Description

I recommend a short position in ITT Educational Services (ESI) due to its unsustainable business model. ITT Educational Services charges too high of a price to its students for its degree (weighted average tuition cost of $51,000 over 2 years), which in turn yields a very poor return on investment of under 7%. Since the end of 1996, ESI has raised its tuition by 126.4% while the the average student's starting salary has only increased by 66.2% over that same time-frame. However, up until recently ESI did not take on the risk of its students not getting their money's worth and in turn not being able to pay off their loans. Given this I believe ESI's reported EPS is dramatically overstated given its less than conservative allowance for doubtful accounts. Over time it is likely that ESI will have to face the music by increasing its allowance, which will lower its EPS causing it to miss consensus estimates and likely result in sending the stock down.

In 2008, the education industry experienced a major fundamental change regarding how it will receive money in the future. The bottom line is that unaffiliated, private education loan companies are going to lend much less because of the increasing loan loss experience coupled with less capital available and a much higher risk premium threshold. For example, Sallie Mae said specifically that it would no longer make private loans to ITT Educational students because of the extremely high default rates it experienced in its portfolio. ESI went from taking no financial risk on its students through 2007 to having to fund 10% of its revenues in 2008. However, ESI only began making loans in Q2'08 so the amount taken on balance sheet going forward could very well be much higher than 10%.

 
In 2008, 73% of ESI's revenues were funded by Title IV Programs by the U.S. government. Unaffiliated, private education loan programs made up 8% of revenues (down from 29% in 2007) while 9% came from other. I have to believe that the private loan companies are likely cherry picking the best students to lend to now. At the same time the "other" segment are grants, scholarships and money from parents. Given the state of the U.S. economy I think that the "other" could decline materially, while private loan programs could be further pressured. Thus my view is that internal student financing will be at least 13% in 2009 and could ultimately be as high as 25%.

In Q1'09 there was a massive balloon in accounts receivables and a further disconnect of what I would call cash EPS (OCF - D&A - stock based comp - provision for doubtful accounts) vs. reported EPS. In 2006, cash EPS/reported EPS was 108.5%, in 2007 it was 86.6%, in 2008 it was 49.4% and in TTM it was 32.8%. ESI's financing of students has ramped up fast and in a material way.

As of Q4'08 ESI reserved 35% of gross A/R. This is likely not conservative enough given the 50% default rates private loan companies had from ESI receivables BEFORE the economy got into really bad shape. In Q4'08 the addition to allowance charged to expenses was $13.8mm while A/R, net actually declined sequentially by $3.5mm. However, in Q1'09 A/R, net ballooned from $29.8mm to $51.5mm while the addition to allowance charged to expenses was just $14.2mm-up a miniscule $0.4mm vs. A/R, net increasing $21.7mm. It appears that ESI is not being conservative in their addition to allowances charged to expenses and as a result the allowance is not increasing fast enough which is likely why A/R, net is ballooning-thus allowing ESI the ability to report it's phenomenal EPS growth.

Q1'09 revenues grew 2.9% vs. Q4'08. If we were to grow A/R, net the same amount then A/R, net would be $30.7mm instead of $51.5mm. Thus this would translate into an additional allowance charged to expenses of $20.8mm. If this was the case EPS would have been $1.26 instead of $1.59. Instead of reporting an "EPS beat of $0.18" it would have been an EPS miss of $0.15. EPS growth would have still been a respectable 16.5% YoY instead of the reported 47.2% growth. Clearly, the market recognizes to a certain extent what is going on here given that it "beat EPS by $0.18 and guided FY'09 EPS above consensus" while the stock was down on a day where the S&P was up 1%. Clearly, we won't know the timing as to when we'll really get paid on ESI, but this short is shaping up to be a great one down the road.

However, in order to get really paid on this, prospective students need to wake up to the fact that they're getting a relatively worse return on their investment vs. traditional schools. Also, specifically as it relates to ESI it would help if the government looks at the schools with the highest default rates and steps in to prevent those schools from enjoying the unintended consequences of the government's motive to provide an education to those who want it. ESI's FFEL/FDL cohort default rate increased from a range of 5.5%-12.9% in 2007 to 9.7%-15.3% in 2008. The low-end of ESI's default rate had ranged from 2.1% to 5.9% from 2001 - 2007, but spiked dramatically to 9.7% in 2008. At the same time ESI's student persistence rates are dropping--down from 78.0% in Q1'07 to 76.1% in Q1'08 to 75.3% in Q1'09. Given Obama's willingness to go after companies that appear to take advantage of the consumer (i.e. credit card companies), there is a good chance this industry is looked at down the road. If so, ESI would be a prime target.

While 80% of ESI's student body receives a degree in IT, drafting and design, the problem is in this economy there is simply less demand for those services. On one hand one could make the argument that ESI provides a comparatively more valuable degree than much of its competition, but the price is much higher and in times like this the risk of getting a return on such a highly priced degree has increased dramatically.

Investors have found educational stocks as a safe haven to hide in during this tough market. The education industry is one of the few areas of the economy that is experiencing revenue and earnings growth for the obvious reason that unemployed people will take advantage of the government's loan to get an education. The question is at the end of the day what kind of return will one get on that education. Each educational company provides a different value proposition based on degree and the price one pays for that degree.

 
Downside (base case): Assume that 13% of ESI's 2009E revenues of $1.25 billion must be financed internally and that the default rate is 50% versus the company's allowance for doubtful accounts of 35%. This would translate into EPS of $5.44 vs. the consensus estimate of $7.16. Applying a 12x P/E multiple would result in a ~$65 price or about a 35% decline from current price levels. While there should be future revenue growth I believe that it will not translate into much EPS growth given an increasing amount of its revenues will be financed internally accompanied by a very high default rate.

Catalyst

ESI has to increase its allowance for doubtful accounts, which thereby lowers EPS and misses consensus estimates.

Prospective students wake up to the fact that they are better off getting an education from a traditional, non-profit college, which would slow enrollment growth at ESI's schools and result in lower EPS.

The Obama administration takes a look at the for-profit education industry to see what companies, if any, are not providing value to its students/our society. This could result in the U.S. government reducing funding to certain companies, which would in turn reduce their profitability. ESI would be a prime target under this scenario.