Corinthian Colleges

Down roughly 80% since May of 2010, Corinthian Colleges has been one of the best shorts in the market.  As a post-secondary education provider to the most underserved demographic in the higher education space, it's a fact Corinthian faces regulatory challenges.  However, at STOCKPRICE, the short thesis has been exhausted, and I believe the evidence suggests the stock is significantly oversold.  Despite regulatory challenges, I have found an overwhelming amount of evidence to suggest this security is severely mispriced.  The evidence seems to be widely known, but in my research I found the reasoning of most investors familiar with the for-profit space to be polluted by emotion.  Perhaps due to the persistently negative media coverage, many investors I have spoken with consider Corinthian an "ick" stock and a leper of the category-either too hard or too risky to even consider.  I think the company has been left for dead but it has a pulse and I believe it's misunderstood (along with most of this industry).  I think the stock is worth multiples of the current price and in what I consider to be a reasonably conservative scenario I see upside of nearly 50% from today's stock price.  Assuming these stocks eventually trade to more reasonable valuations, I think Corinthian could be at least a two-bagger over the next year or two and in the longer-term, perhaps five years or so, I think Corinthian could trade back to the high teens (current price is sub $4.00). 

Background

Corinthian Colleges is one of the largest entry-level, post-secondary career education companies in the United States and Canada.  Corinthian specializes in diplomas (45%) and associate degrees (50%).  The company serves an underserved and relatively underprivileged segment of the population through three different brand names, Everest, WyoTech, and Heald.  As of March 31, 2011, COCO had 102,450 students, (roughly 24% of which were exclusively online), and operated 106 schools in 26 states and 17 colleges in the province of Ontario, Canada.  Corinthian's top market is California (26 locations or 22% of total) but they also have a significant presence in Canada and Florida where they have 17 and 15 locations, respectively.  Other notable states are Washington and Texas where they have 8 locations each.  (Note: there are significant capacity issues in California, Texas and Florida and this acts as a tailwind for operators like Corinthian).

 Corinthian differentiates themselves from their competitors by specializing in entry-level post-secondary education-diplomas and associate degrees with a focus on programs in Healthcare (52% of program offering).  They offer a practical, career-oriented curriculum that caters to non-traditional students.  A non-traditional student is basically anything other than your typical high school grad matriculating to undergrad with mom and dad footing the bill.  For example, over two thirds of Corinthian's enrollment is female, the average student is over the age of 30, has over one child, a full-time or part-time job, and many are single moms.  Non-traditional students are considered the "worst" demographic to serve because they drop out and default at higher rates.  Additional details on Corinthian's offering and brands follows:

Brands

Wyotech: Mechanical and auto-trading trades.  10% of enrollment.

Everest: Diploma, associate, bachelor and masters programs.  72% of enrollment.

Heald: Diploma, associate, bachelor and masters programs. 18% of enrollment.

Programs

Healthcare: 52%

Criminal Justice: 19%

Business: 14%

Mechanical & Trades: 10%

Other: 5%

Level

Associates: 50%

Diploma: 45%

Bachelors: 4%

Masters: 1%

Corinthian has operated WyoTech and Everest for years and acquired Heald on January 4, 2010 for $395mm.  By virtue of Heald's limited liability ownership structure, Corinthian received a tax "step up" in the assets of Heald Capital LLC and its subsidiaries.  The company estimated the present value of these tax benefits were worth approximately $70mm, implying an effective net purchase price for Heald of $325 million, or 8.5x Heald's projected fiscal 2009 adjusted EBITDA of $38mm.

 Heald is a regionally accredited ground based institution that prepares students for careers in healthcare, business, legal, IT, and other fields, primarily through associate degree programs.  At the time of the acquisition, Heald had roughly 12,900 students enrolled (12% of total COCO enrollment) and operated eleven campuses; nine in California, one in Hawaii, and one in Oregon.  Heald provides Corinthian with a regionally accredited, well-established brand in the underserved west coast market.  Regional accreditation is important because it means the credits students earn are transferable to other institutions. (Note: every college has the right to reject transfer credits but for the most part, nearly every school accepts transfer credits from regionally accredited institutions.)  Everest and WyoTech are fairly well-established brands but are mostly nationally accredited (students can rarely transfer credits.)  In my opinion, the most significantly misunderstood piece of Corinthian's value is their ownership of Heald, so that's where I will start.

Heald

In the press release announcing Corinthian's January 2010 purchase of Heald, Corinthian reported Heald had eleven campuses in Northern California, Oregon and Hawaii and 12,900 students.  Corinthian reported the $325mm adjusted purchase price represented 8.5x Heald's projected fiscal 2009 adjusted EBITDA of $38mm (fiscal yr. end June 30^th) but following the acquisition, management commented that results at Heald had been even better than expected.

Q3 2010 Earnings Call

"Our newly acquired Heald Colleges reported higher-than-expected growth in the quarter."

Q4 2010 Earnings Call

"The (Heald) acquisition has performed even better than expected and we expect to launch Heald's recently accredited online platform for two-year degrees by the end of this calendar year."

"Heald Colleges reported higher-than-expected growth in the fourth quarter."

Based on these comments and conversations I have had with the company, Heald likely earned EBITDA of around $40mm, instead of the expected $38mm.  Assuming Heald earned $40mm in EBITDA in the quarter ended June 30^th, 2010, then Heald was earning roughly $2,589 in EBITDA per student (Heald ended the quarter with 15,447 students).  Since then management has made more comments regarding Heald's better-than-expected results and while management won't quantify it, in conversations with the company, investor relations has confirmed Heald's EBITDA per student has improved since the acquisition.  

Q1 2011 Earnings Call

"Heald is performing well and is ahead of expectations set at the time of the acquisition and we're seeing good growth with the Heald team."

Q2 2011 Earnings Call

"Heald is performing very, very well."

As of the most recent filing, Heald's enrollment has increased to 18,476 students (43% growth since the time of the acquisition and 23% growth yoy).  Meanwhile, enrollment growth at other for-profits has been anything but impressive.  (Note the companies showing positive enrollment are those with primarily online course offerings.  Heald is nearly all ground based.)

Y-o-y enrollment growth at various for-profits as of most recent filings:

Bridgepoint: 34%

Grand Canyon: 9.25%

Capella: 7.3%

Devry: 6%

UTI: 0.5%

Strayer (campus based): 0%

ITT Tech: -0.6%

Strayer (online): -3%

Lincoln: -7.8%

Apollo: -11.6%

In regards to their fundamentals, Heald operates a terrific model.  On page 47 of the 6/30/2010 10-K (Corinthian's fiscal year end is June 30th), Corinthian reported Heald had 15,447 students and revenue at Heald for the six months ending June 30, 2010 was $121mm ($242mm annualized).

In the section marked "Management's Report on Internal Control Over Financial Reporting" on page 91 of the 6/30/2010 10-K, management states the following:

 "As of June 30, 2010 we excluded from our assessment of our effectiveness of the Company's internal control over financial reporting the internal controls of Heald, which was acquired by us on January 4, 2010. Heald is included in the 2010 consolidated financial statements of Corinthian Colleges, Inc. As of June 30, 2010, Heald constituted $89.1 million of total assets and $23.5 million of net assets, excluding intangible assets of $351.0 million. For the year ended June 30, 2010, Heald constituted $121.0 million and $8.1 million of revenue and net income, respectively. We will include the internal controls of Heald in our assessment of the effectiveness of our internal control over financial reporting for fiscal 2011."

These disclosures provide the following details regarding Heald:

Industry Specific Items

Enrollment (6/30/2010):  15,447

Revenue per student (annualized):  $242 / 15,447 = $15,666

Net Income per student (annualized):  $1,048

Balance Sheet

Total Assets:  $89.1mm

Liabilities:  $65.6mm

Equity:  $23.8mm

Income Statement

Annualized Revenue:  $121 * 2 = $242mm

Annualized Net Income:  $8.1 * 2 = $16.2mm

NI margin:  6.7%

Returns

Implied FY2009 ROE: $16.2 / $23.8 = 68.1%

Implied FY2009 ROA:  $16.2 / $89.1 = 18.2%

Obviously Heald has an attractive business model and when you consider their position regarding growth potential and pending regulations, it's clear they should not only survive in a more heavily regulated post-secondary education world, but thrive.

It probably makes sense to address the regulatory risk facing Heald before valuing it, as this is the risk on most investor's minds.  It should be noted there is ample evidence to suggest gainful employment regulations will be watered down, but since all I have to go on is the current proposal, that's the criteria I will measure Heald against (and later Everest and Wyotech). 

Background on Gainful Employment

To qualify for federal aid, Title IV rules require for-profit operators to "prepare students for gainful employment in recognized occupations".  The problem is for-profits were never required to substantiate the claim that they prepare students for gainful employment because "gainful employment" was never defined.  Increasing cohort default rates and the expanding percentage of the Title IV loan program going to for-profit institutions led the Department of Education and Congress to start asking questions.  They wanted to make sure taxpayer money was being well spent and that students weren't being shuffled through diploma mills which ultimately leave students worse off then they were before enrolling (i.e. stuck with the same job, but new student loan debt).  Recognizing the need to define gainful employment, the Dept. of Ed, led by former deputy undersecretary of education Robert Shireman, began a process formally known as a Notice of Proposed Rulemaking (NPRM) to define gainful employment and provide the Dept. with a yardstick to measure schools by.  With gainful employment defined, they could hold schools more accountable for arguably abusing the Title IV loan program.  After a year-long negotiation between the U.S. Dept. of Ed and higher education stakeholders, the Department published a proposal on gainful employment on July 26, 2010. 

Defining gainful employment has arguably been the primary driver of the enormous sell-off in the for-profit education stocks, but I believe if you actually take a careful look at the rules, the effects they will have on COCO are minimal compared to what the current stock price reflects. 

It's quite possible the language in the proposal will change (in fact, there is a pile of evidence that suggests it will be watered down), but in its current form, the Department has drafted rules that would determine the level of access to Title IV aid by classifying each of a schools programs into one of three buckets: (i) full eligibility, (ii) restricted status, or (iii) ineligibility.

Fully eligible programs would have unrestricted access to Title IV aid, meaning they could enroll as many students as they want from the pool of our country's students who rely on Title IV aid to pay for tuition.  To be eligible, a program would have to demonstrate that over 45% of their former students (regardless of completion status) are paying down the principal on their federal loans; OR demonstrate their graduates have a debt-to-earnings ration of less than 20% of discretionary income or 8% of total income (discretionary income is defined as the difference between adjusted gross income and 150% of the federal poverty line corresponding to family size and state of residence).  Debt includes federal and private loans used for the cost of obtaining the diploma or degree and will be based on the median student debt for the three most recent award years prior to the earnings year of students who completed the program.  This includes students who graduated without debt (although according to Mark Kantrowitz of Finaid.org, over 90% of students at for-profits graduate with federal and private student loans so the inclusion of all completers as opposed to just completers with debt will have a minimal impact on the debt to income ratios at for-profits).

Ineligible programs will have less than 35% of their former students paying down the principal on their federal loans; AND their graduate will have a debt-to-earnings ratio above 30% of discretionary income AND 12% of total income.  An ineligible program would be allowed to provide one additional year of aid to enrolled students (provided it warns them about the high debt-to-earnings ratio of other students) but would not be permitted to offer federal student aid to new students.

Restricted programs would be those that are not fully eligible or ineligible.  Restricted programs would be subject to limits on enrollment growth (proposal is average of the last three years enrollment), and the institutions must both demonstrate employer support for the program and warn consumers and current students of high debt levels.

What complicates the rules even more is the method of measuring a students earnings.  Despite the fact their exists nearly irrefutable evidence that attending a post-secondary institution improves lifetime earnings potential, the Dept. of Education, in all it's wisdom, has selected a measurement of gainful employment that considers debt relative to a student's earnings over one of two potential three year payment periods selected by the school.  By default, the measure would use the most current income available of the students who completed the program in the most recent three years (three-year period or 3YP).  In cases where an institution could show the earnings of students in a particular program increase substantially after an initial employment period, the measure would use the most current earnings of students who completed the program four, five, and six years prior to the most recent year (i.e. the prior three-year period or P3YP). 

So those are the rules in a nutshell (how nice of the Department to make the rules so clear!)

If you are scratching your head (like I was), then hopefully you will find the following charts to be helpful. 

Importance of OPE IDs

This is a bit of a side note, but I believe it's worth mentioning.  One important aspect of these rules is that they apply on a (i) program by program basis and (ii) per OPE ID.  During my research I found many in the investment community ignored this.  The OPE ID is an identification number used by the U.S. Department of Education's Office of Postsecondary Education (OPE) to identify schools that have Program Participation Agreements (PPA) so that its students are eligible to participate in Federal Student Financial Assistance programs under Title IV regulations.  The OPE ID is a 6-digit number followed by a 2-digit suffix used to identify branches, additional locations, and other entities that are part of the eligible institution.  Why is this important?  Some for-profits, like Apollo, only have one single OPE ID, while others, like Corinthian, have over 40.  This means if Apollo has a program that doesn't meet gainful employment standards, than they would lose access to Title IV aid at every campus they operate.  If a Criminal Justice program didn't meet gainful employment standards at one of Corinthian's Everest campuses, they would only lose access to Title IV for that particular program, at that particular OPE ID.  Corinthian, by maintaining so many OPE IDs, is arguably much safer than some of their peers who operate under relatively few OPE IDs., or in Apollo's case, a single OPE ID.  Regardless of the number of OPE IDs, it's likely certain programs will be impacted the same way, no matter what part of the country they are in.  So while it's possible having lots of OPE IDs as opposed to few is an advantage, it may not be a big one.  Either way, it differentiates Corinthian, and I think to some extent places them at lower risk.  These gainful employment rules will have an impact on Corinthian, but Heald appears to be safe.

Heald & Regulations - Why Heald Will Survive

Heald serves the same demographic Corinthian's Everest brand serves but due to better default management the school has been able to maintain relatively high repayment rates compared to their peers.  For example, out of 12 Heald campuses, one has a repayment of 58% and seven have repayment rates over 35%.  This means only four Heald campuses will need to demonstrate reasonable debt to income ratios to avoid being deemed ineligible for Title IV funding.   Considering Heald programs are relatively inexpensive (average cost of tuition is about $14-$15k), I estimate students would only have to earn over $12,337 to avoid ineligibility ($17,624 if weighted by placement rate.  I'll explain this below).  To avoid restricted status, students would have to report earnings over $18,506 ($26,437 if weighted by placement rate.  Again, I'll explain this below).

I arrive at these ballpark figures by taking the average program cost of $15,000 and assuming the student pays for 85% of the program with debt, therefore borrowing $12,750.  Based on the 10 year Stafford Loan rate of 6.70%, the student would have to make annual loan payments of roughly $1,480.49.  To avoid program ineligibility the average student would need to earn enough money to make this amount less than 12% of their income (less than 8% to retain total eligibility).  Dividing $1,480.49 by 12% yields an income level of $12,337 and dividing $1,480.49 by 8% yields an income level of $18,506. 

Now obviously these are pretty low annual earnings numbers but there is speculation the department will apply debt-to-income ratios to EVERY student who completes the program and this means the denominator in the debt-to-income ratio could be dragged down by students who don't enter the workforce after graduation.  The Department hasn't addressed this issue but assuming this is the case, then it would make sense to weight these numbers by a placement rate.  On average, about 75% of Corinthian's graduates have historically been placed in jobs after completing their program.  Currently that rate is in the low 70% range (where it tends to bottom-out).  If we weight the required earnings figures by a 70% placement rate, then the income required to pass the 12% and 8% debt-to-income tests jumps to $17,624 and $26,437, respectively. 

While the Dept. has demonstrated an affinity for illogical thinking (ex: Harvard Medical school has a repayment rate of 24.4% and likely wouldn't pass gainful employment criteria.  How can a rule designed to identify quality indicate Harvard Medical is doing a bad job?) I believe it's unlikely these ratios will ultimately be weighted by placement rates.  However, even if they end up being weighted by placement rates, Heald graduates stand a decent chance of making the most stringent debt-to-income measurement even if we assume the average student graduates into the relatively low-paying field of medical assisting  (according to payscale.com, the average medical assistant earns around $25k - $30k).  Also, it's worth mentioning that according to Table 9 in the US Census Bureau's Current Population Survey, 2006 Annual Social and Economic Supplement (includes only individuals who are employed) the mean earnings for someone aged 25-34 who has obtained an Associate's degree was $38,077, well above the threshold needed to make gainful employment cuts.  

So in regards to gainful employment, I think Heald is O.K.  Moving on down the regulatory ladder, the next big item is the cohort default rate (CDR).  On CDRs, Heald is also safe.  For example, in the 2008 academic year, the average CDR at one of Heald's campuses was 9.8%, well below the 40% immediate violation threshold and 25% threshold measured over a three year period (one year over 40% or three years of consecutive breaches at 25% leads to ineligibility).  Furthermore, the Heald OPE ID with the largest CDR was only 15.3%, still a healthy distance from the thresholds (see 10-K for data).

It should be noted the CDR rule has changed and I will provide more detail on this when I discuss Everest, but a good rule of thumb is to multiply the two year CDR by 1.5 or 2x and if the value is below 30%, the school should be fine under the new CDR measurement criteria.  Applying this rule of thumb to Heald shows they only have one campus near the 30% threshold.

After CDR's, the next issue is 90/10.  To remain in compliance with 90/10, each OPE ID must not accept more than 90% of their revenue from Title IV aid.  Heald is also safe on this metric as the average percentage of revenue from Title IV sources in the last reported academic year was 79.63% and no OPE ID exceeded 83.3%.  (http://federalstudentaid.ed.gov/datacenter/proprietary.html).

So after reviewing the regulations, I think it's fairly clear Heald will survive.  Now let me explain why I think they will thrive.

Why Heald Will Thrive

Following the Heald acquisition, Corinthian started reporting enrollment figures and enrollment growth pro-forma, which gave the investment community the opportunity to back into historical enrollment figures at Heald and therefore calculate the historical growth rate at Heald.  If you back into the numbers you will see that in March of 2009, Heald had 10,286 students (based on the data Corinthian has provided, this is the earliest figure you can calculate).  Today, they have nearly 19,000 students and according to management, EBITDA per student has improved at a decent clip.

Perhaps what is most impressive about Heald has been their ability to increase enrollment while so many of their peers are shrinking (ex-online operators, which aren't good comps to Heald).  If we assume Heald can continue to increase enrollment at 3% per quarter and EBITDA per student has only grown by 5% since June 30^th, 2010, than I estimate Heald's run-rate EBITDA will be roughly $58mm in F2012. 

I believe a $58mm EBITDA estimate is conservative, but even at $58mm, Corinthian seems way too cheap.  Heald is arguably a best-of-breed operator in that Heald reports low CDRs, has low 90/10 risk, limited gainful employment risk,  has highly coveted regional accreditation it can use to leverage an online offering, and is small and operates in a market with severe capacity issues (great growth potential). 

Regarding the growth potential, states are overwhelmed by growing demand for education and shrinking education budgets.  In a July 24^th, 2010 article in the Economist, titled, "Monsters in the Making", the author reported that California estimates tight capacity forced community colleges to turn away 140,000 students that year.  The capacity issue was highlighted again more recently in an April 1, 2011 article titled, "California Community Colleges Could Turn Away Up to 400,000 Students" featured in Education News.  In the article, California Community College Chancellor Jack Scott announced the CCCS, which already stand to lose $400mm of its funding under Gov. Brown's plan, is now facing even steeper cuts and there's no other way out of the budget hole but by cutting programs and turning away students.  Capacity issues are not unique to California but the precarious situation the state education system finds itself in will act as an enormous tailwind for institutions like Heald who are growing and can absorb the students who's options for post-secondary education are limited.  With that said, I think my assumption for only 3% growth per quarter is draconian.  However, even at this rate, the valuation is extremely compelling.

Considering Heald's fundamentals, I believe a fair multiple is at least 10x EBITDA, however, it's quite clear the market isn't willing to assign any for-profit operators reasonable multiples until there is more clarity on the regulatory front.  Therefore, the following sensitivity analysis applies EBITDA multiples from 5.5x to 8.5x (8.5x was the acquisition multiple).  I think 8.5x for a business with Heald's return profile and growth potential is a bargain, but at 8.5x, an investor is being paid to own Everest and Wyotech, which together account for over 80% of Corinthians current enrollment.  (assumptions below are in bold).

The sell-side currently estimates Corinthian will earn $100mm in EBITDA in F2012.  If we back out the $58mm Heald should earn, the sell-side is forecasting $42mm in EBITDA at Everest and WyoTech.

This means an investor is paying anywhere between 4x and 0x EBITDA for Everest and WyoTech (depending on the multiple you give Heald).  I believe Everest and WyoTech will be impacted by the regulations but over the long-term they will survive and the economics of these businesses will remain to be very attractive.  If I am right, I think a rational investor would be willing to pay at least 6x EBITDA for the Everest and WyoTech brands and at that multiple, the market expectation is EBITDA at Everest and WyoTech will decline by anywhere from 32% to 100%.  (assumptions below are in bold)

I think EBITDA at Everest and WyoTech is near trough as enrollment declines are due to one-time issues like a reset in admissions standards regarding regulatory risks (elimination of ATB students).  However, at the current stock price, I think the margin of safety is significant.  If EBITDA is in fact near trough and Everest and WyoTech will be o.k. under new regulations, then I think there is significant upside in Corinthian shares.

Furthermore, after regulations are finalized, I think it's likely the earnings and return profile at Everest and WyoTech mean revert and readjust to the historical average.  Applying normalized margins at Everest and WyoTech leads to a valuation that significantly exceeds the current price.

Everest and WyoTech Will Also Survive

Regarding gainful employment

Everest, like Heald, offers low-cost programs primarily in the diploma and associate degree space, the majority of which are in healthcare.  The analysis I applied to Heald can also be applied to Everest and doing so implies the majority of Everest programs should survive the current draconian form of gainful employment (which I believe will be watered down).  WyoTech is at higher risk of breaching debt-to-income ratio's because auto-technical programs are relatively expensive and only two of six WyoTech campuses make the 45% repayment rate cut-off (one is at 46% and one is at 44% so they would need to see improved default management at the campus with a 44% rate).  Of the remaining four campuses only one has a repayment rate that exceeds 35% (rate of 39% at the Sierra campus) so three would be at risk of losing eligibility if they didn't demonstrate debt-to-income ratio's greater than 12% of total income AND above 30% of Discretionary Income.  As of FY2009 these campuses accounted for only 7k students and account for a smaller amount now.  It's unclear how much EBITDA each of these students contributes but at peer UTI (all auto-tech) at average capacity utilization levels they earn about $800in EBITDA per student, per quarter, which means if none of the three at-risk WyoTech campuses made the 12% and 30% debt-to-income thresholds, Corinthian could lose out on $23mm in annual EBITDA.  Considering WyoTech isn't as profitable as UTI and OEM relationships tend to lead to decent employment prospects at decent wages for WyoTech grads (I've received estimates between $35-65k depending on whether they land with BMW or local auto shop), I think this is highly unlikely.  Also, Corinthian has explained they could restructure the programs and improve default management efforts to ensure they meet gainful employment criteria (for example UTI has a 54% repayment rate and WyoTech enrolls a similar demographic so there is a case to be made Corinthian could improve repayment rates at WyoTech simply by doing a better job of educating their students on their alternatives to default).

Regarding CDRs

(Note: CDRs are primarily an issue for Everest, not Wyotech, so Everest is my focus.)  Starting in January 1991, the Secretary of Education initiated proceedings for immediate loss, suspension, or termination of schools' eligibility to participate in Title IV loan programs if their default rates were above specified thresholds.  Currently, if an institutions CDR equals or exceeds 25% for three consecutive years, the institution is in violation of Title IV eligibility standards and can lose access to Title IV funding (typically 70-89% of revenues).  Starting with the 2009 cohort, this method of measuring CDRs will change.  The measurement period is increasing from two years to three years and the eligibility threshold is increasing from 25% to 30%.  The reporting of the new CDRs will begin in FY2012 (i.e. for borrowers entering repayment in FY2009), but the department won't hold colleges accountable for the rule change until FY2014, because that's when three consecutive years of new CDR data will be made available.  At that time, a 40% default rate in one year or a 30% default rate for three consecutive cohorts will result in a school losing access to federal student aid funds for the breach year and two subsequent years.  A lot of misguided speculation exists that this could place a lot of schools who already have double digit CDRs, at or above the CDR threshold and at risk of losing eligibility.  Last fall, Inside Higher Ed obtained data from the Dept. of Ed who released preliminary three-year default rates for all colleges and overall, the proportion of for-profit college students who defaulted on their loans nearly doubled from 11% to 21.2% (as a result, doubling an OPE IDs CDR is considered a good way to estimate their position under the new CDR rule).

One reason the rates will jump is because many schools have been able to manage default rates through forbearance, deferment, and more recently, income-based repayment (IBR).  For example, students typically have a six month grace period after leaving school before their first loan payment is due.  Students can take advantage of this period to save money for repaying college loans.  Secondly, depending on their circumstances many students are eligible for deferment or forbearance.  Loan holders can grant forbearance for up to five years and can grant deferment for up to three years.  Deferments and forbearances count in the denominator but not the numerator of the CDR calculation and therefore if a school can get in contact with a borrower they can help manage their default rates by encouraging students to apply for these considerations.  According to FinAid.org, this is one of the reasons why medical schools have such low cohort default rats, because medical students routinely take advantage of these alternatives to default.

Also, recently the DOE established something called IBR.  This allows students to payback their loans based on the amount of income they collect, and caps their monthly payments at 15% of their discretionary income, which is defined as the difference between their adjusted gross income and 150% of the federal poverty line corresponding to their family size and state of residence.  IBR also has a maximum repayment period of 25 years and if the borrower is near or below 150% of the poverty line, they aren't required to make any payments.  Obviously this is an attractive option for those who qualify and like forbearance and deferment, IBR count in the denominator of the CDR calculation, but not the numerator.  IBR only became available on July 1, 2009 and one would have expected this to dramatically improve CDR rates, but according to Mark Kantrowitz of FinAid.org, as of six months ago only about 200,000 people were enrolled.  One potential reason IBR hasn't caught on yet is because in the first several months of its availability, there was no option on the drop-down menu on the Department of Ed's website (basically the Dept. designed it and then forgot to tell people about it).  The only way to apply was to go through a paper process, which obviously could disorient the applicant, especially considering the profile of many of these applicants.  With time, IBR should catch on, and should help reduce CDRs.

Forbearance, deferment, and IBR have allowed schools to manage their two year default rates and now that the CDR rule is changing, while these alternatives to default are still available, schools will have to manage defaults for an additional year.  While CDRs will definitely pop as a result of the extra year of default management, I think the street has made a mistake regarding the extent to which certain institutions will be at risk of violating the new standard.  For example, one of the knocks on Corinthian has been exceedingly high CDRs.  Certain sell-side analysts have basically told me it's a waste of time to even consider Corinthian as an investment because they will breach CDRs in 2014 and won't have a business anymore.  The mistake I think these analysts have made is they are applying the 2x rule of thumb on default rates to inflated statistics.  If you normalize the CDR data at Everest, you are left with a company that is in good shape under the new CDR rules. 

In February, Corinthian released an 8-K reviewing the recently released 2009 cohort default rate data and they made a very important disclosure.  The disclosure is only a single sentence, but it supported the thesis Everest will survive the CDR rule change.

Here is an excerpt with the key sentence highlighted...

We believe that continued high unemployment, which is particularly challenging for the student demographic we serve, has contributed to higher cohort default rates. In addition, major structural changes in the student lending business have negatively affected rates. Prior to the credit crisis in 2008, three types of entities played a role in managing student loan defaults in the FFEL Program: lenders participating in the FFEL Program, such as Sallie Mae; guaranty agencies; and post-secondary institutions such as ours. Since the credit crisis in 2008, many student loan portfolios have been "put," or sold, to the federal government by lenders that either went out of business or could no longer fund their FFEL program loans. Lenders still in existence became servicing agents for the loans held by the government. Accordingly, guaranty agencies no longer play a role in default management, and lenders' roles have been significantly reduced. In addition, since May 2008, ED has distributed "put loans" to multiple servicers, and many of our students have loans with more than one servicing organization. This has made our default prevention efforts more complicated and difficult. Taken together, the structural changes in student lending have significantly reduced the level of default management activity previously provided by lenders and guaranty agencies. These changes have also negatively affected the timeliness and accuracy of federal databases and thus hindered the Company's efforts at data collection and analysis. Loans held by bankrupt lenders and so-called "put" loans, which together comprised more than sixty percent of the loans to our students in the 2009 Cohort, defaulted at more than twice the rate of other loans during the 2009 measurement period.

In the same document Corinthian reports a consolidated average two year 2009 CDR of roughly 22%.  So if you do a little algebra (60% * 2x + 40%x = 22%), you find the 40% of loans that weren't put to the government or are being held by bankrupt lenders are only defaulting at a 13.75% rate.  That's an implied 3yr. rate of only 27.50% which is below the 30% threshold under the new CDR rules.  The reason this is important is the loans held by bankrupt lenders and loans that were "put" to the government should cycle through the system and only a small slice of them will be included in the 2010 cohort and none will be included in the 2011 cohort.  What this means is the 40% bucket will basically comprise the entire balance of outstanding loans in the 2010 and 2011 cohort measurements.  If that's the case, Everest's potential to stay below CDR thresholds for three consecutive years is much better than the street anticipated because prior analysis was based on inflated CDRs (the street has been saying nearly all of the 3yr. CDRs at Everest will exceed threshold and the brand is effectively doomed to fail.  Obviously the problem is the sell-side analysts were multiplying these 22% rates by two and that 22% rate is inflated). 

Furthermore, Corinthian rolled out a default management program in April of 2010 and this will ultimately reduce CDRs.  (Note: Heald serves the exact same demographic as Everest and reports CDRs in the high single digits to low teens, so Everest should be able to do produce similar CDRs).  The 2009 cohort data measured students who entered repayment in F2009 and defaulted in F2009 or F2010 (fiscal years end is Oct. 1st).  Therefore, Corinthian's default management program was only in place for six months of the measurement period and isn't reflected yet in the 13.75% adjusted rate.  Also, the students in this measurement period entered repayment in 2009 so many hadn't been in school for a couple years when Corinthian started tracking them down to educate them on their alternatives to default.  With that said, Corinthian should be able to have a much larger impact on the 2010 and 2011 cohorts (the 2011 cohort is still in school) so the 13.75% CDR should decline with the 2010 and 2011 Cohorts.  The bottom-line is Corinthian should have ample room under the new three year CDR rule.

Management basically confirmed this theory in the last earnings release when they said,

"As previously reported, we continue to see positive trends in the area of cohort default rates (CDR), and now estimate that our average two-year CDR for the 2010 cohort of students will be 9% - 12%. This represents a substantial improvement over our average preliminary two-year CDR of 21.9% for 2009 cohort, and our average final two-year CDR of 19.0% for the 2008 cohort. Given the improvement in our projected 2010 CDR, the company believes it is no longer at risk of exceeding federal default thresholds under the current two-year measurement rules, and believes it has significantly reduced its risk under the new three-year measurement rules. Sanctions under the new three-year rules become effective in 2014." 

Despite these comments, I have found the street still considers CDRs to be a serious risk.  I think the data provides ample evidence CDRs are coming in and therefore are not a serious issue. 

Regarding 90/10

Corinthian has some of the lowest pricing available and should be able to increase pricing and still have ample room under debt-to-income ratios.  Recently they instituted an across the board price increase to stay within 90/10 and even considering this price increase they should be relatively safe under debt-to-income ratios.

To sum up Everest and WyoTech, I think there is ample evidence that indicates they will survive the regulations.  It's possible draconian debt-to-income ratio's lead to over a $20mm EBITDA hit at WyoTech (on normalized margins and normalized capacity) but I think it's highly unlikely.  Even if you hit EBITDA by $20mm and hit them for another $20mm for costs associated with teach-outs and operating leases on the WyoTech facilities, you have a one-time EBITDA reduction of $40mm.  This is basically priced in right now and I think the probability of this happening is low. 

Conclusion

Based on my analysis, Heald is a high quality business and there is little evidence to suggest it is going away.  Capacity issues in California, Heald's primary market, lead me to believe Heald should see solid growth going forward. 

Corinthian is priced as if Everest and WyoTech are going away and they appear to be capable of surviving.  while my focus of this write-up was to explain why they should survive, I also think margins are near trough levels as Corinthian had to deal with a price increase to avoid breaching 90/10 and stopped enrolling ATBs out of concern for violating CDRs (ATBs defaulted at over 2x the rate as non-ATBs).  Corinthian announced last quarter they will start enrolling ATBs again in response to the amount of progress they have made on the CDR front.  These were one-time items that hit the top-line and Corinthian didn't have a chance to adjust the cost structure.  With a right-sizing of the business model and a return to enrollment growth, I think there is reason to believe Everest's margins trough this year and since it looks like both Everest and WyoTech will ultimately survive the regulations, I think its reasonable to assume margins approach their historical average over time. 

Applying more reasonable multiples to each of Corinthian's brands leaves you with a stock price that appears to be significantly undervalued. 

(Note on ATBs:  ATBs are ability-to-benefit students, i.e. non-high school grads who demonstrate an ability-to-benefit from post-secondary education.  Basically, they have to pass a test before they can enroll.  Corinthian used to serve these students but stopped enrolling them in September).

Catalysts

-          Watered down gainful employment

-          Change to 90/10 (currently an exception in 90/10 for Stafford loans is set to expire in July.  If this exception is renewed, Corinthian said they would roll-back the price increase)

-          Lower CDRs

-          Continued evidence of enrollment growth at Heald