How bad is it going to get?
That’s the question that troubled investors as they dumped the already-depressed shares of ITT Educational Services Inc. in recent days after the Carmel-based operator of for-profit colleges shelled out $46 million for bad student loans it had backed.
That payment, made to settle a lawsuit brought by Virginia-based SLM Corp., was for losses and legal fees on a $180 million student loan portfolio launched in 2007, when economic times were good.
Because ITT Educational also has guaranteed repayment on two other portfolios launched in 2009 and 2010, which total $441 million in loans, investors fret that a similar loss experience could create a cash crunch, as well as scare off potential students.
“We worry that, among other things, this news could indirectly hurt pricing power, enrollments and earnings, and that additional cash payments or charges could negatively impact ITT’s financial flexibility,” wrote Kelly Flynn, a higher education analyst at Credit Suisse in New York, in a Jan. 7 research note.
ITT Educational generates roughly 75 percent of its $1.3 billion in annual revenue from federal student loan programs. Over the past few years, the company has used private loans to help students pay the portion of its pricey tuition that federal loans won’t cover, even as several of its competitors cut prices. But with fewer ITT graduates able to find jobs at all, let alone good-paying jobs, the default rates on these loans has spiked.
In the past three months, ITT started to change course—about two years later than most of its peers. It instituted a scholarship program that eventually will replace private loans and, in effect, cut ITT’s net prices—even though its sticker prices will remain high.
In addition, ITT has halted its aggressive building of new campuses and has identified $50 million in annual operating costs it can cut.
ITT Educational also will renew its traditional focus on computer, engineering and science-based degrees, and de-emphasize things like criminal justice.
“We’re kind of turning the page and hitting the reset button with all the changes going on in the marketplace,” Modany said during a Nov. 14 presentation to investors.
Those changes stem from recession-weary families pushing back on all kinds of higher education institutions on tuition costs that have been running well ahead of inflation for at least two decades.
Pressure also is increasing from Washington, D.C., where the Obama administration and Senate Democrats have issued reports and held hearings that have harshly scrutinized the recruiting practices and poor outcomes of students at for-profit colleges.
Through a spokeswoman, Modany declined to be interviewed for this story, citing a quiet period before the company reports fourth-quarter financial results on Jan. 24.
Liquidity crisis looming?
It may be too late for ITT to avoid drastic outcomes, because it already has burned through so much of the cash it generated during its go-go years from 2007 to 2010, noted Bradley Safalow, an analyst of for-profit colleges at PAA Research in New York.
“Given the company’s shrinking cash position and dwindling free-cash-flow prospects, we think ESI’s liquidity position could become increasingly challenged,” wrote Safalow, referring to ITT Educational by its ticker symbol, in a Jan. 7 research note.
Using a variety of assumptions, Safalow estimated that students defaulted on at least 40 percent of the $180 million in its 2007 loan program with Sallie Mae.
If similar losses are occurring in ITT Educational’s 2009 and 2010 loan programs, it could face payments ranging from at least $125 million to as much as $290 million in the next two or three years, Safalow estimated.
The problem is that ITT Educational—once a profit-making powerhouse—is generating small amounts of cash with which to pay off loans that go bad. During the first nine months of 2012, ITT Educational’s operations generated just $18.8 million in cash—the company’s worst performance in 14 years.
Those paltry earnings forced the company to burn through 45 percent of its cash, cash equivalents and short-term investments over the past year. As of Sept. 30, those three categories totaled just $175 million—a lower level than at any time since 2002, when ITT operated half as many campuses as it does now.
ITT’s cash stockpile has dwindled partly because the company has spent nearly $1.3 billion on stock buybacks during the past four years in an effort to juice its stock price and its earnings per share. The company’s stock was outperforming that of its peers until July. But now, shares are down 80 percent over the past year, and don’t show signs of bouncing back.
In the wake of ITT’s Jan. 4 deal with SLM—better known as Sallie Mae—Barclays and Citigroup cut their ratings on the stock, and nearly all analysts lowered their price targets. The company’s stock price plunged 25 percent in the three days after the SLM deal was disclosed, falling to $14.45 by the close of trading Jan. 9.
“We see material risk of more write-downs and loan guarantee payments,” wrote Citigroup analyst James Samford in a Jan. 9 note to investors. “While shares are down 80 percent from their February peak, we still see additional downside and are downgrading to sell.”
Plans for the future
So how does ITT Educational get out of its trouble?
A big step is, of course, to reverse its declining enrollment. Over the past two years, the number of new students at ITT Educational’s 150 campuses has fallen 28 percent, to 19,298 students.
Modany maintains that ITT Educational is still seeing high levels of inquiries, but is not converting as many of them into enrolled students. Until late October, Modany’s strategy was simply to communicate ITT Educational’s “value proposition” better.
The way Modany sees it, ITT Educational students have average annual incomes of $17,000 before enrolling. He said they leave after earning a two-year associate’s degree with jobs that pay an average of $32,500.
ITT Educational’s sticker price for that two-year degree is a startling $47,000. But with scholarships—including the program launched by the company in October—the average net cost is about $27,500 for a two-year degree.
That means the average ITT Educational graduate enjoys a $15,000 bump in annual income, which could, theoretically, pay for the cost of the degree in less than two years.
“We believe that if our students are receiving a good value proposition, then we are well-positioned to be successful,” Modany said during a JP Morgan investor conference.
Critics, however, note that, in reality, it takes a long time for someone earning $32,500 a year to pay off $27,500 in debt. And the situation is even tougher for students who don’t graduate, and yet still have a large amount of debt dogging them.
Modany’s scholarship plan resembles actions taken by some of ITT Educational’s competitors as students increasingly opted for cheaper community colleges and not-for-profit universities with expanded online programs.
In 2010, Virginia-based Strayer Education Inc. created a scholarship program that reduced its tuition 30 percent.
Arizona-based Apollo Group, which operates the University of Phoenix, implemented a tuition freeze last year and promised students it would hold tuition steady throughout their time at the school.
Apollo Group also said it will close half its campuses, an aggressive cost-saving approach ITT Educational has yet to take.
The problem for ITT Educational is that any reduction in its net prices flows almost entirely to its bottom line. Its challenge is to make its transition to a lower-cost model without breaking covenants on its $140 million in bank debt. Safalow noted that ITT is required by its banks to keep at least $125 million in cash on hand.
He thinks the only way for ITT Educational to survive is to raise money now via a secondary stock offering. And the only way to do that, Safalow argues, is for the ITT board to replace Modany and his current management team.
Otherwise, Safalow argues, Modany’s strategy of putting ITT on the hook for private loans to students of doubtful credit-worthiness is going to keep scaring potential investors away.
“Current management has been in denial (or worse) about their educational outcomes and the changes in demand patterns in higher education,” Safalow wrote in an e-mail response to questions.
“The decision to lever up the company to preserve their current tuition model has proven to be the most damaging to the company’s long term prospects. Ultimately, management thought demand would ‘return to normal,’ rather than making the decision to embrace the new normal.”•