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Lessons Not Learned at ITT Educational Services

ITT Educational Services reported that new student enrollment increased 27.2 percent to 27,738 in its third quarter. With private sector lending still in decline, the for-profit educator is increasingly funding growth through an internal loan program. Despite more lending to sub-prime enrollees, few industry watchers seem concerned that the emperor is wearing no clothes.

Growth metrics looked impressive at quarter ended September 30:

  • Total revenue per student increased 4.5 percent to $4,852 per student, helped by a five percent hike in tuition fees implemented in March 2009. Looking to 2010, management expects to raise tuition another 4 - 5 percent.
  • The third quarter operating margin improved 437 basis points to 36.1 percent, or $122.7 million, helped by lower advertising rates and more effective lead conversion rates (into enrolled students).
"A great deal of intelligence can be invested in ignorance when the need for illusion is deep, " said the great 20th Century writer Saul Bellow. With a 10 percent unemployment rate in this country, the for-profit education industry is a playground for those in need of dreams. Do not be mislead by ITT's numbers, as the trail of money starts and ends back at ITT itself. Federal loan programs are falling short, so the company is dipping into its own coffers to help students cover this widening tuition gap. Up to 65 percent of its students need private lending, and analysts estimate that $100 million to $120 million in loans and scholarship assistance will need to come from ITT's internal lending program.

Per risk sharing arrangements with third-party lenders, ITT also guarantees repayment of student loans, collateralized with company funds. At September 30, $52 million in student borrowings was outstanding.

If a student does not have a high school diploma or recognized equivalent, such as a GED, she can still qualify for Title IV student financial aid programs if she demonstrates the ability to benefit from the training being offered: eligibility is based on successfully passing a federally approved ability-to-benefit (ATB) test. The company admitted on its conference call with analysts that none of its students have historically qualified for federal aid through ATB testing!

Common sense dictates that students who cannot pass an ATB test -- and lower wage earners -- would be more likely to withdraw from school and default on their loans. Yet, ITT claims its persistence rate (continued enrollment) climbed 110 basis points in the quarter to 73.6 percent. (The company does not disclose how many enrolled students fall into these categories.)

When during the semester a student drops out and how much of federal aid is left on the balance sheet -- and for how long -- has been the subject of many a shareholder lawsuit and SEC investigation. For example, rival Apollo Group, the for-profit owner of The University of Phoenix, blithely dropped a comment deep in its Form 8-K regulatory filing for results of operations for its year-ended August 2009 that the SEC had commenced "an informal inquiry into the Company's revenue recognition practices."

Similarly, it is also tough to get a handle on the true health of ITT's balance sheet, as management has historically given out little information on the size or 'quality' of loans made from its internal lending program. What ITT did say in its third-quarter quarterly filing with the SEC is that bad debt increased 180 basis points in the quarter to 6.8 percent. What is telling, too, is that expected charge offs from defaults increased in the first nine-months of 2009 to $56 million, up from $29.4 million last year. In my opinion, the school's default rate is likely much higher -- I stress, however, that it's just my own opinion. The company, nonetheless, has most Wall Street analysts 'gaga' over its guidance of $235 million in free cash flow for 2009 -- more than enough to cover pledges on internal and third-party student defaults.

Why no one seems to care what really makes ITT's balance sheet tick is probably a consequence of those that are mostly affected: a reported 79,200 students on 113 campuses are pursuing their dreams of learning a new trade or graduating with a higher degree to get better jobs and higher salaries after graduation. Sadly, unemployed and low-income laborers who go back to school with such dreams soon find out that the average starting salary for newly employed 2008 ITT graduates as of April 30, 2009 was $32,800 -- probably less than one-half of what they will end up owing in tuition loans. Tough lessons to learn.

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