ESI reported 4Q09 results this morning. You can read the full press release here. Overall we would characterize the results as a solid beat relative to consensus.  Here are the quick highlights:

• Revenues of $374.4 million vs. consensus of $370.6 million (we had forecast $378 million)
• Gross margin of 67.6% increased an astounding 400 bps YOY.  Clearly the company has benefited from an increase in the average number of students per class.  The total number of enrollments per campus for the winter term increased to 721 from 585 a year ago. Incremental margins are the single most compelling element of the for-profit postsecondary education business model.
• ESI’s total educational spend per student (as measured by COGS/average enrollment) declined 3.6% YOY to $6,740, a record low for the company.
• Bad-debt expense as a percentage of revenue increased to 6.9% from 6.8% in 3Q09 and 4.9% in 4Q08
• SS&A expense excluding bad-debt expense as a percentage of revenue declined 3.2%, but on a nominal basis increased 19.2%  YOY. We expect SS&A expense excluding bad-debt expense to increase 20-25% YOY in 2010 due to higher marketing costs.

Winter Term Enrollment Intake – Demand Remains Robust

ESI generated new student start growth of 31.2% YOY against a 29.2% comp in the prior year. Very impressive.  Total enrollment increased 30.3%, which was driven in part by an 80 bps improvement in student persistence.  While these enrollment figures are impressive, we have to wonder about the quality of students the company is enrolling. If APOL, the unequivocal leader in this space has started to “cull the herd” a bit in terms of the types of students the company enrolls, we have to wonder why ESI isn’t following suit.  Based on the cost of ESI’s educational programs and the low return on educational investment, we think this could manifest itself in structurally higher default rates down the line.

ESI’s 2010 Guidance Looks Impressive, but the Delta Relative to Consensus Appears To Be Entirely Predicated on Bad-Debt Expense Improvement

ESI provide initial 2010 guidance for EPS of $10.00-$10.50/share.  This  compares to consensus heading in the quarter of $9.49.  When you factor in the enrollment upside delivered for the winter term, it appears the only meaningful difference between management’s initial guidance and current 2010 consensus EPS is bad-debt expense.  The company has guided to bad-debt expense of 4-6% as a percentage of revenue. We think that most analysts were assuming bad-debt expense for 2010 would be closer to 6.5-7.0% for the full year, perhaps slightly higher.  As a result of the company’s new private loan arrangement (and we use that term loosely), ESI will not recognize the same level of bad-debt expense in the SHORT TERM.  We estimate that the shift in bad-debt expense recognition could positively impact ESI’s 2010 EPS by as much as $0.50-$0.80, in short the difference between current consensus and management guidance.

ESI Establishes a “New Private Education Loan Program” For Its Students, Optically It Will Reduce Bad-debt expense, Economically It “Kicks the Can Down the Road”

After the close yesterday, ESI announced that it had signed a “new private education loan program” for its students with an “unaffiliated lender”.  You can read the company’s 8-K filing here.  The program entitled the PEAKS Private Student Loan program will likely become available to ESI’s students as early as the spring term.  Without finding another private loan provider for its students, ESI would be forced to use its own balance sheet to bridge the gap between the high cost of its programs and government student loan limits.  In a shrewd move, the company has created a quasi-structured finance facility that will optically reduce bad-debt expense in the SHORT-TERM, but will NOT decrease the company’s eventual credit exposure to these students.  Here are the highlights of the facility:

• A trust was established that issued $300 million in Senior Debt to a group of investors
• The proceeds of the Senior Debt will effectively be passed through to an unaffiliated lender that will grant loans for ESI’s students
• The loans will be contributed to the trust as collateral against the Senior Debt
• ESI will pay to the trust a portion of the amount of each private student loan disbursed to an ITT Tech student in exchange for Subordinated Notes.  For those familiar with structured finance parlance, this can be viewed as a form of overcollaterilization.
• ESI will be the guarantor for all of the Senior Debt incurred by the Trust.

The chart below depicts the structure of the new private student loan arrangement and the flow of funds:

Source: Company reports, PAA Research

Overall, we would hardly characterize this deal as a “new private loan” arrangement.  Here are some key observations about the new private loan arrangement:

• ESI retains all of the credit risk associated with these private loans.
• This off-balance sheet arrangement significant reduces investor visibility about the company’s true credit exposure.
• ESI has effectively pushed the recognition of credit losses on private loans (previously known as bad-debt expense) out a few years. Based on the typical loss curves witnessed on SLM’s private student loan program, we anticipate the company will need to make payments starting in years 2-4.
• The unaffiliated lender is effectively a “servicer”, originating and we’re assuming servicing loans but actually has no credit exposure
• We view the payments ESI will make to the Trust in exchange for Subordinated Notes for every loan issued to an ITT Tech as a form of “overcollaterilization”.  It’s unclear how ESI will account for the value of those subordinated notes, which could be viewed as the mezzanine tranche in a traditional ABS facility. 

Here are the questions we would like answered on the conference call about the company’s new loan arrangement:

• Is this the best ESI could do? For almost 6-9 months now, the company has “teased” that it was on the cusp of signing an arrangement with a new lender that would provide private student loans for the company’s students.  Although this can be called a private student loan arrangement, in effect it has enabled ESI to delay bad-debt expense recognition and push receivables off its balance sheet. We have to give management credit, its a savvy move.  However, we think investors will look through this.  Additionally, what type of statement does this make about lender appetite to take on credit exposure to ESI’s students?  Not a very good one, in our opinion.
• How quickly will the $300 million be disbursed to students?  This will impact the company’s bad-debt expense directly.
• What will the cost of these loans be for students?
• What percentage of total loan amount will ESI fund into the trust in exchange for Subordinated Notes (the overcollaterilization)?
• Will the company recognize gross revenues on the tuition received through this private student loan program? An argument can be made that the company should report net revenues on that portion of tuition revenues that will be offset by payments on behalf of the company into the trust.
• When does the company anticipate it could recognize losses on the portfolio?  As we mentioned earlier, we think within 2-4 years is a reasonable time  frame.
• How will the company mark the subordinated notes on its balance sheet going forward?
• Will investors be able to obtain loan performance data for the PEAKS trust?

We recognize ESI shares will likely rally today in response to solid 4Q09 results and initial investor enthusiasm about the implications of the company’s “new private student loan arrangement”.  However, we think the company’s inability to find a “real’ private loan arrangement is a damning statement on lender appetite to take on credit exposure to the typical ESI student. We would argue the new private loan arrangement reduces investor visibility without any commensurate decline in credit exposure for the company.  Overall, we view this as a yet another sign that the company is straining under the weight of its tuition policies and the low returns on educational investment for its students.  Based on recent proposals from the Dept. of Education, it appears that regulators are increasingly likely to focus on affordability and return on educational investment.  We think ESI will eventually need to drastically cut tuition in order to restore the return on educational investment for its students.  We would use any strength in the stock today as an opportunity to sell.

As always, please act accordingly….