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ITT Educational Services, Inc. (NYSE:ESI)

Q1 2009 Earnings Call

April 23, 2009 11:00 AM ET

Executives

Kevin M. Modany - Chief Executive Officer

Daniel M. Fitzpatrick - Executive Vice President, Chief Financial Officer

Analysts

Gary Bisbee - Barclays Capital

Bob Craig - Stifel Nicolaus

Amy Junker - Robert W. Baird & Co. Inc.

Andrew Steinerman - JP Morgan

Trace A. Urdan - Signal Hill Capital Group

Kevin Doherty - Banc of America Securities-Merrill Lynch

Brandon Dobell - William Blair & Company

Corey Greendale - First Analysis

Paul Ginocchio - Deutsche Bank

Kelly Flynn - Credit Suisse

Operator

Greetings ladies and gentlemen and welcome to the ITT Educational Services First Quarter 2009 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow a formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

Joining us today from the management of ITT Educational Services, we have Kevin Modany, Chief Executive Officer and Chairman and Dan Fitzpatrick, Executive Vice President and Chief Financial Officer.

Before we begin, ITT Educational Services Incorporated wishes to remind you that this conference call may include forward-looking information. Actual results may differ from the information presented during this call. For additional information, please review the section on forward-looking information contained in today's news release or in the company's public filings with the Securities and Exchange Commission.

Thank you, Mr. Modany. You may begin.

Kevin M. Modany

Thank you. Good morning everyone and thank you for joining us on our conference call to review our operating and financial results for the first quarter of 2009. Dan Fitzpatrick, our Executive Vice President and Chief Financial Officer is with me on the call this morning. In a few minutes he will provide you with additional detail regarding the financial results released earlier this morning.

We plan to follow our standard format for the call today and begin with a high level review of the operating results for the quarter. We next will provide some insight into the status of our efforts related to several of the key elements of our strategic growth plan that most of you are familiar with. After that, we will take some time to talk about our other press release this morning, where we disclosed the execution of a definitive asset purchase agreement to acquire Daniel Webster College.

I will also touch on the current student learning environment. At that point, I'll turn the call over to Dan so that he can provide a bit more insight into another quarter's simply outstanding financial results. I'll then wrap up our prepared comments with a quick summary of what we project in terms of an operating environment for the remainder of the year and then we'll begin the question-and-answer session.

Given that we have a pretty forward agenda today let's get right to it.

As discussed in the earnings release this morning, we had another incredibly successful quarter both operationally and financially and once again exceeded our expectations. We'd like to take a brief moment to recognize and thank our faculties, staff and college management teams for their dedication and commitment to their students and the employers that hire our graduates, to unwavering passion to help students improve their lives to a high quality career based education, is an inspiration to all of us and we congratulate them for the contributions to another outstanding quarter.

As a result of the tremendous performance of our college personnel in the first quarter of 2009 and our continued optimism for what appears to be a very attractive market opportunity for high quality providers of career-based education. We are raising our internal goal for 2009 EPS from the previous range of $6.50 to $6.75 to new range of $7 to $7.25.

Now let's turn our attention to the 2009 first quarter operating results. As we reported in the earnings release new student enrollment increased 36.8% to 18,935 in the three months ended March 31, 2009 compared to 13,844 in the same period in the prior year. This record result exceeded our internal goal and represents the single largest year-over-year percentage increase in new student enrollment since we became a public company back in 1994.

This increase beats the then record 29.2% year-over-year increase in the fourth quarter of 2008. We had very solid increases in new student enrollment in all six of our schools of study in the three months ended March 31, 2009, compared to the same period in '08.

The new student enrollment results were supported by a 3% increase in marketing expenditures during the first quarter of '09 compared to the same period in the prior year. As we reported in the earnings release this morning the year-over-year increase in advertising expenditures during the quarter was far less than we had originally planned.

We continue to experience a very favorable advertising market as the slow national economy impacts the demand for advertising across the various media outlets that we utilize. This reduced demand continues to favorably impact the cost of our advertising.

Based on the most current information that we have obtained we believe that this favorable advertising environment will likely continue through the second quarter and could potentially continue through the remainder of 2009.

As a result we projected our advertising expenditure for the rest of the year will be at or below our original expectation that 2009 expenditures would increase by approximately by 10% compared to 2008.

In addition, to experiencing favorable ad cost, the demand by perspective students for our programs across all six schools of study remained extremely robust as we ended the second quarter of 2009. We believe that the current economic environment once again contributed to this very strong response rates to our media placement.

Additionally, we are pleased to report that the average tenure of our recruiting representatives increased in first quarter 2009 for the same period in the prior year. As many of you are aware the late conversion rate of student recruiters have historically correlated to the tenure in the position.

As a result, more experienced recruiters typically convert student increase at a higher rate and the less experience recruiters. So, to summarize the key variables impacting our student recruitment efforts in the 2009 first quarter.

Advertising costs were at very attractive levels and we believe that they will remain that way through the second quarter of 2009 and possibly the entire year. Response rates for advertising placements remained incredibly strong in the first quarter and as we entered the second quarter of 2009. The average experience level of our recruiting staff continued to increase in the past two quarters compared with the same periods in the prior year.

We believe that each of these variables contributed to the excellent enrollment results, we reported in our earnings release this morning and that these conditions are likely to continue through the second quarter and possibly through the remainder of this year, which would put us in an excellent position to achieve our internal goals for 2009.

Turning now to student persistence. As we noted in the earnings release, we experienced an 80 basis point decline in student persistence to 75.3% in the first quarter of 2009 compared to 76.1% in the first quarter of 2008. As was the case in the fourth quarter of '08, the first quarter decrease in student persistence was primarily due to another record year-over-year increase and the number graduates in the first quarter of '09 that we had anticipated.

A year-over-year increase in the number of graduates in the 2009 first quarter was of course a by-product of the increase due to retention from prior period. Excluding the impact of the increase in the number of graduates student persistence in 2009 first quarter improved compared to the same quarter in the prior year, primarily as a result of higher student retention.

In the remaining quarters of 2009, we do not believe that the number of graduates in each quarter will increase over the same prior year period at the same rate that we had experienced in the previous three quarters. As a result, we believe that student persistence in the remaining quarters of '09 will be similar to what we experienced in the same quarters in '08.

The incredibly strong increase in new student enrollment combined with student retention that was higher than expected resulted in a 21.1% increase in total student enrollment to 65,620, as of March 31, 2009 compared to 54,194 as of the same date in 2008. The year-over-year increase in total student enrolment as of the end of the first quarter was also a record high quarterly increase for the company.

Turning now to graduate employment. You may recall from our January earnings conference call that as of December 31, 2008 the graduate employment rate of 2008, employable graduates was approximately 700 basis points lower than the graduate employment rate of our 2007 employable graduates, at December 31, 2007.

Our graduates continue to experience the effects of a challenging employment market but we are pleased to report that as of April 15, 2009, the graduate employment rate of our 2008 employable graduates was only approximately 500 basis points lower than the graduate employment rate of our 2007 employable graduates, at the same date in '08. While the gap in the year-over-year graduate employment rate remains higher in comparison to recent years, we are pleased that its the initiatives that we have put in place since the fourth quarter 2008 have closed the gap by approximately 200 basis points since December 31st.

We continue to execute on several of these initiatives and I hope that they will increase our 2008 graduate employment rate before the calculation period ends on April 30, 2009. We will report the final graduate employment rate of our 2008 employable graduates in our 2009 second quarter earnings release.

Now for a quick update on the starting salaries of 2008 employee graduates. The average starting salary we reported by 2008 employable graduates was approximately $33,100 as of April 15, 2009. This average starting salary is approximately 2% higher than the average starting salary we reported by our 2007 employee graduates as of the same date in 2008.

Despite the economic slowdown we are cautiously optimistic that the average starting salary of our 2008 employee graduates will be higher than the average starting salary of our 2007 employee graduates. That increase will be less however than the year-over-year increases of more than 5% realized by both our 2007 and 2006 employee graduates and will reflect the deflationary factors impacting the current labor market.

I would like to take this opportunity to publicly thank our career services professionals throughout all of the ITT Technical Institutes around the country, for their efforts to help our 2008 employable graduates find employment in their fields of study at attractive salaries.

At this point, I would like to provide an overview of our progress, with a few of our key growth initiatives. A core element of our organic growth strategy involves, increasing the number of locations in our system. We expand geographically by adding new colleges of which there are now 106 and new learning sites of which there are currently nothing.

As we reported in our earnings release this morning, we began operations at our 106th college during the first quarter of 2009 with the opening of our new college in Concord, California, a suburb of San Francisco.

The addition of this college brings to 11 the number of ITT Technical Institutes operating in California. We plan to begin operations at six to eight new ITT Technical Institutes locations in 2009 and at this point we are well on track to achieve this internal goal.

Developing and introducing new associate and bachelor degree programs of study in both technology and non-technology fields that can be delivered both in residence and online is an another key part of our interim organic growth strategy that we have deployed over the years.

In the three months ended March 31, 2009, we added 88 program offerings at new and/or existing ITT Technical Institutes throughout the United States. As a result, we are very much on pace to achieve our internal goal of adding approximately 250 programs to new and/or existing ITT Technical Institutes in 2009.

During the first quarter, we continued to expand a number of our colleges that offer associate degree in nursing. We obtained all of the required authorizations to begin offering the nursing program at four additional colleges, bringing to eight the total number of ITT Technical Institutes authorized to offer these associate program in nursing.

The expansion of our nursing program across our network of colleges is a long term initiative and we do not expect that this program will contribute materially to our growth strategy over the short term. However, we remain very excited about the prospects for our nursing program long term. We plan to obtain the required authorizations to begin offering a associate degree program in nursing and several additional colleges throughout the reminder this year.

During the first quarter we also completed the development of a new associate degree program Paralegal Studies to be offered to our School of Criminal Justice. We expect to begin offering the new Paralegal Studies program both online and in residence at a handful of our colleges during the academic quarter that begins in June 2009.

As we began the 2009 second quarter, we had several other programs of study that we are researching and evaluating. These potentially program offerings are in both technology and non-technology areas of study and can be delivered both in residence and online. We plan to begin offering several of these new programs at one or more of our ITT Technical Institutes in the second half of 2009.

At this point, I would like to spend a few moments talking about the announcement regarding our planned acquisition of Daniel Webster College. As we reported in the press release this morning, Daniel Webster College is originally accredited is regionally accredited by the Commission on Institutions of Higher Education of the New England Association of Schools and Colleges. And currently serves approximately 1200 students of its 52 acre campus in Nashua, New Hampshire and that an additional location in Portsmouth, New Hampshire.

The college offers professional and technology based programs of study and the associate Baccalaureate and Master degree levels both in residence and through distance education. We have not disclosed the financial terms of the transaction but we reiterate our comments in the pres release this morning, that the transaction will not have a material impact on our financial condition.

Further, we do not expect that the acquisition of the college will have any impact on our revised internal EPS goal for fiscal 2009 that we disclose in this morning's earnings release and discussed earlier in this call.

We all however extremely excited about this potential acquisition. Daniel Webster College is a very well respected high quality institution of higher learning focused on educating men and women for professional entry and advancement. They have talented and committed administration faculty and staff for dedicated consisting their students improve their lives through high quality education.

This makes Daniel Webster College an ideal fit with the culture and mission of our organization. Beyond the similarities of cultures, Daniel Webster Colleges' strategic plan is consistent with our strategic roadmap which makes this transaction very compelling for both parties.

Our strategic roadmap includes the acquisition of a separately branded institution, to pursue a different audience but that targeted by the ITT Technical Institutes. Currently, the majority of ITT Technical Institutes perspective students are career changers, are people who seeking an education that can help them change their current employment from a non-skilled position to a skilled position in their field of study, typically with a new employer.

Daniel Webster College we expect to execute the same proven and successful growth strategy that we have been executing on to grow the ITT Technical Institutes over the past 10 plus years. That strategy for Daniel Webster College however will involve targeting on new market.

One that we referred to as a career advancers demographic. Career advancers are people are seeking education that can help them enhance their skills in order to advance the higher levels within their career, whether within or outside their current organization. The strategic growth plan for Daniel Webster College includes both geographic and problematic expansion initiatives similar to what we have successfully accomplished with ITT Technical Institute over the past several years.

In addition, our plan calls for an expansion of a number of online programs offered by Daniel Webster College, similar to what we have done with ITT Technical Institute to our extended distance education offerings.

ITT ESI will provide the necessary resources and expertise to assist Daniel Webster College in executing this proven and effective growth strategy. To reiterate we're very excited about this transaction and welcoming Daniel Webster College into the ITT ESI family.

We look forward to obtaining all of the required approvals to consummate the acquisition by early July 2009. I'd like to shift gears a bit and provide a very brief update on the student financing environment.

On the private loan front, there is nothing new of any significance to report here related to traditional student learning organizations. Not much has changed in the first quarter from the prior quarter and we were not aware of any material changes planned on this front, as we entered the remaining nine months of 2009.

That said, I do want to provide a bit more color on the new private lending arrangement that we probably disclosed in February. We are pleased to report that the new loan program is up and running and the lender is processing private education loan applications for our students.

As we reported in the earnings release this morning, we did experience some delay in the integration of our system with that of the origination sector. The integration issues are not material and will be resolved such as the new program will be fully implemented in the second quarter of 2009.

The delay however did result in four fewer private student loans being disposed to the program, during the first quarter of '09 than originally planned. The delay in the full implementation of the program resulted in a DSO of 16.1 days as of March 31, 2009, which was higher than our internal goal of between 10 and 15 days. We are confident, however that we can still achieve our internal DSO goal for 2009, as the program becomes fully operational.

Now just brief comments about the federal student loan market, which for the most part is a repeat of what we reported to you in our January call. Our students continue to have uninterrupted access to federal loans to FFEL program, we did not experienced any disruptions in FFEL servicing or in the disbursement of those loans during the first quarter of 2009.

Several student lenders are offering FFEL loans to our students, and we do not anticipate any disruption in our students' ability to access federal student loans from FFEL lenders, for the foreseeable future. The FFEL program is operating very effectively and efficiently for our students at this time.

That said, we are very aware of the provisions in the President's budget to eliminate the FFEL program. All of our colleges are prepared to immediately convert to the direct loan program as soon as we believe that it's prudent to do so.

We continue to monitor the situation very closely and are making preparations to fully integrate our financial aid information system with the direct loan program in advance of the proposed end the FFEL program on July 1, 2010. We do not believe that any future direct loan integration effort will be significant and have a material impact on our financial division or results of operations.

Now to close out the student financing portion of our prepared remarks, let me just reiterate a comment that I have made several times in past communications. We continue to believe with the financial aid that is currently available to our students including our internal student financing is more than sufficient to provide to students with access to the funds needed to pay the cost of their ITT Technical Institute education and allow us to achieve our 2009 goals.

At this point, I would like to toss it over to Dan for his portion of our prepared comments.

Daniel M. Fitzpatrick

Thank you, Kevin. I'll begin as usual by reviewing the key financial highlights of what proved to be a record breaking quarter for us. In the three months ended March 31, 2009 revenue increased 22.6% 288 million compared to 234.9 million in the same period in 2008.

Revenue increase was mostly due to a solid increase in total student enrollment as of December 31, 2008 compared to the same point of 2007. Earning per student increased 4.9% in the three months ended March 31, 2009 compared to the same period in the prior year primarily as a result of the improved student retention and a 5% increase in tuition became effective with the academic quarter that began in March 2008.

Cost of educational services increased 9.1 million or 9.8% to 101.1 million in the three months ended March 31, 2009 compared to 92 million in the three months ended March 31, 2008, primarily due to the higher cost to support increased number of our student and to operate our new colleges.

Cost of educational services as a percentage of revenue decreased 410 basis points to 35.1% in the first quarter of 2009 compared to 39.2% in the three months ended March 31, 2008.

What we're seeing once again is that the leveraging that's available with our model when we post very strong total enrollment growth. As a reminder, we begin the quarter with 16.9% increase in total enrollment as of March 31, 2008 compared to the same point in the prior year.

Student services and administrative expenses increased $12.7 million or 17.1% to $86.8 million in the first quarter of 2009, compared to $74.1 million in the same period in the prior year. The increase was primarily due to an increase in bad debt expense to 4.9% of revenue for the first quarter of 2009 compared to 3% in the same period in 2008 as a result of the increased amount of internal student financing that we provided.

We expect to continue offering internally funded financing for our students who require GAAP financing but do not qualify for third-party private loan. We believe that the amount of internal student financing that we will need to provide in 2009 will be in the range of $50 to $75 million and that our bad debt expense will be in the range of 3% to 5% of 2009 revenue.

Despite the 190 basis point increase in bad debt as a percentage of revenue, student services administrative expenses as a percentage of revenue declined 140 basis points to 30.1% in the three months ended March 31, 2009 compared to 31.5% in the three months ended March 31, 2008; primarily as a result of the favorable advertising environment.

To reiterate we believe that we will continue to experience a favorable advertising market in the second quarter and possibly the remainder of 2009. We also believe that the year-over-year increase in 2009 advertising expenditures will likely be equal or less in the originally planned 10% increase over 2008.

Operating income increased a very impressive $31.4 million or 45.8% to $100.1 million in the first quarter 2009 compared to $68.7 million in the three months ended March 31 2008.

Operating margin increased 550 basis points to 34.8% in the three months ended March 31, 2009 compared to 29.3% in the first quarter of 2008.

Earnings per share in the quarter increased 47.2% to $1.59 compared to $1.08 in the prior year. Cash, cash equivalents, restricted cash and investments was 365.7 million at March 31, 2009 compared to 309.1 million at the same point in 2008.

Day sales outstanding increased 10.3 days to 16.1 as of March 31, 2009 compared to 5.8 days as of the same date in the prior year. As Kevin already mentioned DSO was negatively impacted by the delay in the implementation of a new private loan program for the students. The minor systems integration issues have caused the delay of being address and will be result in the second quarter. As a result, we believe our DSO for 2009 will be a range of 10 to 15 days.

In the first quarter we repurchased 527,833 shares of our common stock for approximately 64.4 million with an average price of $121.93 per share. There are approximately 3.4 million shares of our common stock remaining under the share repurchase program authorized by our Board of Directors.

Turning on market conditions, we intend to repurchase additional shares of common stock during the remainder of 2009. Cash flow from operating activities in the three months ended in March 31, 2009 were $61.3 million company to $79 million in the same period in the prior in year. The decrease was primarily due to reduction funds received from private education loans on behalf of our students, due to tighter underwriting standards, implemented by lenders in 2008.

The tighter lending terms, began to impact our cash flow from operating activities in the second quarter of 2008. So, these changes we're anniversarying in next quarter. Our internal goal for free cash flow in 2009 is in a range of 2010 to 2025 million compared to the 160 million we generated in 2008. We believe that we are very well position to achieve our internal goal, 2009 free cash flow.

Free cash is a non-GAAP metric. The reconciliation of the calculation of free cash flow to the related GAAP measure can be found on our website at www.ittesi.com. I'd like to end my comments by reiterating that we believe the fundamentals of the business have never been stronger. We remain very confident in our ability to achieve our 2009 internal goals. We believe the outlook for the business in 2009 is very attractive and we are incredibly well positioned to achieve our internal 2009 EPS goal in the range of $7 to $7.25.

And now I will turn the call back over to Kevin.

Kevin M. Modany

Thanks Dan. Obviously, we have a great deal of confidence in our ability to achieve our goals in 2009 and we feel really good about the prospects for the business. Our single internal focus continues to be on maximizing student success and helping our students improve their lives through a high quality career-based education offered by our ITT Technical Institutes. We believe that significant shareholder value can be generated over the long-term through this focus.

Although these are very trying times economically for a nation as a whole, we have an opportunity to play a very critical role in helping to educate the nation's work force to be competitive in a very challenging 21st century global marketplace and we are certainly eager to do our part.

At this point, I would like to ask the operator to open the lines so that we can entertain your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Thank you. Our first question comes from Gary Bisbee of Barclays Capital. Please state your question.

Gary Bisbee - Barclays Capital

Hi guys, congratulations on the quarter.

Kevin Modany

Thanks Gary.

Gary Bisbee - Barclays Capital

I guess, I guess the question is as it relates to demand you've talked about the response rates being up obviously, which grows up despite not spinning much more I guess. We all know you comp a lot of tougher number last quarter, can you give us any color on how strongly flow is and how much is the response rates are up such that, I know you're not going to tell us what you think you'll grow when you lapped that, but it seemed to you like there is still opportunity for attractive new student growth as we look out over the next four quarters, despite much tougher times?

Daniel Fitzpatrick

Yeah, I think you're reading right Gary. We're seeing consistent -- consistently strong response rates as we headed into the second quarter. We're not -- certainly not seeing any slowdown in that regard. Obviously, we're not going to break that down into any kind of detail in terms of what we're seeing but, we're optimistic, and we think that the variables associated with on the front end of our business and we touched on some of those in our prepared comments.

We think those are aligned properly and the advertising market continues to be very favorable and then the response rates for those placements those more efficiently placed advertising spots, the response rates are very strong. So and then sort of handle that we got more experience recruiters handling those increased number of inquiries with regard to our program. So, we're optimistic, we're pretty up beat but I would definitely stop short of giving you any specific number.

Gary Bisbee - Barclays Capital

Okay and than I guess just a follow up question. Can you provide anymore details on exactly how this new lending program works or at least give us some sense of the accounting behind it is likely to work or show up in your book?

Kevin Modany

Sure. Yeah it's a no different on the accounting front and any other private loan program that we've had in the past. So, there is no recourse, there is no reserve requirements on our part. We do have a riskier arrangement but the level of risk here is much higher and besides much higher than historical rates such that that we certainly do not anticipate that ever being triggered. Even with consideration for the current economic environment.

So I want to make sure people understand we are certainly thinking about that. So what happens is the same is any other private loan program where we can get funds dispersed for students upfront and we process the transaction in a similar way. So nothing special on the accounting front there I'll just add a little color you didn't ask about but I'll add it with regard to just processing some delays in the startup which is nothing that would seem to be unusual these things occur in terms of us processing some of these transactions so we didn't see up and disperse anywhere new that our number of loans that was anticipated. But very optimistic that all of those issues will be addressed in the second quarter and we'll have the program up and running. So we are very pleased with we're at with that.

Gary Bisbee - Barclays Capital

Thank you.

Kevin Modany

Okay.

Operator

Thank you. Our next question comes from Bob Craig with Stifel Nicolaus. Please state your question.

Bob Craig - Stifel Nicolaus

Good morning guys.

Kevin Modany

Good morning, Bob. How are you?

Bob Craig - Stifel Nicolaus

I am fine. Couple of questions for you here, is the growth rate at all straining the organization in any way and how do you think about potentially metering that growth as to avoid any diminution in academic quality? And I guess something associated with that aren't you bumping up against capacity issues in that?

Kevin Modany

Sure. We certainly are always mindful of quality, student outcomes, student success, that's our number one priority in terms of the way we manage the business. It has always been the number one priority for us. So everything that we do takes that in to consideration.

What I am pleased to report much you can see in numbers is that we're seeing better student results so this growth is not straining our ability to provide high quality education to our students nor is it impacting the outcomes that we're seeing and in fact seeing slightly better retention, slightly better student outcome.

So we are pleased on that front. In terms of I think you have touched on capacity as well in terms of capacity, luckily we had prepared ourselves for some changes in our infrastructure in the way that we're processing transactions. In the way that we're scheduling, what -- we're handling this very well. We always have a handful of schools that are in the pipeline to increase capacity and that's the case now. There might be one or two more but not more than that, nothing that we can't handle, nothing that you would expect to see an increase CapEx.

When we look at capacity and we gave you a measure of that we always talk about it in terms of -- the unit of measure is classrooms. And so if we look at the number of classrooms being utilized and then we always preface it by saying it's really only a measure for us to be concerned within the evening, because we still have 70%-75% of the students going to classes in evening.

When we look at that, we're probably at about 75%, so we're really in deepen shape there of course we'll have investments and we're not showing away from investments, but we set ourselves up to handle this additional volumes and at this point, the output if you want to use that as a proxy for quality and I know a lot of people could talk about a lot of different things there. But the outcomes and the retention numbers are moving in the right direction as well. So, we're pleased.

Bob Craig - Stifel Nicolaus

Kevin, another quick one is the average class size increasing?

Kevin Modany

Very slightly, you're seeing a little bit of that now obviously there is lot of leverage power in that section size increasing -- you get a have a student which wouldn't mean anything to anybody in that classroom. It means a lot when you are spread out across 106 locations in 65,000 students that you're servicing. So, we're seeing a little bit there but nothing that I would say as material?

Operator

Thank you. Our next question comes from Amy Junker with Robert W. Baird & Company. Please state your question.

Amy Junker - Robert W. Baird & Co. Inc.

Good morning. I was hoping you could talk little bit more just about the strategy with respect to the acquisition interesting that it's a regionally credited school, I'm wondering if you're thinking of doing what acquisitions along those lines looking to may be get regionally accredited in your core business if you could talk about that a little bit?

And then just perhaps touch on kind of the mix of the students there in terms of or may be even mix of the programs that are offered associates versus bachelors versus masters and how it looks breaking down online versus on ground? I would appreciate that thing.

Kevin Modany

Sure. I'll try to touch on all those if I miss something may be you can comeback on a follow on. With regard to the strategy just touching on that briefly, certainly do not anticipate additional acquisitions. This goes back many years but I personally and I am sure Dan as well talked to many of you guys over the years and said that if we could find very high quality institution that was smaller and we weren't looking to acquire revenues that was smaller then presented us with an outstanding platform for us to potentially execute our strategy in a different demographic that we would always be interested in that.

Now, we just over the years hadn't found an opportunity like that, current conditions being what they are, the economic conditions are I think as many of you can se creating buying opportunities. And, this is one that occurred here on financial resources constrained somewhat at the college. This presents us with an opportunity to partner with a very high quality institution that enables us to do what we do in a different demographic.

So, I touched on some of these in the prepared comments. We're talking about their strategy which is consistent with what we like to do in new locations, new programs, increasing the distance education offerings at the associate baccalaureate and master level. And so that's what we intend to do with this going forward. We'll provide the resource and the expertise to do it.

In terms of mix of students and everything, we're not going to get into all of those details in this call we'll give you some more insight on that. I would anticipate however as we look at that demographic that career advancer demographic that, you might see a mix longer term and I am talking about where they are today. But longer term, you might see a mix sought of the inverse of what you're seeing with us, where we may be 80/20 on the associate side it might be the other way around. But that's probably premature for me to project that but I think just based on a demographic that's what we're likely to see.

Amy Junker - Robert W. Baird & Co. Inc.

Great that's helpful. I'll let some one else jump on. Thank you.

Kevin Modany

Okay, thank you.

Operator

Our next question comes from Andrew Steinerman with JP Morgan. Please take your question.

Andrew Steinerman - JP Morgan

Hi there guys. I really like the positioning of the acquisition. Can we talk about the core business areas that we're investing and obviously the operating margin expansions here has been really strong. Are we taking advantage of that environment to also kind of healthily reinvestment in the business? And if you could speak specifically on the educational services lines that you mentioned a little bit of capacity expansion. What other things are you investing in here now?

Kevin Modany

Hi, Andrew. Yeah absolutely we're investing in that kind of business. We're doing that all the time, but we do it on a relative basis, so as we get larger you're going to see a larger percentage of resources allocated investing in the business. Certainly a big part of that would be on the ad services side. I think just because when I say that I mean relative to our educational delivery. And I say that because that's a big huge part of the business I mean that what's we're all about, maintaining quality there and requires that we continuingly make investments on improving what we do.

So, I won't get in to a lot of specifics, and we've not been known to do that, but I would tell you, you mentioned one certainly we're talking about capacity. And secondly I would say technologies and then just making constant reviews of our programs and our outcomes, and doing some innovative things there just to make sure that we're really linking up with our expected outcomes and we've done that all the time and we're just trying to use technology, to make us more efficient in collecting that data and analyzing that data to see that whatever we expect in terms of the program outcome, and we're actually achieving that goal.

So I would say technology capacity and those are the two big areas where we're spending some money on that ad services side of the business.

Andrew Steinerman - JP Morgan

Great. And in that services do you feel like you're able to accomplish the level of investment that you want with an eye towards the intermediate term, or do you feel like the next two quarters might have a different kind of spending pattern as a it occurs to investments for the intermediate term on the ad services line?

Kevin Modany

No different level of investments there. We don't have anything timed in that perspective, we're making investments, we're always making investments and we'll continue to do that throughout the remainder of the year quite frankly.

Andrew Steinerman - JP Morgan

Okay. Thank you very much.

Kevin Modany

Thank you.

Operator

Our next question comes from Trace Urdan with Signal Hill. Please state your question.

Trace Urdan - Signal Hill Capital Group

Thank you. I just have one kind of quick follow up to Gary's questions about the new loan program. Is there any accounting for this risk factor, I know you mentioned that is minimal probably not material, but is there someway of accounting for the liability associated with the risk sharing?

Kevin Modany

The accounting would be that we would report a reserve if thought that we had some risk associated there. So at this point in time there is no expectation for that. But over the long term if we changed our view on that then yes there would be some reporting of that, but that's nothing we're anticipating at this point, Trace.

Trace Urdan - Signal Hill Capital Group

Okay. And then Kevin you spoke about your expectation that the level of salary increase is going forward would probably be below the historic average of around 5%. I wonder if that make you think any differently about pricing as you look forward in your model.

Kevin Modany

Well, Trace you have heard me say this many times, I mean we are going to price and put the two issue cost out there totally on a basis of the value proposition. The value proposition is driven in part by starting salaries.

But certainly we would look at it as in a one year micro cause and just like when we saw increases over the last two years over 5% and we saw increases in federal funding on a program side, our reductions in interest rates on the loan side; increases in federal loan limits which have lower interest rates away from private which further reduce the debt service cost.

Just as you saw those favorable things happening that would have suggested if we were doing a one year or two year analysis then we would have increased to wishing more than 5% and we didn't. Likewise you wouldn't look at it in one year microcosm in here and say okay I got a 2% so I'm going to go below that. And again those other variables are still on play on a year-over-year comparison to a certain extent driving it forward.

So, and driving the value proposition higher I should say on a year-over-year basis; so its not just the salary but it is a variable, absolutely it is something we always look at and we will continue to monitor that and that along with all the other variables we talked about drive value prop which drive the tuition, but short term no it doesn't change our view, long term its absolutely part of the equation.

Trace Urdan - Signal Hill Capital Group

Okay. And then last question is Daniel Webster online and if it's not are you intending to take it there?

Kevin Modany

It is online and I would tell you that certainly expansion of the distance education offerings is part of our strategy.

Trace Urdan - Signal Hill Capital Group

Great. Okay, thanks.

Kevin Modany

Thank you.

Operator

Our next question comes from Mark Marostica with Piper Jaffray. Please state your question.

Unidentified Analyst

Hi, it's actually Mark Scotovich (ph) for Marostica is traveling. Just a couple of questions as it relates to direct learning program, I am just wondering if you're anticipating any incremental costs there if we do move that direction specifically default prevention costs given the guarantee agencies are absolute in the deal program?

Kevin Modany

Yeah, nothing at this program and I think all that has to wash out yet there's a lot of discussion and right now, about default prevention and default management and how would that be handled in any kind of elimination of FFEL program. I think what's encouraging is that everybody in Washington agrees that we need to provide sufficient resources to manage defaults and we certainly no one in Washington or at the schools -- no one wants to back away from that.

So it's my expectation and I don't like to predict what will occur but its my expectation that those resources will be provided as part of a direct loan program should we end up with an elimination of our FFEL and I would expect that they will be similar to the services that we have available to us now.

What form they take I honestly don't know and there likely will be a lot of discussions between now and in the time when does get sort of formula. But I really do expected to be there. I can't imagine anyone looks at what we dealing where there is nation and says that we want to pull back resources there.

Unidentified Analyst

Sure makes sense. And just one question on the FFEL line down and impressive by our calculations 14% in the quarter that compares to roughly 6% down in '08. Just looking at that '08 number, can you just give some sense of how much the ad environment contributed to that decline and looking at this quarter and based on your comments about less than or equal to that 10% looks like we're obviously well ahead of that. Can you give some sense of direction there, as to where that how that might play out in this year?

Kevin Modany

Well I can tell you certainly the advertising environment remains very favorable. Certainly it contributed during the quarter and was a big part of the contribution, quite frankly. So that certainly played itself out and as we look forward expect it to play itself out.

We talked a lot about how we're taking advantage of this environment and we certainly want to make sure that we are reaching out and attracting the appropriate number of students, so we are not going to back away from spending but at the same time we're going to let some of those efficiencies flow through.

So, I don't know that anything you're seeing in the first quarter is materially different than what you'll see on a relative basis for the remainder of the year, if in fact as we suggest it might occur this favorable advertising market remains in play for the rest of the year.

Unidentified Analyst

Okay, great. Thank you.

Kevin Modany

Thank you.

Operator

Our next question comes from Kevin Doherty with Banc of America-Merrill Lynch. Please state your question.

Kevin Doherty - Banc of America Securities-Merrill Lynch

Great. Thanks for providing some of the commentary for the free cash flow outlook. And but just I am curious if you can just drill down a little more on deferred revenue, may be talk about what influenced that in the quarter and what's the outlook for the rest of the year?

Daniel Fitzpatrick

Kevin this is Daniel. Actually that's pretty consistent with what we have been talking about for a while. the shift from private to federal, the private monies were disbursed upfront and mainly there is less of those now. But then when you're replacing that with federal loans that are staggered and in our world of academic years how they are calculated but they are staggered over three quarters.

So that's had a significant impact. So that's nothing that hopefully folks that were paying attention what we were talking about would be surprised and where it goes, its really hard to say we think that you're seeing pretty much how things are going to play out going forward. It shouldn't change dramatically from what you are seeing now, relative to students, relative to future revenues and things like that -- things along those lines.

Kevin Doherty - Banc of America Securities-Merrill Lynch

Okay. And then just in terms of your internal lending program, I guess there is an expectation you guys are begin to surcharging interest and may be some fees this year. Where do you think stand in front?

Kevin Modany

Kevin, this is Kevin. We've got the mechanism in place to do that and so we are ready to go as we expected to be as we sort of headed into the second quarter. I would not if I were building a model make any changes to my model with expectations for interest income or anything along those lines. We have the capacity to do it; we are just going to see how that plays out with our new private loan program and how we ultimately put that vehicle to play.

We right now have non-interest bearing loans for students and then we have the new private lending program. We're just going to let the two play each other out. Just tell you that for the rest of this year I would not adjust my model for any kind of impact from interest income of these loans.

Kevin Doherty - Banc of America Securities-Merrill Lynch

Okay. And if I can just get one more and could you just talk about your current thinking in terms of the size of this risk share program, because I guess when you initially lowered the range from your internal lending, it kind of imply that this program could be anywhere from 5 to 25 million, but what do you guys thinking at this point?

Kevin Modany

Well, I am not sure when we get the 5 to 25 million, but we're not giving the details on what the size of the program is right now, except to say that our internal financing expectations are $50 to $75 million right now. So, but I would tell you, I'm not going to quote on the numbers but 5 to 25 is much lower than we're at with this.

Operator

Thank you. Our next question comes from Brandon Dobell with William Blair & Company. Please state your question.

Brandon Dobell - William Blair & Company

Thanks. I want to go back to the capacity metrics for a second. Are you assuming any kind of real shift in the times that students want to go to class, I know you guys talked about evening capacity, but is there a different distribution of what the classes look like these days and they are related to that? Anything to give us some color on what the adjunct versus fulltime faculty mix looks like now, generally you used to report it I think but we didn't see in the recent 10-K?

Kevin Modany

And sure, in terms of the shift in times, we've seen a little bit of that and probably not enough to move without significantly. But may be a couple of points to be honest what we're seeing a little bit more during the day time and slightly more in the afternoon, but probably nothing to speak up. But we're still predominantly in the evening so, to the extent that we talk about better utilization and capacity, we are getting a little bit there, I will tell you that, but more so just because we're being more efficient with the schedule.

In terms of the adjunct versus the fulltime and we're pretty much very close to the levels we've been at and we talked a lot about how we're kind of moving that around and trying to make sure that we put the right type of faculty member in the right type of class and where adjuncts do really well they bring that real world experience to the classroom and they do incredibly well in courses that we refer to as our core courses or tactical basic courses and those folks can bring well load of experience to the class and to students on the tell us on the surveys but we see in the results and you're seeing in better retention quite frankly that's what they like to see.

So, that initiative per say if you need want to call that or the movement that we seen over the past couple of years result purely as a result of our effort to try to get higher student success rates and thankfully its worked and so we've not tweaked it materially and I don't anticipate that we will and but we'll just keep managing be it the best student success rate we can.

Brandon Dobell - William Blair & Company

Okay. And then I just want to make sure that I got your statement earlier about persistence and retention correct. I think you said that persistent should be relatively flat versus last year. But into that with or without the changing graduations I mean how much difference do you think that will make to how we should think about that metrics for the balance of the year?

Kevin Modany

Sure. I will split it out and talk a little bit, provide a little color on it and obviously we talk persistence we're talking graduates and retentions. So there is two variables there. We've over the last couple of quarters we've seen some very significant increases in the graduates because of improved retention going back to probably three quarters in 2007, little bit of 2008.

So that really shows some significant increases in the number of graduates and that put pressure on the persistence but obviously that's a good thing that's we are trying to do. During that time we've held or are seeing slightly better retention over that period of time, so its enough to ask that significant increase in grads but still yet moving in the right direction.

As we look forward, we're taking -- think about it in terms of being flat year-over-year the grad number is not expected to be at the same level but we'll have increases of course but not expected to be at the same sort of record levels that we've seen over the last three quarters.

On the retention side of things again not given a lot of guys but seeing fairly decent things they we're cautiously optimistic obviously last couple of quarters we've seen some improvement there; early part of this academic period we're seeing the same kinds of things but we're saying if you model out flat you won't too wrong.

Brandon Dobell - William Blair & Company

Okay. Great, thanks guys.

Kevin Modany

Sure.

Operator

Our next question comes from Corey Greendale with First Analysis. Please state your question.

Corey Greendale - First Analysis

Hi, good morning.

Kevin Modany

Good morning, Corey.

Daniel Fitzpatrick

Hi Corey.

Corey Greendale - First Analysis

First question was on the placement rates Kevin, could you give the absolute number of the placement rate? And the second question is have you had discussions with ACICS what is the impact if you do have a little dropping below to 70% placement rate?

Kevin Modany

Sure. Not given the color on that sort placement rate that we're providing on an interim basis but just a kind of related to year-end number because quite frankly I gave the April 15th number and we cut it off at April 30th. So we are only two weeks away at the time of that number. We ended last year at 82% so for 500 basis points off that would sort of equate to 77%. So that's just to give you a little bit of a relative comparison in terms of those numbers. When you talk about ACICS, ACICS as part of their accreditation where view processes looks for schools to be about 65%.

So we're at 77% right now. Even that being said, I want to qualify that and not try to go too far off on the regulatory discussion here but even its 65% its not like its some sort of debt penalty, I don't want people to take that run within; really what would happen is you would be on reporting if you're at 65 and again more talk about being at 77. But if you are at 65 and you're on reporting and then you have to go through a couple of additional processes and procedures to get new programs in new schools and things of that nature. But by no means is it prohibitive.

Further I'll just add one other comment, ACICS is not unaware of what's happening in the marketplace and ACICS understands that these measures are relative and will look at and has told us and told other schools that they are looking at these things and they want to be mindful of what's happening in the marketplace. And make sure that they set their expectations in accordance with what's happening out there today in the market.

So if you're asking me and I think you are indirectly. If you are asking me if we have a material concern here relative to any of that on the ACICS front, I can tell you and frantically no.

Corey Greendale - First Analysis

Okay, that is very helpful. And my second question is for Dan, I just want to go back to the cash flow, I think you said people should have expected the cash flow to lag it internally. We did expect that. And that said cash flow has been lagging but it's still been up year-over-year for the past couple of quarters.

DSOs have been up and it bumped up more significantly, sequentially this quarter, so it seems like some thing did change I am wondering if your other private lenders tightened their standards more and you to do more private lending temporarily until this new program came online if there is something else that changed in Q1 relative to Q4?

Daniel Fitzpatrick

Not really Corey, with the change in Q1 if you will we'll have to do with the timing of the lenders tightening their granting of private loans last year. We really were not impacted till the second quarter, so when you think about what we were putting out there relative to some expectations in terms of free cash flow we still feel comfortable that and if you look at how that's going to play out over the quarters obviously you're going to see improvement going forward. It's just the fact that 2008 we were able to or our students were able to enjoy a better private loan environment throughout the first quarter.

Corey Greendale - First Analysis

And so any rapid change with respect, the cash flow to grow inline with net income in future quarters?

Daniel Fitzpatrick

Yeah, in fact if you look at the guidance you'll see that it should be pretty in that stuff.

Corey Greendale - First Analysis

Okay, thank you.

Operator

Our next question comes from Paul Ginocchio with Deutsche Bank. Please state your question.

Paul Ginocchio - Deutsche Bank

Thanks for taking my question. Just wondering with your exposure to Michigan, Ohio and Indiana if you're what kind of preparations you're making for potential bankruptcy be either crisis or GM and how, what opportunities or threats that may present? Thanks.

Kevin Modany

Sure, thanks for your question. Nothing really specific to speak to relative to any of those companies. Obviously there is definitely correlation and the opportunity for us to help people improve their life through education. When we see the unemployment rates -- unskilled individuals go up. And that's what we are seeing right now.

Those markets likely with any kind of change in the status of those companies and by the way we're seeing some of that, but change in status of those companies and how it impacts our employees and in particularly the unskilled employees likely presents a opportunity for us to help those folks, we too and reposition themselves, on some high growth employment opportunities.

So nothing again to speak to overly, specifically of those regions but I think what's happening there is happening in a lot of places and we're hopeful we can play our part in helping those folks redo (ph).

Paul Ginocchio - Deutsche Bank

Thank you.

Operator

Our next question comes from Kelly Flynn with Credit Suisse. Please state your question.

Kelly Flynn - Credit Suisse

Thank you. Hey guys.

Kevin Modany

Hey Kelly.

Kelly Flynn - Credit Suisse

Sorry to ask you this, but can just chime in on the view that the department of education over the side is getting tougher and specifically tell us if there are any departmental enquiries or audits or any key time or other losses that are out there they are having interest close? Thanks.

Kevin Modany

Sure Kelly, we can't speculate on what is likely to happen. I certainly can tell you that there is nothing unusual going on here. Obviously, we didn't report anything we don't anticipate reporting anything in our Q. So, there is nothing to report on that front; obviously lot of folks trying to speculate on what likely could happen with the changes in the administration and what not.

Let me give our view on it and take it for what its worth. We hear the President talking about every American participating in one year post-secondary education and when we hear the President talking about having the highest participation of citizen range with post-secondary education degrees by the year 2020, the highest percentage in the world. We really struggle to reconcile with the argument that in some ways then they are going to put measures out there to reduce capacity in order to do that, its just doesn't make a lot sense quite frankly

We're encouraged by the focus on post-secondary education. We are encouraged by the President's budget that provides more money for post-secondary education that provides additional programs, that provides potentially another loan program for student. I think the administration and Congress recognize the need and everything that we hear in our channels and our contacts there is overwhelmingly favorable in terms of their emphasis and focus and willingness to make investments in post-secondary education.

Any discussion coming out of Washington, whether it be from the administration or the secretary or others about access and accountability while we welcome that that's what we're all about that's we do everyday. So, we see this is a very favorable environment quite frankly and we realize what needs to take place here in this country. I mean people need to get additional training.

The unemployment rate for unskilled people is extremely high. And, if we're going to be competitive in a 21st global century, global work force, excuse me, 21st century global work force, we have got to train these people and quite frankly, we don't have capacity to do it today. So again the emphasis I think its going to be on increasing capacity and increasing access and then holding those accountable for results which again we do every day that's in our DNA.

We can't conclude anything other than this is the positive step forward for post secondary education and again we think we have a part to play in that.

Kelly Flynn - Credit Suisse

Great, thanks. Just one more quick one. Do you guys know what the average interest rates are in the private loans that your students have outstanding?

Kevin Modany

That they have outstanding or that we have...

Kelly Flynn - Credit Suisse

Yes not your loans but the private loans that are still....

Kevin Modany

Well, I don't know that I can say exactly on the average private loan. I can tell you that the average blended interest rate for our students on their debt is probably around 5% or 6%.

Kelly Flynn - Credit Suisse

That includes the federal loan.

Kevin Modany

That's correct.

Kelly Flynn - Credit Suisse

Okay, thanks a lot. I appreciate it.

Kevin Modany

Sure.

Operator

Thank you. And there are no further questions at this time. I will now turn the conference over to management for any closing comments. Thank you.

Kevin Modany

Thank you very much. Just want to thank all of you for participating in the call today and look forward to talking with you in July for our second quarter earnings call. Thanks again.

Operator

This concludes today's teleconference. Thank you all for your participation. All parties may disconnect now. Thank you.

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Source: ITT Educational Services Q1 2009 Earnings Call Transcript

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