ITT Educational Services, Inc. (NYSE:ESI)

TMF10KChallenge (< 20) Submitted: 4/23/2010 12:23:35 PM : Start Price: $110.30 ESI Score: -112.92

Education Stocks Overview
Negative Sentiment Towards the industry
Most for-profit education companies rely substantially on federal financial aid programs for funding their student’s tuition payments, which subjects the companies to regulation by the Department of Education (“ED”) pursuant to the Higher Education Act (HEA) of 1965). Under the HEA, regulatory authority is divided among each of the following components:
A)   The federal government, which acts through the ED;
B)   The accrediting agencies recognized by the ED;
C)   State higher education regulatory bodies.
Currently, the market has really punished this heavily regulated industry because of the concern for potential legislation over the following issues:
1)   Cohort default rates and Title IV funding
2)   the “ability to benefit” issue
3)   internal lending
4)   potential restrictions on marketing practices
5)   the general value proposition offered by for-profit education companies
It is my belief that the education stocks have been beaten down too hard, which has created significant investing opportunities.
1)   Cohort Default Rates and Title IV Funding
A significant requirement imposed by Congress is a limitation on participation in the Title IV Programs by institutions whose former students defaulted on the repayment of federally guaranteed or funded student loans at an “excessive” rate (so-called “Cohort Default Rates” or “CDR”).
Currently, an institution’s CDR is calculated on an annual basis as the rate at which student borrowers scheduled to begin repayment on their loans in one federal fiscal year default on those loans by the end of the next federal fiscal year. Any school whose 2-year CDR (the CDR for the two years post commencement of scheduled repayment) equals or exceeds 25% for three consecutive years may lose eligibility to participate in federal grant programs. In addition, if an institution has a CDR for any federal fiscal year that exceeds 40% , it may have its eligibility to participate in the federal programs limited, suspended, or terminated.
In addition, schools cannot have over 90% of their revenue come from Title IV funding for two consecutive years (90-10 rule). This number is obviously different for every school, but I haven’t seen any of the for-profit schools have a problem with this, and there are steps they could take to prevent this from happening as well (as mentioned below).
However, changes have recently been made to this regulation.
Beginning with the fiscal 2009 cohort, the 2-year CDR metric will change to three years, and the 25% threshold will increase to 30%. Thus, the first year that this revised CDR test will be measured officially is 2012, and the first year it could result in sanctions would be 2014. This change is important because default rates increase with time, and CDRs are expected to be higher after three years than two years.
The ED recently released to schools its illustrative calculation of historical 3-year CDRs for fiscal 2007, and many for profit schools were hovering at or above the 30% threshold. This has made investors very uncomfortable because most of these schools have over 80% of their revenue from Title IV funding, and if they cannot take care of this CDR issue, that funding could be restricted. However, is the panic sell-off really warranted?
Let’s put them in context. First, realize that the for-profit schools have been trying to manage their two-year CDR’s because that has been the standard, so the 2007 3-year CDR data that the ED released was not managed at all. These schools still have ample time to refocus their efforts on default mitigation to include three years instead of two. They are well aware of the 3-year CDR issue and are taking steps to address it such as enhanced entrance/exit counseling, an internal department focused on early stage delinquencies, and use of external resources to inform borrowers of alternatives to default. Finally, there is a huge amount of runway to address these issues before any sanctions would be imposed (2014 at the earliest), and even then there is an appeal process the schools could pursue before being subject to sanctions. The absolute worst case for these schools (which the market is overlooking) is that these for-profit schools slow enrollment to obtain a better mix of financially sound students that are less likely to default. These sort of steps would also help them manage their Title IV funding. Therefore, while the CDR and Title IX regulations should be closely watched, they are not a disaster for any of these schools, and I believe the market is overreacting.
2)   “Ability to Benefit” Regulations
Although the CDR issue is clearly the most troubling one for the market, a secondary issue concerns the so-called “Ability to Benefit Regulations” (“ATB”). Under certain circumstances, an institution may elect to admit non-high school graduates into certain of its programs of study. In such instances, the institution must demonstrate that the student has the “ability to benefit” from the program of study with such a determination based on the student’s achievement of a minimum score on a test approved by the ED and independently administered in accordance with ED regulations. In addition to the testing requirements, the ED regulations prohibit enrollment of ATB students from constituting 50% or more of the total enrollment of the institution. ATB students currently represents about 15-25% of most for-profit schools. There have been some concerns that the ED will toughen the rules, and this uncertainty has hurt the sector.
3)   Internal Lending
Many schools such as ITT and COCO have recently begun underwriting student loans to replace Sallie Mae and other 3rd party lenders that have exited the business due to high default rates, particularly amongst sub-prime borrowers. However, as the company seeks to address CDR issues, the default rates on internal lending should improve.
4)   Illegal Marketing
Another other issue that has been raised with respect to the industry and other players such as APOL and ESI involve marketing practices and the general value proposition offered by for-profit education. APOL in particular is receiving considerable scrutiny of its allegedly aggressive marketing practices. Investors are concerned that any such constraints on marketing will tend to slow growth. This is a generalized concern that I believe has been overblown, but only time will tell what constraints emerge and what impact (if any) they have on the ability to recruit new students. Although the market has taken this uncertainty to be a risk, I do not think this is as big a deal as it is made out to be because it is very hard to prove this case against the schools. Apollo is definitely under the most scrutiny for this issue, but I think it is all priced into the stock by now.
5)   Value Proposition
The final issue raised about the industry is a generalized view that it does not offer a value proposition and thus is doomed to failure. The reality is that for-profit education serves an essential need in a knowledge economy, a need that is only bound to grow given the extraordinary constraints and associated cutbacks facing publicly funded education. Moreover, private non-profit institutions continue to offer a massive price umbrella for the for-profit education industry. I am sure that there are cases in for-profit education where students are ill-served from a strictly ROI perspective, but the same is certainly true for many of the extremely expensive educations offered at private colleges.
The reality is that for-profit education is a large, established business that employs lots of people and fills a real need in the market, a need that is likely to grow not diminish. This is not to say there haven’t been abuses in the industry, there have, but the government has shown absolutely no willingness to issue a “death sentence” for any of these institutions. The penalties for past instances of wrongdoing have been relatively mild. In addition, the politics of cutting education funding for disadvantaged students just aren’t appealing, particularly during challenging economic times. For this reason, I think that the negative sentiments have already been priced into the education stocks, and that many of them (trading at 5-8X EBITDA) provide compelling opportunities for long-term investors today.
Conclusion:
While there is considerable regulatory risk for these companies, they have already been priced into the stocks. There are many ways to play this sector, but they all look cheap given the fixed costs of traditional universities. Strayer, ITT, Apollo, and COCO look especially attractive at current levels.