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ITT Educational Services, Inc. (NYSE:ESI)

F3Q11 Earnings Call

October 20, 2011 11:00 am ET

Executives

Kevin M. Modany – Chairman of the Board & Chief Executive Officer

Daniel M. Fitzpatrick – Chief Financial Officer & Executive Vice President

Analysts

Trace A. Urdan – Signal Hill Capital Group

Gary Bisbee – Barclays Capital

Bob Craig – Stifel Nicolaus

Corey Greendale – First Analysis

Jeff [Volstein] – JP Morgan

Amy Junker – Robert W. Baird & Co., Inc.

Paul Ginocchio – Deutsche Bank

Sara Gubins – Bank of America Securities – Merrill Lynch

Brandon Dobell – William Blair & Company

George Tong – Piper Jaffray

Scott Schneeberger – Oppenheimer & Co.

James Samford – Citi Investment Research & Analysis

Kelly Flynn – Credit Suisse

Suzanne Stein – Morgan Stanley

Michael Tarkan – FBR Capital Markets & Co.

Operator

Welcome to the ITT Educational Services 2011 third quarter earnings call. At this time all participants are in a listen only mode. (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, Inc. 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 new release or in the company’s filings with the Securities & Exchange Commission. Thank you. Mr. Modany you may begin sir.

Kevin M. Modany

Thank you for joining us on our 2011 third quarter conference call to review our results. As usually, Dan Fitzpatrick our executive vice president and chief financial officer will join me on the call this morning. We’ll hear from Dan in a few moments. I’d like to briefly review our agenda for our prepared comments this morning. We will start by providing a review of the third quarter marketing and advertising activity. We’ll then offer additional color on our new student enrollment results in the 2011 third quarter. Next, we’ll discuss student retention and persistence during the quarter. We’ll then update our student outcome metrics including the graduate employment and average annual salary of our 2011 graduates. I will then close out my section of the prepared comments with an update on the execution of our strategic plan.

At that point I’ll turn the call over to Dan and he’ll comment on the financial results included in this morning’s press release. Additionally, Dan will provide you with an update on our efforts to facilitate additional third party private education loan options for our students. Upon the conclusion of Dan’s prepared remarks we’ll open up the call to your questions.

Let’s begin with a review of our third quarter advertising results. Advertising expenditures in the third quarter of 2011 increased approximately 12% compared to the same period in 2010. This was below our planned increase of 20% primarily due to our transition from traditional television sources to Internet based alternatives, and our efforts to eliminate sources that do not meet our hurdle rates for return on investments.

As we head into the fourth quarter we anticipate that advertising expenditures in the quarter will increase by approximately 15% to 20% as compared to the final quarter of 2010. Consistent with recent trends and primarily due to the adjustments in our advertising strategy, we experienced a decrease in the number of perspective students who expressed an interest in our programs of study during the third quarter of 2011 compared to the same period in the prior year.

Much of the year-over-year decrease in inquiries was caused by the purposeful elimination of advertising sources that generated perspective student inquiries that converted to new student enrollment at an unacceptable cost. The decrease in perspective student inquiries coincided with a managed reduction of approximately 20% of our recruiters at September 30, 2011 compared to the same date in the prior year. Recruiter productivity as measured by the number of new student enrollments per recruiter was higher in the third quarter of 2011 compared to the same period in 2010.

Additionally, the rate at which perspective student inquiries converted to new students increased in the third quarter of 2011 compared to the same period in the prior year. We believe that most of these trends are likely to continue throughout the remainder of 2011 and into the early part of the new year.

Turning to the programmatic mix, there were a few notable shifts in new student enrollment in the third quarter of 2011 compared to the same period in the prior year. We experienced a more substantial year-over-year decline in new student enrollment in the criminal justice program compared to the year-over-year declines in new student enrollment in other curriculum areas. Additionally, new student enrollment in our drafting and design programs declined more year-over-year in the third quarter than the year-over-year decline in total new student enrollment in the third quarter.

On a positive side, new student enrollment in our registered nursing program increased substantially compared to the same period in the prior year as we now have 38 campuses approved to offer this resident based associate degree program. Further, we are pleased to note the new student enrollment in our core information technology and electronics technology programs declined at lower rates than the total new student enrollment in the three months ended September 30, 2011 compared to the same period in the prior year.

When we look forward to the academic period that begins December 2011, we’re happy to report that on our student enrollment metrics they have improved modestly compared to the same point in the recruitment period for the academic quarter that begin September 2011.

Moving on to a discussion of third quarter student persistence metric, the 90 basis point decline in our persistent rate as of September 30, 2011 compared to the same date in 2010 was primarily due to the increase in the number of graduates in the third quarter compared to the same prior year academic period. Total graduates in the three months ended September 30, 2011 increased approximately 20% compared to the same three month period in the prior year. Our current forecast contemplates a year-over-year increase in total graduates of approximately 25% to 30% in the fourth quarter. As a result we believe we will experience a year-over-year decline in the persistence rate as of December 31, 2011.

Student retention in the academic period that concluded September 30, 2011 was slightly higher than in the academic period that conclude in September, 2010. We believe that student retention in the fourth quarter 2011 will be approximately the same as the fourth quarter of 2010.

At this point I’d like to provide a current update on our graduate employment metrics. We’re happy to report that the graduate employment rate of our 2011 employable graduates as of October 18, 2011 was approximately 600 basis points higher than our graduate employment rate of our 2010 employable graduates as of the same date in the prior year. The average annual salary reported by our 2011 employed graduates as of October 18, 2011 was approximately $32,000 or 1% lower than the approximately $32,400 annual salary reported by our 2010 employed graduates as of the same date in 2010.

We are cautiously optimistic about the progress we are making with our graduate employment rate but there is still much work left to do. We plan to continue focusing on higher starting salaries and increased returns on investment for our graduates. As improving student outcomes has always been one of our primary goals. We recognize that student outcomes across all higher education has been negatively impacted by the slow and lingering economic recovery as well as the high rate of unemployment and we intend to work diligently towards helping our graduates obtain positive results.

Employer interest in our graduates increased in the third quarter compared to the same period in the prior year. And we are hopeful that this higher level of interest leads to additional improvement in the year-over-year employment and salary metrics of our graduates. In an attempt to further improve our students’ outcomes we have implemented several strategic initiatives that we believe will enhance our graduates’ employment opportunities. These long term initiatives focus on increasing the level of student participation in relevant, professional experiences during their programs of study.

Lastly, to give you a sense of the resources allocated to improve graduates outcomes, we have increased our career services staff by roughly 17% to approximately 340 dedicated professionals nationwide as of September 30, 2011 compared to 290 as of the same date in the prior year.

While unemployment remains high with 14 million Americans out of work, jobs for skilled workers are available. US Bureau of Labor Statistics reported on September 7, 2011 that approximately 3.2 million job openings existed as of July 31, 2011. The vast majority of these positions seek candidates with a post secondary education credential and many are in disciplines that align with our programmatic focus in health sciences and technology. As a result, while the touch economic conditions present us with headwinds, we remain optimistic about the long term prospects for our graduates and the roll that our institutions play in increasing the supply of skilled workers sought by employers.

As most of you are aware, a key part of our growth strategy involves increasing the number of our collages. We expand geographically by adding new ITT Technical Institute across the country. During the third quarter of 2011 we begin operations of five new locations in Marlton New Jersey, Hanover Maryland, Philadelphia Pennsylvania, West Palm Beach Florida and Germantown Wisconsin. These new campuses raised the number of our locations to 136 campuses and four learning sites for a total of 140 locations in 39 states. We plan to begin operations at two or more new locations during the remainder of 2011.

We continue to evaluate additional programs that offer future graduates the potential for attractive returns on investment and we have several programs of study in various stages of research and development. As we have stated in prior earnings calls, we believe that new ITT Technical Institute programs in the future will likely focus more on technology and health science disciplines based on the projected growth and employment opportunities in these fields at salary levels that offer our graduates an opportunity for a solid return on their educational investment.

We begin teaching a set of new programs in 12 ITT Technical Institute locations in the academic quarter that began in June 2011. These new programs are both at the associate and bachelor degree levels and involve a modified delivery format which reduces the amount of time required for a full-time student to graduate. The associate degree programs are also comprised of fewer credit hours which reduces the total tuition cost of the program by approximately 6%.

Thus far in 2011 we have obtained approximately 80% of the necessary regulatory authorizations to offer these new programs at all of the ITT Technical Institute locations and believe that we are on track with our planned implementation and rollout of these new programs. An additional 87 locations began teaching one or more of the new programs in the academic period that begin in September 2011 bringing to 99 the total number of locations teaching the new programs.

We anticipate that approximately eight additional locations will begin teaching the new programs in the academic period that begins in December 2011, with the remaining locations offering the new programs throughout 2012 and beyond. There were no significant developments with the other key elements of our strategic plan during the third quarter of 2011.

As we reported in our earnings release this morning, we have raised our 2011 internal EPS to the range of $10.40 to $10.60. Our ability to estimate our 2012 results with any degree of certainty at this time is constrained by the volatility in the new student enrollment and the implementation of our revised advertising strategy. That said, we are pleased with the progress we have made with our revised advertising strategy. We are cautiously optimistic about the improvements in recruiter activity productivity, and we continue to see signs that we believe may allow for a return to year-over-year increases in new student enrollment in 2012.

One of the other variables that will impact our 2012 revenue is our tuition. We don’t currently intend to increase tuition rates in 2012 and we believe that the amount of institutional scholarship and rewards per student in 2012 should be fairly consistent with 2011. We also do not believe we will experience any material changes in our total expenses in 2012 compared to 2011. But we do believe, we should experience some deleveraging in the operating model as a result of year-over-year declines in total student enrollment in 2012 compared to 2011. The decline in total student enrollment in 2012 will be a byproduct of the declining new student enrollment in 2011.

All that having been said, at this juncture our very preliminary 2012 internal EPS goal is in the range of $7.50 to $8.50. This range is based on a number of assumptions and estimates including the conservative scenario that we would not repurchase any additional shares of our common stock in 2012 and no new private education loan programs would be available to our students in 2012. Our modeling with respect to share repurchase assumption is based on capital allocation opportunities that we believe could be available in 2012. We are very bullish on the post secondary education industry and believe that the current economic environment has created some attractive investment opportunities.

Depending upon what actually transpires in 2012 we will adjust our assumptions and estimates and revise our 2012 internal EPS goals accordingly. We will continue to update you on our 2012 operating goals as the key operating variables solidify over time.

At this point I’d like to turn the call over to Dan who will provide some color on a few key financial points.

Daniel M. Fitzpatrick

As we noted in the beginning of the call I’ll begin my comments with a review of the key financial results for the third quarter of 2011. As anticipated revenue per student was down 3.2% in the three months ended September 30, 2011 compared to the same period in the prior year primarily due to the increased levels in scholarships and rewards as well as the accounting impact on the revenue received from certain private education loans made to our students. We believe that the year-over-year decline in revenue per student will lessen somewhat in the fourth quarter of 2011 as we begin to anniversary the increased amount of institutional scholarships and awards.

In the three months ended September 30, 2011 our students received approximately $22 million in scholarships and awards compared to approximately $14 million in the same period in 2010. In the third quarter of 2011 we received approximately $30 million of net disbursements of private education loans made to our students. We originally estimated that third party private education loan programs offered to our students would be mostly exhausted in the third quarter of 2011. However, as a result of increased levels of grants, scholarships, and awards approximately $26 million of private education loans remain available to our students as of September 30, 2011. We believe that this remaining funding capacity will be sufficient to satisfy the majority of our student private education loan requirements in the fourth quarter of 2011.

As Kevin alluded to, our efforts related to finalization of a new third party private education loan program in the third quarter of 2011 were impacted by material disruption in the debt markets. Based upon our discussion with parties involved with the new program for our students, the interest rate spread on debt instruments similar to the new loan program were above our comfort level. In light of this and considering approximately $26 million of the private education loans remain available to our students, as we began the fourth quarter we concluded that it was not imperative to provide support for a new third party private education loan program in the third quarter 2011.

As we head into the fourth quarter, discussions continue on pricing and execution of a new third party private education loan program that will offer our students access to another cost effective private loan option to help meet their gap financing needs. Given the volatility of the debt markets, however, we cannot predict at this time when a new third party private education loan program will be offered to our students.

Moving on to a look at accounts receivable. Days sales outstanding decreased 5.3 days to 14.3 days as of September 30, 2011 compared to 19.6 days as of the same date in 2010. This is primarily due to increases in the amount of funds received from private education loans available to our students along with scholarships and other rewards received by our students in 2011 compared to the prior year.

Bad debt expense as a percentage of revenue decreased 170 basis points to 3.8% in the three months ended September 30, 2011 compared to 5.5% in the same period of 2010. Our 2011 internal goals for DSO and bad debt expense remains as follows days sales outstanding in the range of 10 to 15 days, bad debt expense as a percent of revenue ranging from 4% to 6%.

Moving on to an update of our share repurchase activity. We repurchased 370,000 shares of our common stock in the three months ended September 30, 2011 for approximately $30 million or an average price of $79.94 per share. Approximately 6.3 million shares remain under our share repurchase authorization as of September 30, 2011. In accordance with the board’s stock repurchase authorization we plan to repurchase additional shares of our common stock from time-to-time in the future depending on market conditions and after consideration of other potential investment opportunities consistent with our strategic plan.

With that, I’ll hand the call back over to Kevin.

Kevin M. Modany

This concludes our prepared remarks. Operator would you please open the line for questions.

Operator

(Operator Instructions) Your first question comes from Trace A. Urdan – Signal Hill Capital Group.

Trace A. Urdan – Signal Hill Capital Group

It looked as though the buyback activity, the average price there seems very high relative to where the stock was trading even into September, and I’m wondering if that is a sign that you guys pulled back a little bit on the buyback since September and whether that relates at all to the situation you described with respect to PEAKS to and the possibility that maybe in the fourth quarter you might have to lend the students yourselves?

Kevin M. Modany

I would stop short of linking the share repurchase activity with the private lending discussion. I would really separate those two at this point. From a share repurchase perspective we had a pretty set amount that we were going after in the fourth quarter. It was a little front loaded in the quarter, that’s definitely true, and I think you see that in the share price as you point out. But there was nothing specifically correlated to any activity on the private lending that impacted any of our decisions on the timing of the share repurchase activity however.

Operator

Your next question comes from Gary Bisbee – Barclays Capital.

Gary Bisbee – Barclays Capital

I just want to make sure I heard this right, that the early indicators for the December term were better than the indicators you saw at the same time period ahead of the September start. Was that the comment?

Kevin M. Modany

That is correct.

Gary Bisbee – Barclays Capital

Seasonally historically December has had much lower starts than September, so should we read into that on an absolute basis that the number of starts could be up? Or, is that more of a relative comment?

Kevin M. Modany

It’s relative to the year-over-year. So just to add a little more color, as we look at different timing points in the recruitment cycle, which for us is about a 12 week period, we’ve tried to pick a couple of points in that cycle right in front of the call just to look at the leading indicators. And then we look at them on a year-over-year basis. So if I were to look at this same point in the September recruitment cycle and did a year-over-year analysis of those leading indicators and then I did the same thing for the December, and looked at the year-over-year of those same leading indicators, we’re seeing improvement and positive trending for those December year-over-year indicators versus what we saw at this same point for the September year-over-year indicators.

Gary Bisbee – Barclays Capital

I was curious to hear that rep productivity is improved so soon after you made the changes to incentive comp. Is it people getting comfortable with that, or do you think it’s more to do with getting better leads, or any color on why that’s happening?

Kevin M. Modany

I think certainly impacted by the latter where, as I mentioned in the comments, we’re very focused on the return on investment aspects of our advertising strategy. So we’ve seen improvement in let’s just say the quality of those inquiries that is driving improved conversion rates if you will. Obviously, that will ultimately impact the rep productivity. But I would also say, and we said this before and I think it’s playing itself out in the actual facts here, that we weren’t looking at substantial changes in the compensation structure per say for representatives. They were on a salary before, they’re on a salary now and so the major impact or change on that was not significant to those individuals as we implemented it in July.

So we haven’t really seen anything yet. We may see something when we get to the point of year-over-year changes in their salary where they would get an annual merit increase relative to the fact that we had to eliminate all performance indicators there or any performance measures whatsoever on determining their annual increase. Which, doesn’t make a lot of sense, but that’s what we had to do, potentially there could be an impact there. But right now we’re not seeing anything and, as we noted, productivity is actually up on a year-over-year basis.

Gary Bisbee – Barclays Capital

Kevin, your comment on capital allocation is that an indication that maybe you’ve got an increased desire to look at M&A in the space or am I reading the wrong thing into that statement?

Kevin M. Modany

No, I think you’re reading the right thing into that statement. We’re looking at the markets right now. We continue to be bullish on the sector. We like what we see in terms of the long term trends and the dynamics of the sector and we see continued dysfunction in valuations and we think there’s an opportunity potentially to take advantage of that. So, we just want to be prepared to do that. That by no means suggest that we’re not going to be repurchasing shares. Obviously in the ’12 guidance, we were conservative there, but we are very mindful of some of these opportunities and we want to look around and see if there’s a way for us to put some capital to work and get a good return.

Operator

Your next question comes from Bob Craig – Stifel Nicolaus.

Bob Craig – Stifel Nicolaus

I’d like to follow up on that last question from Gary, what might be of interest for you? I know you don’t want to tip your hand too much but perhaps you can provide some color on that?

Kevin M. Modany

I think you answered your own question there Bob. We definitely wouldn’t want to tip our hand per say, but I’ll just say certainly we’re bullish on post secondary and I think there’s opportunity for our organization to be thinking about diversification. And diversification across many different segments; we could be talking about programmatic, we could be talking about delivery modality, we could be talking about demographic. We see interesting opportunities across all of those different sectors, or groups, or characteristics if you will.

So again, without getting overly specific bullish n the sector and think there might be some opportunities there. That could include expansion here domestically, and also potentially internationally. We’ve said publically before that there are certainly some markets that look fairly attractive and so we’re exploring those and looking for opportunities.

Bob Craig – Stifel Nicolaus

A question on the PEAKS, or at least the first PEAKS program, can you give us some idea of the percentage of students packaged under that first program that are still in school and/or that have dropped out? What I’m looking for specifically is relative to the 80% completion rate historically for second year students, how has that trended?

Kevin M. Modany

Let me just answer that latter part without getting into the specifics of the loan participations and what not. You know, we’ve not seen any material changes in terms of retention or completion rates on our students. And I’ll go a step further to the point I think you’re trying to get to, as we look at performance of the PEAKS program and we’re tracking that against our expectations on the default curve and what not, we’re on track and within ranges anticipated. So, it’s early admittedly, but we’ve got all of the date, we’ve got all the preliminary and early data but we’re on the trends right now and tracking where we expect to be. We’ve got a lot of folks helping us model that and make sure that we’re looking at that the right way and so far so good.

Operator

Your next question comes from Corey Greendale – First Analysis.

Corey Greendale – First Analysis

I just wanted to get a little more detail on your thoughts on 2012. Kevin, I think you said that you’re assuming no additional private lending so I’m assuming that means you’re going to be doing more of the gap lending yourselves. Is that the assumption?

Kevin M. Modany

Well yeah, let me very, very clear so nobody gets confused. That’s the assumption, that doesn’t mean that’s what we’ll be doing. I’ve tried to point that out in the comments that we’ve included fairly conservative scenarios. I’m not going to speak to every point in the model, we don’t have enough time to do that obviously nor would it make sense, but we wanted to speak to a couple of the key points that folks have been asking about. Obviously, share repurchasing being something and with us being very interested in some opportunities we wanted to point that out. So that could be an impacted variable and so conservatively we excluded them.

Likewise, a lot of questions about the private lending, we excluded the impact of private lending in the model but that’s just an assumption. That’s not intended to be any kind of indicator or prediction on our part as what we think is going to happen. We continue to make progress there, as Dan said, when he was providing some color and commentary. The debt markets they’re disrupted.

Anybody that was paying attention to that knows that, that’s not an ITT Technical Institute or ITT Educational Services issue, that’s a debt market issue. And, mostly what we’re seeing as we survey the scene, and as we have been doing so for quite some time now, it’s a spread issue. We’re talking about spreads that are well beyond reasonable levels. So we’re just paying attention to that and we’ll see where we go with it. But for the model, we wanted to be conservative and we assumed that we wouldn’t have any, but it’s just an assumption.

Operator

Your next question comes from Jeff [Volstein] – JP Morgan.

Jeff [Volstein] – JP Morgan

Can you talk a little bit about the inquiry levels? Have you seen any changes? Have you seen folks being a little more sensitive to pricing and that sort of thing?

Kevin M. Modany

From an inquiry perspective or number of perspective students, I think probably the best way to give you some color on that is for us to look a response rates, because we made so many changes in allocation of dollars to different sources. We’ve eliminated some sources that generate large volumes and really don’t convert. We’re really focused on the ROI there so just to speak in total on inquiries probably wouldn’t give you a sense of what’s happening or really get to the crux of your question.

But from a response rate perspective, we’ve said this last quarter and the same is true for this quarter, we’re not seeing huge changes there. A couple of blips on the radar screen on our traditional sources and so demand seems to be pretty constant and for us it’s a matter of managing that mix of sources to get the optimal result, the best return on investment, the best quality outcome we can get for that spend. Again, not major changes there. Nothing that we’re seeing that’s unusual other than things we’re driving as a result of change in our advertising strategy.

Operator

Your next question comes from Amy Junker – Robert W. Baird & Co., Inc.

Amy Junker – Robert W. Baird & Co., Inc.

Can you just talk a little bit more about retention? You said that it was up a bit, retention was up a bit if you kind of adjust for the graduations in third quarter but that it should be flat in the fourth quarter. I’m curious what’s driving that, if there’s something specific happening there? And then a second one, if I can just sneak it in on the bad debt, Dan if you can just talk about your expectations for bad debt in 2012?

Kevin M. Modany

On the retention front as far as what’s driving that, there’s nothing unusual that I’d point to per say. I mean, we always have a number of academic initiatives that we’re executing on to try and drive better results there. A lot of it’s focused on our analysis of individual performance of faculty, and sections, and making changes to curriculum as we assess that information that we collect on a very regular and frequent basis so no magic bullet, no initiative. Looking forward to the fourth quarter we’re guiding to flat retention. There’s some sense of conservatism there. I don’t know if we’re going to see anything materially different there and there might be some opportunity for some upside there. But for now, if I’m building a model I’m putting that in at flat, but nothing specific to point to relative to any particular initiative. Dan, if you want to take the bad debt.

Daniel M. Fitzpatrick

With respect to bad debt a couple of things, one is as Kevin mentioned before, the guidance for 2012 is very preliminary. And the commentary around whether private loans would be available or not again, we wanted to go with a very conservative approach so that is not necessarily our expectation at this point in time but that’s what we’ve basically put out there relative to conservative guidance. But it stands to reason, if we don’t have private loans next year, bad debt is going to rise. I mean, that’s one of the things we’ve seen over the past year is the fact that it’s gone down because of the PEAKS program and because of the Credit Union Program. So at this point in time we’re not really able to speak to any more specifics, if you will, under the model but if there are no private loan programs it’s only going to go up.

Kevin M. Modany

I’ll add, our goal for this year is 4% to 6% on bad debt. I think you can see we’re well inside of that range for 2011. If you’re looking at that model for 2012 750 to 850, that absolutely includes an expectation that we would be above those ranges. Now, if private lending comes through, and again we’re making progress there, and hoping spreads come a little back down to earth, then it would be an entirely different scenario and there would be some upside there.

Operator

Your next question comes from Paul Ginocchio – Deutsche Bank.

Paul Ginocchio – Deutsche Bank

Your operating cash flow year-to-date is $292 million. If you didn’t have a third party lending program in place this year, what would operating cash flow be?

Kevin M. Modany

Well, you could probably estimate on an annualized basis somewhere around $100 million of private lending on a go forward basis. So that will give you a rough idea of the range, we’ve talked about that, on that relative basis. Then I would anticipate that to be the range. That’s kind of what our thinking is as we modeled the year so it will give you a rough sense of it.

Daniel M. Fitzpatrick

The other thing you want to consider Paul is if you look at last year, we’ve talked about this before, we got quite a bump last year from the PEAKS program that wasn’t in place for a while and so there was some [AR] if you will refinancing of that. So just comparing year-over-year that needs to be kept in mind.

Operator

Your next question comes from Sara Gubins – Bank of America Securities – Merrill Lynch.

Sara Gubins – Bank of America Securities – Merrill Lynch

So you haven’t really been acquisitive in the past besides from Daniel Webster, and I’m trying to understand more about the change in view. Is there any change in your longer term view about your own business and its growth rate? And then secondarily, when you think about M&A potential, are these for operations that you could put into ITT such that it might help on some of the regulatory metrics, or would they be really more adjacent separate time businesses?

Kevin M. Modany

The first part relative to what our view of the opportunities are and what that means about our current business, I can tell you that has no – it is not resultant of our review of the current business, or a change in our expectation for the current business. We still are very bullish on our current business and like our prospects, and like the future dynamics of the business so nothing has changed there. It’s really driven more by what we had mentioned, opportunities that we see in the marketplace. We like what we see. We see a material dysfunction in this marketplace and it just creates opportunities. So we’re opportunistic.

We generate excessive cash flow over and above our needs to continue growing our current business and we’re always looking to put that capital to work for the benefit of our shareholders in a way that generates the highest rate of return possible. And right now it appears as if there are opportunities to do that by making investments in a sector that we are bullish on and we think we know very well.

In terms of specifics regarding whether these are kind of tuck in investments or if they’re separate division, if you will, I think there’s opportunities for both types of investments. So, I wouldn’t limit it to one or the other. I think both are possible and we see some targets that kind of look interesting on both fronts.

Operator

Your next question comes from Brandon Dobell – William Blair & Company.

Brandon Dobell – William Blair & Company

I was wondering if you could address where you are headcount wise with the reps and perhaps what kind of assumptions you embedding in the 2012 commentary about either rep headcount or rep productivity?

Kevin M. Modany

We’re about 20% down year-over-year on rep headcount as of September 30, somewhere in that range. In terms of looking forward, we haven’t projected any kind of material changes there. The productivity increase we’ve seen this quarter over the prior year leads us to think that we’re probably looking at the same level of productivity. If there’s some upside there that’s great, but we’re not modeling that in. 20% down, probably similar levels in ’12, productivity being consistent.

Operator

Your next question comes from George Tong – Piper Jaffray.

George Tong – Piper Jaffray

I know you touched on this earlier but could you give us some more color on admission counselor productivity? Specifically, whether you expect productivity will be a headwind or a tailwind in starts performance in 2012? Then, briefly could you give us some details on what drove the year-over-year increase in cost of educational services this quarter and what your expectations are going forward?

Kevin M. Modany

In terms of rep productivity, we mentioned in the prepared comments that we saw an increase in productivity. It is measured by starts per representative, some of that being driven by the fact that there were some changes in the advertising strategy that improved qualitatively the perspective student inquiry mix. As far as what we’re expecting for ’12 headwinds or tailwinds, we’re not expecting much change at all to be honest with you. We haven’t modeled in any improvement or any degradation in terms of the performance of those individuals. So the model just assumes consistency of performance consistent with what we’ve seen in the third quarter.

Daniel M. Fitzpatrick

As far as Ed services, the primary difference year-over-year is going to be the fact that we are now in the default prevention business in a big way. That’s a cost that we did not incur before 2011. And also the fact that we’ve got a number of new locations that we opened this year that wouldn’t be baked into last year’s numbers. Those are the two primary differences, if you will, year-over-year.

Operator

Your next question comes from Scott Schneeberger – Oppenheimer & Co.

Scott Schneeberger – Oppenheimer & Co.

Looking at it next year, to the extent you care to share, any discussion with regard to new locations? And along that same ilk of next year, how should we be thinking about graduation and persistence rates?

Kevin M. Modany

In terms of new locations for 2012, I would say a great deal of specificity is included in our 2012 modeling with regard to that. You can anticipate somewhere between eight and 10 new locations. But from our perspective, really our team, the development team and the real estate group, they’re working on 2013 and beyond. So obviously, you’ve got to be ahead of this. But, eight to 10 is a good expectation in terms of new locations or that component of our strategic growth plan.

In terms of graduation and persistence rates for 2012, we’re not modeling at this point any major improvements there. Although, we’ve seen in the last quarter or two some improvements in retention so there might be a little bit of an upside there. But, the model includes pretty much a status quo persistence, retention and graduation consistent with what we’ve experienced recently.

Operator

Your next question comes from James Samford – Citi Investment Research & Analysis.

James Samford – Citi Investment Research & Analysis

A couple quick questions, I just wondered how’s the mix shift occurring in terms of bachelors versus associates this quarter? And just a quick follow up on the default prevention, when do you lap some of the investments you’ve made there? And, is that potentially a source of leverage in 2012?

Kevin M. Modany

As far as the mix of bachelors and associates, we have not seen much change there so we’re right in the range of the 85/15 or very, very close to that. A little bit of a pick up on the associate side. I believe at this September 30 we were 87% associates, but that ebbs and flows and I think an 85/15 mix is what we probably should expect to see going forward.

Daniel M. Fitzpatrick

With respect to default prevention, we started our efforts in Q1 and we continue to expand that. So really, when you think about the run rate it could be the mid part of next year when we’ve really anniversaried where we’re at right now relative to all the efforts and all the costs we’ve incurred.

Operator

Your next question comes from Kelly Flynn – Credit Suisse.

Kelly Flynn – Credit Suisse

My question relates to the Sallie Mae program, the risk sharing student lending program you guys had a couple of years ago. I was wondering if you could just give us an update on that as specifically whether or not you anticipate having to make any incremental cash payments to Sallie Mae related to that, or take any additional charges?

Kevin M. Modany

With regard to the initial risk share program, the Sallie Mae program as you referred to it, I think it’s probably important that we separate that program from the PEAKS program for a couple of important reasons. The major differences in the program, and I think most people know this, but we’ll just kind of rehash it to make sure everyone remembers, that includes first year students which obviously, those folks drop at a higher rate and obviously repay at a lower rate. And so those folks were included in that limited program we had with Sallie Mae. And that obviously has an impact on the results.

Further, the risk share cap on that program was substantially lower than the risk share cap we have on any subsequent programs. So for those two reasons, it’s materially different. We can tell you we have recorded reserves there so there is an expectation that there’ll be some expenses incurred there relative to that program. But, I will tell you, at September 30, 2011 or the end of the quarter, we had reserved, from our perspective and already included in our expenses, the full amount of any exposure that we had based on all of the available data that we had.

So we feel like we’re fully reserved for that at this particular point again, based on the data we have. And again, just to close out, kind of close where I started, that’s a materially different program than the PEAKS program and the Credit Union Program for the reasons I mentioned.

Operator

Your next question comes from Suzanne Stein – Morgan Stanley.

Suzanne Stein – Morgan Stanley

I’m just wondering if you can address the change in differed revenue this quarter? And also, just wondering what’s in the other non-current liabilities that’s causing that number to trend up?

Daniel M. Fitzpatrick

The deferred revenue year-over-year you’re going to see the change related to a couple of things. Keep in mind we had the incremental build, if you will, of the private lending programs. Even though we’re phasing out of PEAKS now and hoping to put something else in place, still last year at this time we were still basically rolling out that program so you didn’t see the full impact of it. As far as the other liabilities, that’s comprised of a couple of things. One would be contingencies, the contingencies we’ve recorded, some of which Kevin mentioned before, other uncertain tax liabilities, the accounting we have for that now is included in that line as well. Those would be the two primary components of what’s in there at September 30, 2011.

Operator

Your next question comes from Michael Tarkan – FBR Capital Markets & Co.

Michael Tarkan – FBR Capital Markets & Co.

I guess just following up on bad debt expense, if I look back over the past year or so the amount you provided for bad debt was in excess of the increase in gross accounts receivable and it looks like that trend flipped around this quarter. I know you guys have talked about over reserving in the past. Is this a situation where either you guys, or the auditors are more comfortable with performance there?

Kevin M. Modany

I’m not sure I understand the question exactly but let me see if I answer it and hang on the line so you can have a follow up here in case I don’t. We’re obviously as conservative as we can be as we have mentioned many, many times with regard to reserves relative to AR. I guess I can comment that we haven’t made any major changes in terms of methodology, self directed by management or requested by the auditors. There’s been no change there, probably just an ebb and flow of what happened with the receivables, and the mix, and any write offs that may have occurred that caused any kind of unusual trending there. But again, I can unequivocally say no change in methodology and we continue to be as conservative as we’re allowed to be.

Operator

Your next question comes from Gary Bisbee – Barclays Capital.

Gary Bisbee – Barclays Capital

A follow up on the recent theme of questions here, do you have enough experience at this point with students entering repayment on the PEAKS loans to have a good sense if the reserve rate you were using there was reasonable, conservative, not high enough? Any sense or since this is really only a year and a half old, is it just too early to have a big enough group of students there that you really can make a strong statement on it?

Kevin M. Modany

Well, it’s still early that’s for sure. This is 10 to 12 year payback on these loans and we’re maybe 18 months or so into this thing so we’re very early on. But you estimate the performance of any portfolio all along the path and at this particular point we’re in line with our expectations with that regard with performance on the portfolio and expectations there. So it’s early, we’re in line with expectations. I think it’s probably important to point out that – and people know this, but it gets confusing because there’s a lot of missed information that gets set out there for various reasons, but this is a program that’s over collateralized in terms of the assets that are backing the notes associated with this program.

The performance on the loans have to be substantially worse than any historical experience we’ve seen for us to have exposure here. I can’t emphasis that enough. Again, lots of mis information out there. For various purposes, we need to be very clear on that, that performance has to be substantially worse than historical for us to have exposure. To go back to your question now, we’re following the trends but it is early.

Operator

Your next question comes from Paul Ginocchio – Deutsche Bank.

Paul Ginocchio – Deutsche Bank

Kevin, your answer to Gary’s question kind of perfectly dovetailed to mine. From your answer that it’s over collateralized and the performance has to be substantially worse than historical for you to have any, I guess, recourse I guess I’m just trying to figure out why then you can’t get some investors to give you a reasonable spread, or a reasonable interest rate. I assume you’ve talked to some of these investors before the market turmoil. I’m just trying to understand what the hang up is for lending you the new program based on what you just said about your existing program.

Kevin M. Modany

Thanks for that question. I think that’s a very good question and important to be asked for those people that are unfamiliar with what’s happening in the debt markets. Those of you who are familiar with the debt markets and what’s happening today understand the issue and understand it very clearly. I think even looking at a few historical transactions, and when I say historical I’m talking about the last couple of weeks, transactions that attempted to go out, some that were let’s just say a particular party went out with a FELP loan portfolio attempting to get a transaction done there and the spreads were so unfavorable on a government backed guaranteed student loan program that they pulled the offering. That’s just one example.

Again, I encourage all of you out there to actually talk to some people in the debt markets, experts who understand what’s happening and I think you’ll see that the spreads are there. I want to go back to a comment you made though in the early part of your question when you’re saying, “Why can’t you get a deal done?” Nobody is saying we can’t get a deal done. I think what we’re trying to explain here and maybe we’re not doing a good job of it so I apologize for that, we’re trying to explain that this is a spread issue. The spread is higher than we like.

We have funding taking us into the fourth quarter. We see no reasons to be impatient at this point recognizing where we’re at in the cycle. But, we hope maybe we’ll see some movement in spreads. Admittedly, we haven’t seen it yet but we’re trying to take action in accordance with the best rate of return we can get for any program that we’re going to have to sponsor so to speak as we have done here. Hopefully, that clears this up a little bit. And again, I encourage all of you to maybe do a little homework on the debt markets and what’s happening there. I don’t believe this is a secret in terms of what is happening out there.

Operator

Your next question comes from Kelly Flynn – Credit Suisse.

Kelly Flynn – Credit Suisse

Just back to the other question I asked. I had also asked you if you expect to make any cash payments to Sallie Mae. You didn’t answer that part so if you could address that, that’d be great.

Kevin M. Modany

I’m sorry Kelly, I thought I did, but let me be more clear; we have booked a reserve for that so we would not have done so if we didn’t anticipate that there’d be some payments there. In terms of timing, or what they will be, or how much they will be I can’t really speak in detail to that. But, we have booked reserves in accordance to what we believe our exposure is and therefore we would anticipate that there’d be some payments at this point in time. Obviously, that’s the justification for the accrual. Hopefully that answers the question.

Operator

Your next question comes from Corey Greendale – First Analysis.

Corey Greendale – First Analysis

The prior question just evoked another question for me. Can you just talk a little bit about kind of your long term thoughts on the gap lending? The way that you’re dealing with it now is kind of this continual cycle where you’ve got a certain amount of capacity and then you need to reenter negotiations. Do you see any prospect for a longer term solution where something would be in place and you wouldn’t have to kind of keep renegotiating this continually?

Kevin M. Modany

That’s a great question too Corey, and yes that’s exactly how we think about it. I would say in the absence of any kind of material debt market disruptions that’s probably what you would have seen, a much longer term deal that would buy us multiple years in terms of available financing for students. At this particular point where the spreads are, it encourages us to think a little more short term unfortunately with the hope that you don’t have to lock yourself in long term with spreads that are too high.

Now, I guess some could argue that position but that’s our view on it right now. We don’t want to lock ourselves in long term. But, we do agree that in normalized markets with normalized spreads then yes, a longer term approach to this makes more sense and we expect that at some point that’s exactly where we’ll get.

Operator

There are no further questions at this time. Would you like to make any closing remarks?

Kevin M. Modany

Thank you very much operator. We just want to thank everybody for their participation on the call. Thanks for all your questions and we look forward to talking to you in January when we conduct our fourth quarter and full year call at that time. Thanks again.

Operator

This concludes today’s presentation. You may disconnect your line.

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