Apollo Group's Strong Earnings Are Misleading

Last week, The Apollo Group (APOL) reported what appeared to be strong quarterly operating profits in their for-profit education business, which is primarily derived from operating the for-profit University of Phoenix (UOP below). But before investors get too excited, we recommend people read the 10-Q details, which indicate the growth is more of a one-time bump than a sustainable trend. More importantly, the company discloses a lawsuit with some troubling implications for the near future.

It seems like just another piece of every day litigation. According to the Q:

On December 9, 2008, three former University of Phoenix students filed a complaint against Apollo Group, Inc. and The University of Phoenix, Inc. in the United States District Court for the Eastern District of Arkansas. The complaint alleges that with regard to students who dropped from their courses shortly after enrolling, University of Phoenix improperly returned the entire amount of the students’ federal loan funds to the lender. The students purport to be bringing the complaint on behalf of themselves and a proposed class of similarly-situated student loan borrowers.

THIS IS THE LAWSUIT APOLLO GROUP MANAGEMENT DOES NOT WANT THE GOVERNMENT OR INVESTORS TO SEE.

What seems to be merely a lawsuit against the institution by some disgruntled students is actually MUCH MORE MATERIAL and cannot be overlooked. I'll explain why shortly.

Before discussing, it is important to note that Title IV loans are the backbone of the revenue stream for the entire for-profit education industry. Apollo derives over 77% of their revenue from these loans, and is the largest single recipient of student loan funds in the country.

As such, institutions receiving Title IV funding are required to meet a variety of regulations, including a cap on the ratio of government loan funds to cash revenue (the “90% - 10% rule”), limits on defaulted loans extended to their students (the so-called Cohort Default Rate), and other regulatory requirements on financial status and academic standards. Institutions that violate these requirements risk losing their Title IV accreditation, which for a company like Apollo, could be devastating by their own admission.

This class action represents a group of students who withdrew shortly after enrolling at The University of Phoenix. Each student was enrolled long enough to incur pro-rata tuition and costs that UOP should have been paid from the student’s already-approved federal student loan. In each case, although UOP had already received the student’s loan proceeds, they refunded 100% of it to the government, and opted instead for the far less lucrative path of trying to collect directly from the student, employing such tactics as collection agents and credit report dunning, while pressing for accelerated terms far more onerous than the terms of the student’s government-backed loan had been.

So here’s the question: why would the UOP surrender cash in hand that is rightfully theirs, in exchange for a hard-to-collect receivable, plus collection costs and risks? Why would UOP intervene in a lender/borrower relationship that they actually helped facilitate?

Lets get this straight – the action UOP chooses here is financially worse for the company, worse for their students, and better for the US Government … in stark contrast to all the prior lawsuits and consumer complaints, you could at least see the company was acting in its own interests to increase its profits.

Has anyone ever heard of a company voluntarily giving up money in hand for a questionable receivable?

This lawsuit lays out a rationale that describes how in the actions in question, UOP is not only trying to deceive their clients, but more importantly, the Department of Education and investors through manipulation of their reported numbers. By removing these early-withdrawing students from their loan rolls, this lawsuit suggests understatement of Cohort Default Rates, plus other impacts on enrollments, retentions, and revenue ratios are implied. As stated in the lawsuit:

By returning the money to the government, they are effectively prohibiting that person from being factored in their cohort default rate. This manipulation is a clear violation of the mandates of HEA.

Now we don’t know the full explanation of the company’s motives for this clearly illegal policy. Nor is Citron suggesting that APOL is at immediate risk of losing their Title IV eligibility (an event which would cause devastating changes to the company’s business model.) We can speak from experience in saying that when a business forgoes profits, it is time for investors to pay attention.

We also note that according to its most recent 10-K, APOL’s current Title IV eligibility status is on a month-to-month basis, with review pending for the last year and a half. As far as we can verify, none of their competition in the for profit education space is on the same month to month basis.

University of Phoenix was recertified in June 2003 and its current certification for the Title IV programs expired in June 2007. However, in March 2007, University of Phoenix submitted its Title IV program participation recertification application to the Department of Education. We have been collaborating with the Department of Education regarding the University of Phoenix recertification application. Although we have submitted our application for renewal, we are continuing to supply additional follow-up information based on requests from the Department of Education. Our eligibility continues on a month-to-month basis until the Department of Education issues its decision on the application

A third possible reason for the manipulation of numbers is the current qui tam lawsuit where the US Government accuses Apollo of false claims that costs taxpayers $500 million a year. For those who think the suit is old news and done with, we refer you to a November 10, 2008 court document which shows the government has requested that discovery demands Apollo made under the Freedom of Information Act, be denied as litigation has become a real possibility.

The third, and in our opinion, most probable reason for the potential of manipulation of numbers is the fear of a new administration. During the past 8 years under the Bush administration, Wall St. and corporate America have been able to set the regulatory agenda at the current expense of the taxpayers. This includes private education — it is no secret to insiders that the Bush era education team has been favorable to for-profit education. In fact, the Assistant Secretary for Post Secondary Education, the highest ranking official overseeing private for-profit schools, has been Sally Stroup, an 8 year lobbyist for the University of Phoenix.

Count on the Obama administration to take a fresh, critical look — as the largest single recipient of student loans in this country is a for-profit institution whose insiders have sold hundreds of millions of dollars of stock while collecting over 75% of their revenue from government guaranteed loan funds, while delivering an education of questionable value amid a history of unsavory business practices.

We’re In the Money

Thorough analysis of the company’s revenue mix and trends is a topic for a future report. For now, we’ll just identify that the “one time bump” comes from the event described in the 10-Q:

In May 2008, the Act increased the annual loan limits on federal unsubsidized student loans by $2,000 for undergraduate students, and also increased the aggregate loan limits on total federal student loans.

This was a bonanza for Apollo, both in terms of revenue per student (they increased tuition immediately following the government action) as well as allowing them to increase enrollment among even more financially marginal students allowed under the higher aggregate loan limits. Back out these effects, and “organic growth” shrinks to a fraction of the reported numbers. The sustainability of this growth is topic one for the rest of this report.

Conclusion

It is the goal of Corporate America to deliver profits. While it’s intriguing to speculate about the various theories that explain the company’s acts, the bottom line isn’t their motives, but their actions. As fun as it might to be speculate as to why they might be employing this policy is irrelevant. When it comes to the law, it is the action not the explanation on which investors should turn their focus. When a company opts to leave easy money on the table, especially when executing company policy that’s explicitly in violation of the laws it operates under, we suggest that it might be prudent to look under the table.

Cautious investing to all.

Disclosure: Author is short APOL

Comments

[KSTHANE:]

Andrew,

If the company was really manipulating numbers in a material way shouldn't there be a corresponding increase in the company's accounts receivable and then bad debt expense? Bad debt expense has only risen 80bps as a percent of revenue over the last 4 years, and has actually declined from 4.1% to 3.3% in the last 3 years. Accounts receivable have been relatively steady as well.

Also, were you aware that the cohort default rates are measured over 2 year periods in arrears? It seems like it would be difficult to manipulate that type of number.

Apollo is the largest university in the world and by far receives the most Title IV loan funding of any other education provider. They have had a policy of returning gov't money to the gov't in the case of dropouts for several years. Any movement of Title IV money is highly scrutinized by the DOE, I'm not sure that they would have just glossed over this in the many comprehensive reviews that have been done on the company in the past.

Last, the title of your report on Citron yesterday was just too sensationalistic for my tastes: "Citron Releases the Document that The Apollo Group (NASDAQ:APOL) Does Not Want You or the US Government to See." What was new in your report that the government is not aware of? Do you think they're not aware of a court case that was filed? Do you think they're not aware of the qui tam lawsuit that has been there forever? Do you think they're not aware that they themselves have APOL on month to month certification for Title IV?

The only thing your report does is highlight a new regulatory disclosure in a 10-Q that was brought on by students...not by the DOE, not by the SEC, not by the DOJ, but by 3 students.

Oh, and don't let me forget how ridiculous it is to assume that the company just had a one time bump in earnings due to price increases. First of all, this is the second quarter in which the company has experienced some tailwinds from price increases, and second of all enrollments jumped y/y as well. If pricing had stayed the same the company would have seen positive earnings results just from the higher enrollment, which you completely failed to mention.

Jan 14 10:19 AM

[JellyBean:]

It wasn't but a few short weeks ago that Seeking Alpha listed APOL as one of the best 8 stocks to get you through the hard times. Don't know why she fell out of love over the filing of a lawsuit - anyone can file a lawsuit but that doesn't mean there is any merit to it. I also find her subjective comments about the company's educational programs interestingly biased - left wondering if she is an APOL grad so has some foundation upon which to base that statement? This institution is not dealing with phantom paper like our Wall Street friends - it has accountability to over 300,000 students and thousands of investors who keep coming back, so its educational programs and business practices surely has some validity. I like this stock and will continue to keep it in my portfolio. Sorry for the sour grapes, Alpha

Jan 16 11:34 AM

[Robert Wein...:]

I am short APOL with both stock and by writting naked calls.

Most of the time my trades are in such a short time frame that I just record them after the fact. This time is one of the rare times where there is still plenty of time to get in and short it as there is a lot of downside in APOL.

Jan 18 08:23 PM

[Shamoun - P...:]

Looking at the charts May 2008 to Jan 2009 the stock has been moving up consistently. if there were any merit to the above article. it would have been re-adjusted in the stock price.

i am looking to do a call option on this and have done so in the past and made 150% profit

Jan 19 07:36 AM

[KSTHANE:]

Ah ha ha ha ha. The lawsuit that Citron highlighted in this sensationalistic piece has already been voluntarily dropped by the plaintiffs. That's what happens when you have no case.

The government's not even participating in the qui tam suit; there's probably not much merit to that one either.

Jan 22 11:34 AM

[forprofited...:]

I think its an issue, but not a big one... its something that shouldnt be done, but not something that will cause loss of title 4. This IS NOT EVCI

Jan 29 07:15 PM

[4eyedbuzzard:]

So, er, ah, exactly why are all the big insiders selling big positions(@$48M total) if the stock isn't overvalued and the company so healthy?

Feb 01 11:37 PM