Fast Times At ESI

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 |  About: ITT Educational Services Inc. (ESI)
by: Nick Mulcahy

Summary

Significant new holdings by investment funds with short horizons.

Sale and leaseback of real estate worth up to $119 million.

Questions remain over private loans program.

Background

To paraphrase Henry Kissinger, there can't be any more crises for ITT Educational Services (NYSE:ESI) in the coming months; its schedule is already full.

Among other problems, the company has a current short interest above 65% of the free float, poor comparative financial results, a 10-K that was due in March but has still not been filed, recent insider selling, complications with its credit and guarantee arrangements for the PEAKS program covering private loans of some of its students, SEC and other government inquiries and pending litigation. It has been very challenging for most investors who entered the stock since 2009; the price is down about 80% from the high of $130 in late January of that year. General investor sentiment has been consistently negative.

It's also fair to say that a lot of this bad news is already priced in. A rough estimate of the intrinsic value of the company, assuming zero growth from the 2013 results (and, of course, its continued survival) is around $80 per share. The depressed price of the stock relative to both intrinsic and relative value estimates has it starting to show up on Graham value and Greenblatt magic formula screens. This is because ESI, despite its many and significant challenges, is still profitable and cash-flow positive and is trading on relatively low multiples of each of those metrics.

Two recent developments may end up as catalysts, or perhaps precursors to catalysts, for the stock. They are worth reviewing via the excellent SEC Live, which makes this sort of task much easier than it is at EDGAR.

New investors - significant events coming?

Last year's sell-down by Blum Capital Partners was covered here, and that firm has continued to trim its holdings. However, between February and April 2014, three new institutions - Putnam Investment Management, EverPoint Asset Management and Point72 Capital Advisors - accumulated just over 17% of the outstanding share capital of the company.

Most of the stock acquired by Putnam, which now holds 11.5% of ESI's issued capital across several mutual funds, is in the growth-oriented Voyager Fund (MUTF:PVOYX). That stake is significant enough to be disclosed in Voyager's top 20 holdings as at 30 April 2014. With an annual turnover of around 130%, the Voyager Fund's average holding period is just over nine months.

Informed and alert readers will have already noticed that EverPoint and Point72 are not really two institutions: they are the successors to SAC Capital Advisors, now engaged only in managing the Cohen family assets. These Cohen interests now hold 5.7% of ESI's issued capital. The Wall Street Journal's research during 2013 indicated that the former SAC Capital also had a very short average holding period, often less than six months.

Since these new shareholders are hardly "buy and hold" types, they will be expecting materially positive developments in the period between now and December 2014.

Sale and leaseback of real estate: a need for working capital or value unlocked?

One such development could be the transaction notified to the SEC on May 14th.

On May 8th, ESI entered a sale and leaseback agreement with a company called College Portfolio Buyer, LLC [CPB]. Under this agreement, and subject to certain conditions to be met by June 9, 2014, ESI plans to sell CPB up to 24 parcels of real property, buildings, fixtures, improvements and other interests and then lease those parcels from CPB. The properties are used for ITT Technical Institutes operated by ESI and, if all 24 of them are sold, the parties estimate that ESI will receive about $119 million from CPB.

It's not immediately clear why ESI would need additional cash. Its last 10-Q disclosed $168.7 million in cash and a current ratio of 1.26. It may be that the company's obligations under the PEAKS private loan program are becoming problematic: finalizing the accounting related to PEAKS is the reason the company gave to the SEC for the delay in its 10-K filing.

The ESI filing does not provide any details about CPB. A search of the Delaware Division of Corporations site shows only that CPB was incorporated on May 7, 2014. It is likely that CPB is a special-purpose real estate investment vehicle associated with a private equity firm or a hedge fund.

According to its most recent 10-Q, on September 30, 2013, ESI had 147 ITT Technical Institute campuses, which was 30 fewer than on December 31, 2012. Assuming that the percentage of total campuses where the property was owned, rather than leased, remained the same as at December 31,2012, ESI would have owned about 55 of those properties. ESI also owns its headquarters building in Carmel, Indiana.

ESI disclosed the net carrying value of all of its property and equipment on September 30, 2013 as $174.4 million. However, in the notes to the financial statements in its 2012 Annual Report, ESI disclosed that "furniture and equipment" made up 45% of the gross value of its property and equipment. Furniture and equipment are typically not fixtures, and therefore would not be included in the agreement with CPB.

Land, buildings and related improvements only made up 52% of the gross total, with software assets the remainder. If those proportions have remained the same, and the depreciation charges apply more or less proportionately to all categories of its property, then ESI's net land, buildings and related improvements would be carried at approximately $91 million.

But that value represents the campuses of 55 ITT Technical Institutes plus the corporate headquarters, which itself comprises 43,000 square feet. The average Institute occupies 30,000 - 40,000 square feet.

Therefore, if the sale component of the CPB transaction represents an arms-length valuation, then the fair value of ESI's property assets is likely to be significantly higher than their carrying value. If roughly 43% of those assets are worth $119 million (treating the corporate headquarters as if it were the same size as a typical Institute), there could be an additional $185 million, or about $7.90 per share, worth of property and equipment on ESI's balance sheet.

Disclosure: I am long ESI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.