Since August 2010, the companies belonging to the For-Profit Education sector have been under pressure after the U.S. GAO (Government Accountability Office) launched an investigation designed to uncover potential frauds based on trying to enrol more students even when they didn't have the right profile to be admitted to the school and/or to repay a federal loan provided by the Department of Education.
Let's give a look at GAO original documentation:
"To conduct this investigation, GAO investigators posing as prospective students applied for admissions at 15 for-profit colleges in 6 states and Washington, D.C.. The colleges were selected based on several factors, including those that the Department of Education reported received 89 percent or more of their revenue from federal student aid"
Here are the results:
"Undercover tests at 15 for-profit colleges found that 4 colleges encouraged fraudulent practices and that all 15 made deceptive or otherwise questionable statements to GAO's undercover applicants"
What kind of fraudulent practices did they put in place?
· Encourage applicants to falsify their financial aid forms to qualify for federal aid
· Exaggerate undercover applicants' potential salary after graduation
· Fail to provide clear information about the college's program duration, costs, or graduation rate
· Pressuring applicants to sign a contract for enrollment before allowing them to speak to a
Of course the investigation involved different companies that implemented practices with different levels of "fraudulence".
Each company tried to cope with this issues, and to anticipate future regulatory actions in order to limit their impact.
In June 2011, the Department of Education released a new set of regulations designed to prevent future potential frauds.
In order to qualify for federal aid, "the law requires that most for-profit programs and certificate programs at nonprofit and public institutions prepare students for gainful employment in a recognized occupation".
Gainful employment is a simple concept: education institution should prepare their students for their future jobs, so they should make sure that most of them successfully achieve the desired result.
This is why they should not enrol students who can't reach the target, whether they cannot do it for professional or for economical reasons.
This regulation will go into effect on July 1, 2012, so companies that do not fit in the regulations yet are trying to do it by every possible means, in order to avoid losing access to Federal student aid.
More than a quarter of for-profit institutions receive 80 percent of their revenues from taxpayer-financed Federal student aid, so losing access to it means catastrophe to them.
Career Education regulatory issues
Career Education (NASDAQ:CECO) is a For-Profit Education company engaged in offering highly specialized education in the US and in Europe. It is organized in four business segments: University, Health Education, Culinary Arts and International.
Like its peers, the company was subject to several investigations and impacted by the Department of Education last regulation release.
The company tried to solve all its issues in time, but, in November 1, 2011, reporting their third quarter results, the company admitted that there were "improper placement determination practices" at some of their schools.
The Accrediting Council for Independent Colleges and Schools (ACICS) placement rate standard is 65%. 36 of 49 their Education and Art & Design segment schools didn't meet ACICS' 65% minimum placement rate standard for the 2010-2011 reporting period.
The ACICS is in charge of education companies accreditation. If a company fails to meet their standards they could decide to suspend an institution's accreditation.
So, now it's clear why CECO must take care of this issue. Let's have a look at the steps they're implementing to improve.
On the same day (November 1), they announced the resignation of their Chief Executive Officer Gary E. McCullough:
"Given the complexities of the regulatory environment and other issues that have arisen over the last year, Career Education is moving towards a new phase and the Board views it as the appropriate time to start the process of putting in place fresh leadership at the CEO level. At the same time, the Board and the Company's experienced management core will move forward to address the issues before Career Education"
In the meanwhile, the company appointed Steven H. Lesnik, who is Chairman, as President and Chief Executive Office.
Ok, I know what you're thinking. Why the hell are you still considering this sinking boat as an investment?
Just a moment. I want to show you that there are some aspects of this troubled situation that are worth the time to investigate.
Career Education 2011 Financial Results
On February, 27, Career Education "reported its 4th quarter and 2011 results, with revenue of $439.5 million, and a net loss of $120.4 million, or $1.64 per diluted share, for the fourth quarter of 2011 compared to total revenue of $531.6 million and net income of $12.1 million, or $0.15 per diluted share, for the fourth quarter of 2010"
For the full 2011, CECO reported total revenue of $1.88 billion, and net income of $18.6 million, or $0.25 per diluted share, compared to $1.95 per share for the previous year (2010).
What caused Career's huge decline? Let's have a look at significant items for the last quarter of 2011:
Quarter Ended December 31, 2011
Earnings per diluted share impact
So the company decided to realize some goodwill and asset impairments, in order to reflect on the balance sheet the real value of their assets (especially immaterial ones).
Although I think this is always a good and necessary practice, I didn't understand why they decided to charge so much at one time. Most of what was clear at the end of last year must also have been clear at the end of the 3rd quarter…
Anyway, seeing it from a positive side, there's "only" $212 million of goodwill and $77 million of intangibles left on their balance sheet, so it will be impossible to apply charges of the same size in the following quarters.
What really gives to Career Education a downside protection is its cash.
CECO has $280.5 million of cash and cash equivalents, with 73.62 million of common shares outstanding, so that's around $3.80 per share.
In addition, the company is aggressively repurchasing its shares at very low prices. There are around 9% less shares outstanding this year compared to last year.
Again, I generally love companies that buy back their shares, but in this case, given the critical situation, I would be a little more conservative..
Adjusted for net cash, Career is currently priced at 2.40x P/E and 0.47x P/B, referring to its non-GAAP financial measures (that better reflect CECO core business earning power), that exclude the one-time significant items we've just seen.
What I think the market is (legitimately) worried about is Career's new student starts.
As the company implements its actions in order to avoid losing accreditation, it is forced to avoid enrolling students that have little chance to fit into the gainful employment rules.
Here's the breakdown of latest quarter new student starts:
For the Quarters Ended December 31
|New student starts|
2011 vs. 2010
Art & Design
Total New Student Starts
If, for sake of simplicity, we project for next year proportionally (related to new student starts) lower earnings, we get around $1.65 per share (excluding share repurchases), so, at today prices, the company would still have a P/E of 3.15.
Of course, if we reiterate this reasoning, 2013 earnings could be even lower, and so on, but it means that we're forecasting Career earnings as if they were highly predictable, but it's evident that this is not the case.
Career Education will clearly face several challenges during this year (and probably beyond), but, in order to justify the current depressed price, it should lose market share (and earnings power) for a long series of quarters.
The real danger is that of losing accreditation from ACICS (and consequently from the Department of Education), with catastrophic results.
I don't think a conservative investor should buy this stock right now (even if there are big potential profits on the table), but I would carefully follow next CECO's earning results in order to understand if the company is finding its way to turn around.
If Career succeeds in doing it, I'm sure it will thrive.