ESI: ITT Educational 10K Gives Us Earnings Quality Concerns

By William Trent, CFA of Stock Market Beat

Small Cap Watch List member ITT Educational Services (ESI) is up more than 20% year-to-date on the back of strong earnings and guidance given in January. We reviewed the recently issued 10K and came away with a few concerns over the quality of those earnings.

Summary: ITT Educational Services has provided career-oriented education programs since 1969 under the “ITT Technical Institute” name. It is a leading for-profit provider of postsecondary degree programs in the United States. As of December 31, 2006, it was offering diploma, associate, bachelor and master degree programs to approximately 47,000 students through 87 institutes and nine learning sites of those institutes located in 33 states. All institutes are authorized by the applicable education authorities of the states in which they operate and recruit, and are accredited by an accrediting commission recognized by the U.S. Department of Education (“ED”).

Income statement analysis

Sales growth – Revenue increased $69.8 million, or 10.1%, to $757.8 million in the year ended December 31, 2006 compared to $688.0 million in the year ended December 31, 2005

Unit vs. dollar – Sales gain resulted from a 5.0% increase in tuition rates in March 2006, a 5.2% increase in total student enrollment at December 31, 2005 compared to December 31, 2004, and a 10.8% increase in new student enrollment in the year ended December 31, 2006 compared to the year ended December 31, 2005.

Revenue recognition – Tuition revenue is recorded on a straight-line basis over the length of the applicable course Other – In 2006, we indirectly derived approximately 61% of our revenue determined on an accrual accounting basis (or 57% determined on a cash accounting basis as defined by the ED’s regulations) from the federal student financial aid programs. Changes to these programs or ITT’s eligibility could have an adverse impact on revenues. (See lawsuits).Seasonality – Revenue higher in third and fourth quarters because more new students enroll in June (23% of all new students in 2006) and September (34% of all new students in 2006) following high school graduation. Costs are not affected by the calendar, so margins are better in the third and fourth quarter as well.

Earnings quality

Capitalization of expenses – Direct costs incurred relating to the enrollment of new students are capitalized using the successful efforts method. Direct marketing costs subject to capitalization include salaries and employee benefits of recruiting representatives and other direct costs. Successful efforts is the ratio of students enrolled to prospective students interviewed. The higher the rate of interviewed students who enroll, the greater the percentage of our direct marketing costs that are capitalized. Direct marketing costs on the balance sheet totaled $46,706 at December 31, 2006 and $39,705 at December 31, 2005, less accumulated amortization of $25,078 at December 31, 2006 and $22,215 at December 31, 2005. If the costs were expensed as incurred, operating income would have been $4.1 million (2.3%) and earnings per share would have been $0.06 lower in 2006.

Operating margins – Have been remarkably consistent over the three years, as illustrated by the common size statement in the table below. Only legal charges in 2004 resulted in a significant anomaly. Cost of educational services as a percentage of revenue decreased to 47.1% in 2006 from 47.7% in 2005, primarily due to a decrease in compensation and benefit expense arising from the freeze of our pension plans and greater efficiencies.

Year Ended December 31,

Net margins – net profit has not grown significantly but earnings per share grew due to nearly 10% reduction in share count. Stock options – reduced net income by $1.9 million in 2006 compared to 2005 due to adoption of SFAS 123R.

Pensions – froze pension plan. The 8% discount rate and maximum 70% equity allocation implies an expected return on equity investments of at least 9.3%, which under current market conditions is probably aggressive.

Anomalous tax rates – Accruals were close to actual cash taxes in 2004 and 2005 but company paid only $44 million in 2006 compared to an accrual of $71 million.

Balance sheet analysis

Asset depreciation schedule – high end of equipment and software ranges may be aggressive, but generally no concern.

Debt load and maturity schedule – $150 million drawn from credit facility in 2006, compared with no debt the prior year.Pension funding – fully funded

Doubtful accounts – reserve nearly doubled despite a decline in total receivables.

SPEs and other off-balance sheet items – $100 million in future operating lease obligations

Cash flow analysisOperating cash flow and net income trends – both rising, and cash flow higher than net income in all periods.

Free cash flow and net income trends – $107 million in 2004, $108 million in 2005 and $121 million in 2006.

Capital investment relative to depreciation – running at about double, suggesting FCF could increase by $20 million on a no-growth/maintenance basis. Given the $3.2 billion enterprise value, this implies a 4.3% free cash flow yield.

Cash taxes paid relative to tax accrual – Accruals were close to actual cash taxes in 2004 and 2005 but company paid only $44 million in 2006 compared to an accrual of $71 million. This means earnings reported to shareholders were significantly higher than earnings reported to the IRS. While this could signal efficient tax management, it could also be a sign of low earnings quality.

Footnotes

Legal issues – Civil lawsuit alleges that ITT “violated the False Claims Act, 31 U.S.C. § 3729, et seq., by knowingly making and using false records and statements relating to, among other things, student recruitment, admission, enrollment, attendance, grading, testing, graduate placement, programs of study and course materials in order to fraudulently obtain student loans and tuition from the federal government.”

Growth indicators

The company’s growth strategy includes geographic expansion, acquisitions and expanded program offerings. One key risk is that attracting additional students could reduce the overall applicant quality, which could have a negative reputational effect. As it is, the company reports in its 10K that “approximately 76% of the Employable Graduates (as defined below) from our institutes’ programs during 2005 either obtained employment by April 30, 2006, or were already employed, in positions that required the direct or indirect use of skills taught in their programs of study” and that “reported annualized salaries initially following graduation averaged approximately $28,000.”

Peers include Apollo Group, Inc. (APOL), Capella Education Company (“CEC”), Career Education Corp. (CECO), Corinthian Colleges, Inc. (COCO), DeVry, Inc. (DVY), Laureate Education, Inc., Lincoln Educational Services Corporation, Strayer Education, Inc. and Universal Technical Institute, Inc.

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