR for revenue per student over the same time period.

Source: Company reports, PAA Research

Think about it: in 1997 ESI’s cost of good sold per student was $7,064 and this year the company is on track to spend $7,005.  There’s no question that the company has benefited from the transition of a 3-day a week in class schedule to a “2+1″ format (2-days in class, 1 day online) and even a “1+2″ format (1 day in class, 2 days online).  The company should be applauded for its efficiency. However, one has to wonder how sustainable this is.  Based strictly on this metric, it would appear ESI’s investment in its students lags peers even if it has wrung every last drop of efficiency out of online delivery models.  It seems that it’s more likely that COGS/student could revert towards mean levels of $8,000-$8,500 in the next few years, which would meaningfully reduce gross margins.

ESI’s recent improvements in SS&A spending as a percentage of revenue are equally impressive and in our view, even more likely to revert to historical means.  On the surface, SS&A spending appears to be inline with historical averages.  Based on our estimates we forecast SS&A expense will represent 28.1.% as a percentage of revenue in FY09.  This compares to 29.9% for 2008, 28.2% for 2004, and 27.5% for 1999.  We think the simple calculation of SS&A expense as a percentage of revenue masks a bigger trend.  We prefer to look at SS&A expense excluding bad-debt expense.  Over the past decade SS&A excluding bad-debt expense remained in a general range of 25-28% as a percentage of revenue.  However, this year the company is on track for SS&A expense excluding bad-debt expense of 22.2%.  Remarkable.

Source: Company Reports, PAA Research

Clearly the company has been the direct beneficiary of the collapse in advertising rates during this downturn.  The company has been able to purchase huge amounts of remnant inventory on cable networks, which has kept SS&A expenses low despite the company’s ongoing investment in enrollment counselors and new campuses.  There are growing signs that advertising rates have stabilized if not started to improve.  We anticipate higher lead costs will become a meaningful headwind for ESI’s operating margins in 2010, which is not factored into consensus at all.  Overall, mean reversion in SS&A costs excluding bad-debt expense to the lower end of the range over the past decade would negatively impact EPS by more than $1.00 relative to consensus.

We have argued for sometime that ESI’s tuition policies are unsustainable given that it has reduced, if not eliminated the student’s return on educational investment. We expect the company to incur greater regulatory scrutiny due to higher cohort default rates and increasing former student dissatisfaction.  Based on our review of consensus expectations for FY10 we are even more confident that FY09 will prove to be a peak earnings year for ESI.  We continue to see meaningful downside to shares as regulatory concerns mount and spending levels revert to historical means.  We will see if the company’s third quarter results start to expose some of these issues.

As always, please act accordingly….