Value Trap: For-Profit Education

James Chanos
Kynikos Associates

VALUEx Vail 2011

June 16, 2011
Short Selling is:

• Essential

• Not the opposite of going long

• A large alpha-creating strategy

• Important to theoretical finance

• Non-regulatory “watchdog” functions

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Short Selling: Some Recurring Themes

• Booms that go “bust”

• Consumer fads

• Technological obsolescence

• Structurally-flawed accounting

• Selling $1.00 for $2.00

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The Value Trap

• Stock looks “cheap”

– Low P/E multiple
– Cash flow generation at the moment

• Business fundamentals in decline

– “E” under constant pressure
– Deteriorating free cash flow

• Structural issues
– Competition / obsolescence
– Regulatory changes

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For-Profit Education : Classic Value Trap

• Stocks trading at “cheap” valuations

– Forward P/E multiples range from 4.6x to 14.2x1
– Trading at large discounts to 5 year average forward P/E multiples (11.1x - 27.8x1)
– Returns on assets comparable to best companies (Google, Microsoft, Coca-Cola, Apple)
• Free cash flow continues… for now
– Cash conversion rate over 100% (FCF / Net Income)
– Overall enrollment still growing
• “All the bad news is out”
– Legislative scrutiny losing steam due to 2010 elections
– Regulatory rule “events” have occurred

Note: Based on Bloomberg estimates for APOL, BPI, CECO, COCO, DV, EDMC, ESI, STRA.

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For-Profit Education: Are They Really “Cheap”?

• Structural earnings issues - new Program Integrity Rules

– Incentive compensation
– State authorization
– Misrepresentation accountability

• Revenue pressure going forward

– Product sold not bought
– Aggressive compensation for student growth no longer allowed
– Total enrollment growth masks increasing slowdown in new student growth
– Traditionally high churn rates increase pressure to maintain enrollment
• Earnings leverage works both ways
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Free Cash Flow Generation is a Fallacy

• Businesses funded by government largess

– Over 80% of revenues from federal government programs
– Asymmetry of risk for the federal government
– Risk is born by the taxpayer and the student (debt is not dischargeable)
• Timing of cash flow is a key element of free cash flow illusion
– Title IV rules allow cash draws in advance of students attending class
– Negative working capital model reverses benefit when growth turns negative
• Bill for high cost education comes due later
– Median debt levels of for-profit students far exceed debt levels for students in
other sectors

– Disproportionate defaults come from the for-profit sector

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Title IV Funding: Well Drying Up?

• Temporary exceptions to 90/10 rules set to expire

– $2,000 Stafford Loan exception expires in July 2011
– Private student lending will no longer benefit 90/10 as of July 2012
• Accreditor scrutiny is intensifying
– The Higher Learning Commission (“HLC”) is the regional accreditor for most for-profits
– Head of HLC called to testify before Congress twice in the last two years
– Department of Education continues to scrutinize the role of accreditors
– HLC is tightening its standards – Bridgepoint Education forced to seek accreditation
elsewhere
• Manage statistics to lower Cohort Default Rates (“CDRs”)
– “Default management” servicers push students into deferment or forbearance to lower CDRs
– Big jump from 2-year to 3-year CDRs suggest that default rates are heavily managed
– Provisioning rates on private loans indicative of future risk for students
• Military enrollments are being used to comply with 90/10
– Department of Defense (“DoD”) education funds count towards 10% in 90/10
– Recent hearings in the Senate regarding DoD funding for-profit education
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Gainful Employment: Holding For-Profit Education
Accountable

• Less stringent than the proposed rule, but still has teeth

• Students must maintain at least one of three metrics

– 35% Repayment rate,
– 30% Debt-to-discretionary income ratio,
– 12% Debt-to-total earnings

• The Department of Education estimates that 18% of for-profit programs will fail the
Gainful Employment test at least once in the next three years

• Fewer loopholes than appear on the surface

– Benefit from interest only loans limited to 3% of program total
– Real income data will be used to calculate earnings

• Schools required to disclose failure to comply with Gainful Employment

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Adaptability of For-Profit Education: Marketing is the
Model

• Marketing (not education) is the

real core competency

• Educational outcomes
questionable
– High churn model produces poor
graduation outcomes

– Focus on growth worsens

prospects for graduates due to
increased competition in their
chosen field

• High cost relative to other forms

of postsecondary education

• Can the value proposition really

be changed?

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ITT Educational Services (ESI): Prime Example of For-
Profit Education Value Trap
• Looks “cheap” at first glance
– Forward P/E 7.8x1
– EBIT margins over 35%
– Cash conversion over 140% (FCF/Net Income)
• Structural earnings issues
– ITT’s programs are considered expensive even in the for-profit universe
– New student growth has been negative for two consecutive quarters
• PEAKS Private Student Loan Program raises questions and enhances free cash flow
– PEAKS is an off balance sheet entity used to finance student debt
– ITT guarantees performance of the underlying PEAKS debt, yet does not consolidate it on its
balance sheet
– PEAKS reserve rate appears to be substantially below historical default rates in the industry
• Regulatory pressure is increasing
– 2009 2-year Cohort Default Rate doubled year over year
– Securities and Exchange Commission has inquired about PEAKS

Note: Based on Bloomberg estimates.

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 Thank You
VALUEx Vail 2011

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