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We recently downgraded our recommendation on Capella Education Company (NASDAQ:CPLA), the provider of online education, to Underperform with a price target of $48.00 following a decline in new enrollment. Earlier, we had a Neutral stance on the stock.

Capella notified that new enrollment dropped 10.7% during the fourth quarter of 2010, reflecting sluggish demand for its programs, stiff competition and stringent admission criteria, which require students to undergo an assessment to get enrolled.

We observe that growth in enrollments in the quarter under review has decelerated sequentially. After increasing 25.7% in the third quarter of 2010, the rate of growth in enrollment dropped sharply to 16.2% in the fourth quarter. Capella now expects total enrollment to rise in the range of 4.5% to 6.5% in first-quarter 2011, reflecting a slower growth compared with previous quarters.

The current threat to the education sector is the regulation proposed by the Department of Education that is weighing upon students’ enrollments and the company’s profits. The Department of Education proposed that an educational program could only qualify for Title IV funds, if it helps in achieving gainful employment, which includes the criteria of loan repayment rate and debt-to-income ratios.

The institutions are under the scanner due to the rise in the default rate of student loans, and are now being asked to submit information relating to recruitment procedures and use of student’s grant.

Capella cautioned that new enrollment in first-quarter 2011 is expected to fall by 35%. Management hinted that other for-profit education institutes facing tougher norms are chasing away Capella's students who are financially sound and have better loan repayment rates. The company generally focuses on working adults.

Moreover, Capella also projected a slower a growth in the top line. After a registering an increase of 21.3% during the fourth quarter, the company now expects revenue to increase in the range of 8.5% to 9.5% in first-quarter 2011.

To counter sluggishness in students’ enrollment, education companies are resorting to restructuring their cost base. Capella said that it would lower its headcount by about 125, which represents approximately 8% of its non-faculty workforce, and for this it would incur a charge of about $2 million in first-quarter 2011. Management hinted that the eliminations will result in cost savings of approximately $12 million to $12.5 million per year.

Currently, we prefer to have a bearish outlook on the stock until we find any catalyst to trigger growth in new enrollments. Capella Education, which competes with Apollo Group Inc. (NASDAQ:APOL) and Strayer Education Inc. (NASDAQ:STRA), holds a Zacks #5 Rank, which translates into a short-term “Strong Sell” recommendation.

Source: Capella Education Downgraded on Lower Enrollment