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Career Education Corp. (NASDAQ:CECO)

Q3 2007 Earnings Call

November 6, 2007, 10:00 am ET

Executives

Karen King - Vice President, Investor Relations

Gary McCullough - President and Chief Executive Officer

Michael Graham - EVP and Chief Financial Officer

Steve Fireng - Group President, University, Academy and College Divisions

Paul Ryan - Group President, Culinary and Health Education Divisions.

Analysts

Amy Junker - Robert W. Baird and Company, Inc.

Mark Marostica - Piper Jaffray

Jerry Herman - Stifel Nicolaus and Company, Inc.

Jeff Silber - BMO Capital Markets

Sara Gubins - Merrill Lynch

Chris Shutler - William Blair and Company

Jennifer Childe - Bear Stearns

Jeff Lee - Signal Hill

Gary Bisbee - Lehman Brothers

Corey Greendale - First Analysis

Operator

Good day, ladies and gentlemen. And welcome to the Third Quarter 2007 Career Education Earnings Conference Call. My name is Amanda, and I'll be your operator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions)

As a reminder, this conference is being recorded for replay purposes. I would now like to turn the call over to Ms. Karen King. Please proceed ma'am.

Karen King

Thank you. Good morning, everyone and thank you for joining us on our third quarter 2007 earnings call today. I am Karen King, Vice President, Investor Relations and with me today are Gary McCullough, our President and Chief Executive Officer, Michael Graham, Chief Financial Officer, Steve Fireng, Group President for our University, Academy and College Segments, and Paul Ryan, Group President for our Culinary and Health Education Segments.

I want to apologize for the delay on the call this morning. We were dialed in and the conference center dropped our call. Following a brief presentation by management, the call will be open for analyst and investor questions.

This conference call is being webcast live on the Investor Relations section of our website at careered.com. The replay will also be available on our site. If we are unable to answer your questions during the call, please call our Investor Relations department at 847-585-3899.

Before I turn the call over to Gary, let me remind you that yesterday's press release and presentations made by our executives may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995.

These statements are based on information currently available to us and involve risks and uncertainties that could cause our actual results, performance and business prospects and opportunities to differ materially from those expressed in or implied by these statements.

These risks and uncertainties include, but are not limited to those factors identified in our third quarter earnings release and in our annual report on Form 10-K for the year ended December 31, 2006 and from time to time in our other filings with the Securities and Exchange Commission.

Except as expressly required by securities laws, we undertake no obligation to update such factors or to publicly announce the results of any of these forward-looking statements to reflect future events, developments or change circumstances or for any other reason.

Now, let me turn the call over to Gary McCullough.

Gary McCullough

Thanks, Karen. Good morning and thank you for joining us on our third quarter earnings call. The third quarter has continued to reflect our company's transition. We have reason to be optimistic, yet we are realistic about the significant work we have yet to do.

During the third quarter, our key metrics continue to improve. New student starts in our continuing operations for the quarter were up 11% versus prior year and we experienced a year-over-year growth in new student starts in each segment, except colleges.

In addition, October starts were up 14% versus 2006. Population and continuing schools has continued to climb and was up 8% in the third quarter versus 2006. This is our highest population growth level since early 2006. We also continued to see improvements in conversions, show rates and retention.

Despite the progress I described on the metrics, our profit margins continue to be below expectations. We have committed to taken the necessary actions to improve margins and we expect to show improvement in 2008. Our focus in the near-term will be to continue addressing fundamental issues and laying the groundwork for long-term success.

We've made good progress since our last call in a number of areas that I'll spend a few moments discussing. More specifically, I'll review progress we've made in the areas of accreditation, legal and organizational leadership. I'll also briefly address the status of our discontinued operations, which have been held for sale.

First, a special committee on the commission of colleges of facts completed scheduled visits to four AIU campuses on October 17. At the conclusion of the visits, the special committee informed AIU and its -- that its final report to facts will contain no recommendations for further corrective actions. This was a terrific outcome for AIU and for our company at this stage.

However, it's important to note that the commission on colleges is not required to accept the conclusions of the special committee and this is not in anyway constitute a final determination on the probationary status of AIU.

We remain hopeful that we'll receive a positive decision from the commission of colleges at its annual business session in December. Meanwhile, we'll ensure the learning improvements at AIU continue to be reflective in our operations.

We continue to put legal issues behind us. Here are a few things that transpired since our last call. In August, we were informed by the Civil Division of the US Department of Justice that it was closing its review with no action taken against the company or any of our schools.

We have now reached an agreement that was mentioned last quarter. It settles three lawsuits against some of our schools in Southern California. You may recall that we fully reserved for this settlement in the second quarter.

While we have denied all the plaintiff's allegation we believe we made the right decision in settling these matters to avoid the time and expense associated with defending the suits.

We've also made progress on securities litigation involving the company. As you may recall, the District Court has consistently dismissed the plaintiff's complaints in the consolidated security litigation against CEC. The plaintiffs have appeal the dismissal.

We recently reached an agreement that settled the plaintiff's claims to spare the time and expense of further litigation and to continue to put these matters behind us. In addition, we recently received news that the last of our four shareholder derivative suits has been dismissed and the matters have been terminated.

Last month, our board of directors voted to dissolve the special committee that was formed in 2004 to conduct an internal investigation of allegations of securities law violations.

As we previously disclosed, the special committee did not find support for the claims at CEC or its senior management engaged in securities law violation. We are pleased with the progress we have made in resolving our legal issues and our goal is to put these issues behind us for the long-term.

Now let me briefly turn to our current discontinued operations. As noted in our 10-Q for the past several months, we have been working with an interested buyer to finalize a sales agreement that would make sense for both parties.

Unfortunately, despite our best efforts, we could not find a suitable arrangement that would be both physically responsible and also serve the needs and interests of our students, faculty and staff.

During the fourth quarter, we'll be considering alternatives for the dispositions of these 11 schools, including the continued operation of certain schools, conversion of one or more of our core brands, teach-outs or the eventual sale of individual schools. We'll carefully examine these alternatives over the next 30 to 60 days to ensure a decision that will be most beneficial to all of our stakeholders.

Now, let me turn to our organization leadership. Last quarter, I indicated I was in the process of recruiting to fill several positions reporting to me. Since then, we have announced the addition of three seasoned professionals to our executive leadership team. They are already fully immersed in their work and they are helping us to identify and address significant issues that will make us stronger going forward.

I also expect to name a new general counsel during the fourth quarter. Meanwhile, I am pleased that the following individuals have joined our team. Len Mariani, our new Chief Marketing and Admissions Officer with deep expertise in marketing and sales operations, and is an experienced general manager and business strategist.

Tom Budlong, our Senior Vice President of Organizational Effectiveness and Administration, has over two decades of experience in domestic and international human resources and organizational design and behavior.

And now, I would like to introduce you to another new member of our executive leadership team, Mike Graham, our Executive Vice President and Chief Financial Officer.

Mike has experience and proven success in a variety of private and publicly traded companies. His expertise in business transactions, mergers and acquisitions, and establishing efficiencies in large organizations are already proving beneficial to our organization. Mike.

Mike Graham

Thanks, Gary. I'm really excited about being part of the Career Education team and I'm glad that I had the opportunity to participate in the renewal of our company. As Gary indicated, we are making steady progress and we believe we are reaching important inflexion points as shown in many trends underlying key areas of our business.

We are encouraged by the continuing improvement in our operating metrics. Key improvements this quarter include our new student starts both for the third quarter and for October showed double-digit growth.

Our population has steadily inclined each quarter and has reached high single-digit growth a level, which we last experienced in early 2006.

We've continued to see improvements in our retention rate and we have achieved a reduction in student acquisition costs driven by improved conversion and show rates, along with modest reductions in advertising and admission spending. We are making progress on our strategy and putting pending litigation behind us.

Finally, we are pleased with the performance our acquisition of Istituto Marangoni and the face of development of our 2007 startups including Kitchen Academy in Sacramento, the academy in St Antonio, the academy in Sacramento and Le Cordon Bleu in Dallas.

While we recognize that we still face many challenges. We are aggressively addressing each challenge and are optimistic about our potential for continued improvement in the upcoming quarters. Now, let me provide you with some details on our third quarter results.

The third quarter of 2006 revenue of $404 million was down 5.6% from third quarter of 2006. This is an improvement in trend versus a 10.5 decrease in the second quarter of 2007.

While we are experiencing an overall decline in consolidated revenue, due primarily to population declines in our AIU brand and our colleges segment. Our growth in overall starts and population is beginning to have a meaningful impact in improving our overall financial performance.

For our online business, student revenue for the third quarter decreased 16.7% from the prior year, which is less than the decline of 24.5% in the second quarter of 2007.

While AIU Online continues to have a significant negative impact on year-over-year comparisons, the relative overall decline in our online revenue is diminishing each quarter as a result of the significant growth at CTU Online.

CTU Online currently accounts for over 40% of the revenue and over 40% of the operating profit of our total online business. AIU's Online population decreased 8% this quarter versus 11% in the second quarter of 2007.

AIU Online revenue was down 27% versus 33% in the second quarter. CTU Online population increased 39% consistent with the second quarter growth rate and CTU Online revenue was up 3% versus down 5% in the second quarter of 2007.

Finally, campus-based revenue was up $0.06 or 1%, which compares to a decline of 1.2% in the second quarter. Our revenue decline has a significant impact on our operating profits.

Consolidated income from continuing operations was $23.9 million during the third quarter of 2007 down from $38.4 million during the third quarter of 2006. The most significant factor in declining profitability continues to be the impact of probation at AIU. AIU operating profits fell approximately $20 million from the third quarter of 2006.

Our operating profit margin percentage for the third quarter was 5.9% versus 9% for the third quarter of 2006. Operating profit margin in the third quarter of 2007 includes a $2.9 million operating loss from our Marangoni acquisition.

Similar to many our ongoing campuses, Marangoni experiences a seasonal decline in student start activity in the summer and holds a minimum amount of classes in July and August while most of their fixed costs remain.

Marangoni experienced very strong October starts and we continue to be pleased with the performance of these schools. We expect to report an operating profit starting in the fourth quarter of 2007.

Consistent with our strategy to enter new markets and our announcement last January that the DOE restrictions were lifted our startup activities have intensified. And we incurred $4.5 million of startup activity losses versus $2.4 million in the third quarter of 2006.

Adjusting for these two non-comparable items would have resulted in operating margin of 7.7% for the quarter. The university segment's fully online platforms operating profit margin declined to 20.2% during the third quarter of 2007, down from 26.7% in the third quarter of 2006.

AIU Online operating profit was 20.1%, down from 33% in the third quarter of 2006. CTU Online operating profit was 20.3% up from 14.9% in the third quarter of 2006. While CTU population is experiencing significant growth it has historically lagged in profitability to AIU due to its lower paced program and increasing number of associated degree students.

As the introduction of CTU's 2 plus 2 associate and bachelor program began in early 2006, students have not yet had an opportunity to complete their first two years of school.

Starting in mid 2008, the first Colorado students will complete their associate program have the opportunity to continue their education by matriculating into our two-year bachelor program, which is at a higher tuition rate than our associate degree program and a relatively minor cost per start.

We have been successfully utilizing a 2 plus 2 model at AIU Online for many years with approximately 50% of the students in AIU associate program continuing on to pursue their bachelor's degree.

Finally, the decrease in operating profit margins of these factors, I just discussed were offset in part by decrease in our bad debt percentages as a percentage of revenue. Bad debt declined 140 basis points from the third quarter 2006.

As Gary mentioned, we have concluded our negotiations regarding our school's held for sale. Let me provide you a little more information regarding these properties. Our results from discontinued operations, which includes the 11 schools and campuses held for sale at September 30, 2007 was a loss of $4.3 million for the third quarter of 2007, compared to a loss of $6.3 million in 2007.

Last November, when we announced our decision to divest these schools, we indicated that we intended to conclude negotiations within a year. For the past several months, we've been working hard with the highest potential buyer to finalize a transaction that made sense for both parties.

As we have noted in the past, the significant excess capacity and associated real estate investment within these schools was a sustain of issue in our decision to attempt to sell these schools.

The indications of value for the schools and the real estate aspects of a deal were not sufficient in providing an acceptable financial solution for the company, nor in insuring the best potential outcome for our students. We could not find a suitable arrangement that would be beneficial for all stakeholders involved versus other available alternatives.

We've been examining several alternatives with this 11 school as Gary discussed, including continued operation of certain schools, conversion to alternative brands, teach-outs or sale of individual schools. We intend to conclude our decision process for each school by the end of the year.

As a result of the decision not to enter into a disadvantageous sale beginning in the fourth quarter these schools will not be part of continuing operations and the financial results for the schools will be included in continuing operations.

All prior periods beginning in the fourth quarter will be restated to reflect the school as part of continuing operations. For those schools that we will convert formats to one of our core brands these results will be part of the relevant operating segment for the new business.

In the case of a teach-out, the depreciation of fixed assets would be accelerated over a shortened life, which would be the length of the teach-out period.

For the 11 schools of it available for sale, the remaining net book value of fixed assets is approximately $37 million. If all schools were to be taught out this remaining net book value would be depreciated over teach-out period, which is typically around 18 months.

In addition, at the end of the teach-out period the present value of all future rent expense would be immediately recognized in the month of completion or perhaps, earlier if we exit a portion of the space prior to the completion of the teach-out.

The recognition of this expense would be reduced by our anticipated sublet rental income, as we have stated throughout the past year the estimated present value lease commitments before sublet income all 11 schools is approximately $100 million.

Let me wrap up with some comments on the lending environment, our repurchase program and our strong balance sheet. We all realize that the sub-prime market issues have affected all subprime borrowing, as well as, credit markets across the country in one way or another.

To date, we do not believe our business has experienced any significant impacts. We are still able to offer our students many lending alternatives and continue to work with our existing lenders and evaluate potential new lenders to make sure we are offering the best possible options for our students.

We are carefully monitoring each of our third party lenders for change in their credit underwriting standards.

Turning to our repurchase program, during the third quarter the company repurchased approximately 905,000 shares for approximately $24 million at an average price of $26.86

From the inception of the buyback program through September 30, the company has repurchased 15.6 million shares for approximately $516 million and has remaining authorization as of September 30, for approximately $285 million.

While we historically have purchased shares throughout a quarter we felt it was not appropriate early in the third quarter for the company to be active in the market, given our knowledge of hiring several new senior leaders during the quarter. As such, our purchases were made in September.

We continue to be committed to investing our capital for the highest return for the shareholders and will inform you quarter-by-quarter of our repurchase activity. Also during the third quarter, we completed a favorable renewal of our existing bank credit agreement.

The new five-year agreement provides us with up to $275 million of available debt at a cost below our previous agreement. Quarterly DSOs were 15 days, as of the end of the September, an increase of three days from the prior year.

The increase is primarily due to our internal processing and student loans rather than a change in payment patterns. With the exception of two schools the financial aid process at all of our domestic schools and campuses has been transitioned to centralize long processing center.

As part of centralization process we have added more thorough reviews of our federal drawdowns and we have also experienced slight but normal learning curve transitional delays.

To wrap it up, capital expenditures decreased to $12.8 million or 2.9% of total revenue including discontinued operations for the quarter down $16.9 million during the third quarter of 2006. Due to the renewal of startup campus activity, we expect some increase for the full year 2007 and into 2008.

With that, I'll turn it back to Gary.

Gary McCullough

Thanks, Mike. Last quarter, I indicated that we were working for a process that would yield a five-year plan. We shared that plan with our board of directors very recently and our working will corporate their feedback and ideas.

By design our process focused on clearly understanding our current businesses, their issues and their potential. There are a few things that emerged from our planning that I would like to share at this point.

With regard to growing our core institution, we continue to believe there is strength in the diversity of our business mix. We believe culinary arts, allied health, art and design and the key subject areas (inaudible) and CTU continue represent a robust opportunities.

That said, we are working to ensure that our schools offer curriculum that is consistent with the mission of the institution and that we do not dilute the brand with add on program that have little or nothing to do with the focus of the institution. We're also taking a hard look at programs that are not cost effective.

Further, I expect overtime that we will reduce the number of brands in our portfolio. Several of our divisions have begun work to review and sharpen their brands. For example, AIU has undergone a significant transformation as an institution as the result of implementing the SACS recommendations.

The institution is better for it and will reposition the brand early next year, pending its successful outcome in December. Consistent with AIU's brand positioning, we must focus time and resources on reversing the decline in its 100% online programs.

We'll also continue to build on the success of IBT online, which launched during the third quarter. And of course, we'll continue to roll out hybrid programs to our on-ground institutions.

We've also looked at individual school performance and in a number of cases we were dissatisfied with what we saw. Simply put, we were unable to meaningfully differentiate ourselves and where we cannot generate minimum expectable business results, we'll evaluate the ongoing and fit of a school in our portfolio.

As we review the business, we saw opportunities to improve both our academic and operations areas. For example, the company has historically invested in technology and IT infrastructure.

We've identified a number of ways in which systems can aid us in improving institutional compliance in the student interface.

During the quarter though, we also initiated an IT governance process that will enable us to prioritize the most important projects rather than fund virtually any project initiated in the organization.

We're also evaluating on how better to leverage many corporate functions that should be shared across our institutions. Len, Tom and Mike have already identified opportunities to work collaborately and to better leverage our marketing, communication, procurement and HR systems.

Now, with regard to entering new markets, on last quarter's call I talked about the new markets and I've had several follow-up questions since then about our intentions. I want to be clear that our focus in the near-term is on optimizing our current business and on organic growth.

With regard to growing organically, in our best year prior to 2007, we opened just four schools. In 2008, we expect to open six schools with the Le Cordon Bleu Boston opening in the second quarter.

In addition, even as we rationalize our academic programs, we anticipate launching 60 new programs in 2008 to keep our institutions fresh. We believe that this level of growth within our core brands will add value and is fully supportable as we continue to address our fundamentals.

As we begin to execute our plans, I continue to be confident that there's tremendous opportunity in the market and significant untapped value in our current portfolio. We intend to pass that value on behalf of all of our stakeholders.

With that, we'll take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from the line of Amy Junker with Robert Baird. Please proceed.

Amy Junker - Robert W. Baird and Company, Inc.

Good morning. I guess just a quick question on, first Gary, some of the replacements that you've made. You talked about the three adds that you did at the executive level. Have you also made some replacements maybe more at the midlevel area, is there more turnover additions we can expect and in the face of all of that, how would you kind of describe the morale?

Gary McCullough

Amy, thanks for your question. We have not or at least I have not made changes deeper in the organization, there is an ordinary turnover that we've seen in our organization. As I said on previous calls, we're working to reduce turnover.

I will tell you that coming through the planning process that we've come through gave me an opportunity to really see some of our younger leaders in action and we've got strength in the lower levels but we also have areas, I think, of opportunity to continue to strengthen the lower levels and so, we'll work at that over the next couple of quarters.

Amy Junker - Robert W. Baird and Company, Inc.

Thanks. And just one other if I could and then I'll pass it over. Just on the schools that are up for sale that you're looking at, I guess, if and maybe it's too early to discuss this but, I guess what gives you the confidence that it might make sense at this point to continue some of those campuses, where 12 months ago, the decision was made to put those up for sale?

Has something changed, have you seen improvement in any of those schools or what's your thought process there?

Gary McCullough

Yes. It's a fair question. I wasn't here 12 months ago I can tell you though, that the team in place that has been managing that business has done a terrific job. As you can imagine, it's got to be very, very difficult to be up for sale but yet have to run the organization. I think they have done a tremendous job.

Mike described also in his commentary, the fact that our losses this quarter were less than they were before and there's a mixed bag in that group of schools. There are some that are performing reasonably well that and that we believe still can be turned, but there are some that really have deeper losses.

And so I think we owe it to the team underground that's been working them to look closely at the work they have done, determine which ones can continue to be viable and which ones can't and make that decision expeditiously.

Amy Junker - Robert W. Baird and Company, Inc.

Great. Thank you.

Gary McCullough

Thank you.

Operator

Your next question comes from the line of Mark Marostica with Piper Jaffray. Please proceed.

Mark Marostica - Piper Jaffray

Thanks. Good morning. I wanted to first ask about the culinary business, I noticed the stock growth accelerated quite a bit in the quarter and I was hoping to get a little more color as to that dynamic?

Paul Ryan

Well, we have seen -- when you look year-over-year culinary margins particularly, as Gary and Mike both have mentioned, it's impacted in the third quarter by the some startup activity.

In addition, as I mentioned last quarter there's one school in culinary that is dragging down the overall financial performance of the division when we look at that. We recently appointed a veteran culinary president from within our own system. She has a proven track record and she's just been appointed to that school and clearly she's focused on an execution of a well-defined turnaround plan at that one school.

I would also mention that in the third quarter we also took a one-time expense of $1 million that was related to our Le Cordon Bleu licensing fee. And in the agreement, when we hit a certain student population benchmark in our hospitality and restaurant program, it triggered a payout to Le Cordon Bleu that fortunately we exceeded that number in the third quarter to have to make that one-time payout.

When you factor in the startup costs, the one-time Le Cordon Bleu program fee and when you look at the one under-performing school, the remaining schools are performing at a much higher level. The start trend we have seen I think positive starts in most all of the schools, as I mentioned the one school is significantly dragging us down.

Mark Marostica - Piper Jaffray

Great. Thanks for the color on that, Paul. One follow-up question unrelated to culinary perhaps is the admissions headcount reductions that you talked about in the press release. I don't think you mentioned it on the call, but could you give us a sense for how many individuals were cut and what your target level of admissions headcounts will be and what it is at today?

Steve Fireng

Mark, this is Steve. I'll give you a little bit of just broad on the admissions. One of the things we've undertaken, we've talked a little bit on the calls is to really change the admission structure.

There's been different people have called, we have a peer process at CTU where we've changed the job from making a lot of calls to maybe having a group that makes a lot of calls and does live transfers to its admissions advisors.

So although the number of reps could decline, the overall process is changed to give those inquiries or those live transfers to admissions people so they don't have to spend 60% of their time making calls.

So really the change is really a structural, deliberate change due to a change in our admissions structure.

Mark Marostica - Piper Jaffray

Okay. Great. And can you give us some sense as to what your current admissions headcount is today and what your target headcount in admissions is and over what time period?

Gary McCullough

Currently, we have approximately 2400 admissions reps throughout the system, not only in this business but all the businesses. As Len Mariani works through his new programs, we will continue to address what the optimal level is but we feel very comfortable right now at 2400 reps.

Mark Marostica - Piper Jaffray

Okay. Fair enough. Thank you.

Operator

Your next question comes from the line of Jerry Herman. Please proceed, sir.

Jerry Herman - Stifel Nicolaus and Company, Inc.

Thanks. Good morning, everybody. Hey, Mike I just wanted to give clarification on the mechanics of the fourth quarter and how it relates to the discontinued operations. As I understand it, you guys will pull those schools back in make decisions on what to do with them.

On a go-forward basis you will have some amortization of D&A, which should run 18 months or whatever, $2 million Bucks a month. And then you will then the present value of the lease liability will be recorded as a one-time?

Mike Graham

I'm not sure if, it would be a nonrecurring type charge. It would be recorded in the individual month that the school we want dark. So not all teach-outs would be 18 months, so it wouldn't be discreet necessarily to one quarter.

But each time a teach-out is completed you could recognize that liability in the month that we complete the teach-out or if we do subdivide that space, bring that space dark and put it on the market and don't use that space, there is a possibility you could recognize that a little bit in advance at the end of the teach-out period.

Jerry Herman - Stifel Nicolaus and Company, Inc.

And the way that we'll see that is based on your commentary as opposed to a specific line item in any individual quarter?

Mike Graham

You would not see it as a line item within the P&L, but it would be clearly disclosed in the press release and clearly be disclosed in the 10-Q. As we go forward, we would probably look at a press release schedule to make sure that the details are fully laid out for you.

Jerry Herman - Stifel Nicolaus and Company, Inc.

Okay. Great. And in light of that, I guess you guys have lost maybe for the discontinued ops have lost maybe a dime on a year to date basis and in light of what I would expect to be some increase dilution as of -- from pulling those back in.

How does that impact your opening program for '08, it sounds like you're actually getting more aggressive and accepting an even higher level of startup losses in '08. Is that true?

Mike Graham

I think that we intend to continue to open new locations. Our startup activity has intensified and will continue because we see a lot of growth opportunities in our five core brands.

The business has been running for the last year and the last several years. Obviously, the Gibbs portfolio and we've been unable to run that with our management team, so I don't think the Gibbs management team gets distracted by the startup activities.

And we can fully execute the plan to move these schools either in a teach-out and sale change the format or continue to operate them without big distractions to our startup program.

Jerry Herman - Stifel Nicolaus and Company, Inc.

And just one last follow-up and I'll turn it over. The margins in the online business, you know, it was good to see that CTU showed some progress here. AIU, hopefully the prospect's better. Can we have reasonable confidence at this juncture that the online margins have troughed?

Mike Graham

Yes. I mean just, I mean you noted on the CTU margins, I mean we are very pleased with the progress. We talked about that during the last call, you know, that we felt like with the increased population that we're going to soon start seeing the margins. And we've obviously had a better cost per start in our revenue per student particularly on those associate degree has continued.

You know, in terms of AIU, we have a couple different dynamics going on there, obviously, we've somewhat stabilized the population, although we are still seeing increased number as a percentage in our associate degree population.

So while we lowered the price and we anniversary, we have seen an increase of our percentage of our students in the associate degree. So in Q3 of '06, we had 44% in associate degree and this quarter, we had approximately 55% of our associate degree. So we do have that dynamic. The other, we'll continue kind of working post SACS pending a successful outcome, we'll continue kind of spending those dollars to re-brand.

We don't feel like we have to spend significantly more money in the marketing side because we feel like there will be some positive with leave conversions, although there could be spending earlier in the year to kind of re-launch the brand. So really kind of is dependent on how fast AIU can rebuild that population.

Jerry Herman - Stifel Nicolaus and Company, Inc.

Great. Thanks. I'll turn it over.

Gary McCullough

Thank you, Jerry.

Operator

Your next question comes from the line of Jeff Silber with BMO Capital Markets. Please proceed sir.

Jeff Silber - BMO Capital Markets

Thank you so much. I wanted to clarify the data you just gave to Jerry. The 55% and 44% that's your associates as a percentage of your AIU Online population or your total online population?

Steve Fireng

That's total AIU Online population.

Jeff Silber - BMO Capital Markets

And do you have the same data for the total online population?

Steve Fireng

I actually have, I'll give you the CTU Online population. You know we have 60% of our population at CTU as associate degree, 30% is bachelor's degree and 10% is master's degree at CTU Online.

Jeff Silber - BMO Capital Markets

Okay. Great. That's helpful. That's all I needed. Going back to an earlier comment in the introduction about conversion show rate and retention improving, I was wondering if we can just get a little bit of color around that and if possible some quantification of that as well and what you're doing to improve those metrics?

Gary McCullough

Let me start with just some stats for you and then I'll let my partners here to talk about the steps they are taking. Show rate, we have improved our show rate by about 500 basis points from last year's third quarter and we've stabilized our show rate from last year's second -- this year's second quarter. So we're in good position there.

Our retention rates are down from middle of last year by about 200 basis points and we've also stabilized retention rate from second quarter to third quarter. So our matches have improved and they have been sustained.

Steve Fireng

Yes. This is Steve. I'll give you a couple. Certainly, the change in our admissions process has helped our overall student acquisition cost. You know, so we really feel like we'll be able to optimize and that admissions process as Len evaluates the admissions process throughout the company could be rolled out more broadly. Right now, it's really defined at CTU Online but it's been a huge impact.

In terms of the show rate, a lot of it has to do with pricing and also target marketing to make ensure that we're going after some pricing, obviously better packaging. We're packaged stronger at the start date, which when you have a higher package start, you're going to obviously get better retention for those students.

And then the other thing is really beginning to target more of the bachelor's and master's degree students from a targeting vendors, obviously kind of pushing our associate degree and moving them up to bachelor's and master's degrees as well has had an impact.

Jeff Silber - BMO Capital Markets

Okay. And then shifting back to AIU Online, assuming you get a clean bill of health from SACS. I know you haven't detailed exactly what you plan on doing in terms of marketing or re-branding but can you give us maybe some examples of some of the things you're thinking of in order to get that program back on the right track?

Steve Fireng

Well, I'll give you. The first really thing is just we have very, very strong outcomes at AIU. If you look at retention rates, student satisfaction, so some of the metrics, so really putting those metrics out there for the perspective students to show that, boy, when you go to AIU, there's strong outcomes with the students.

The second thing is really targeting our local ground campuses are and rebuild the image. As you've seen our local AIU ground campuses have been probably -- extremely hit by this probation and we have a strategy where we'll do some branding TV type of advertising.

We're going to be very visible in PR campaigns locally and really zero in on those local markets and then we'll broaden that out more of on a national basis as we kind of rebuild and reposition the AIU brand.

Jeff Silber - BMO Capital Markets

Great. If I could sneak one more in just on the tax rate, it was a little bit lower than we had thought. If you could just tell us why and what we should be looking for in the fourth quarter? Thanks.

Gary McCullough

Sure. Tax accounting, you need to book to an annualized rate. The annualized rate now at the end of the third quarter is 34.5 and we anticipate that will be our annual rate for the year.

During the year, we've been booking based on an estimate of our pretax income which has a combination of tax-free income from investments and also lower taxed income from foreign entities.

As the third quarter ended and as we took a look at our accounting, we believe that given that some of our operating earning has fallen and our interest and our foreign earnings have increased, we'll have more of a blended lower rate and we've made the cumulative adjustment here in the quarter.

Jeff Silber - BMO Capital Markets

Okay. That's fair enough. Thanks again.

Operator

Your next question comes from the line of Sara Gubins with Merrill Lynch. Please proceed.

Sara Gubins - Merrill Lynch

Hi. Thank you. Good morning.

Gary McCullough

Good morning.

Sara Gubins - Merrill Lynch

How indicative are the month of October student starts for the rest of the quarter? Is there anything that you think is either particularly low or high in those numbers?

Steve Fireng

I'm not. I am not sure I understand the question.

Sara Gubins - Merrill Lynch

I guess what I'm wondering is the third quarter student starts came in a bit below the 14% growth that had been reported at the month of July. And for example, university student start growth was well below, I think it was 21% in the month of July.

So I'm trying to understand if I look at the student start growth that you reported in the month of October. How indicative you think that is for what we'll actually see for fourth quarter start growth?

Steve Fireng

Yes. I mean, certainly, you know there's a couple of difference things going on, there is some seasonality to the overall business. You know, also bear in mind; AIU in particular was really focused in on their SACS visit was really focused in on readying themselves for the visit.

And so, you know obviously the October start was came the week before, the week of the visits when SACS was there. So there is a driving force in the university group based on kind of, the timing of the SACS visit and the readiness of the SACS visit.

Sara Gubins - Merrill Lynch

Okay. And then in health education, I notice that jumped up to almost 30% start growth in the month of October. Are you seeing any change in trends there or is it sort of the same as what you've been seeing earlier in the year?

Steve Fireng

Well, I believe there's some seasonality there. Number one, but more importantly to me is, we have a seasoned leadership team right now, both on the division level, as well as the school.

The issues that created problems for us in 2006, I really believe we're seeing some positive results of that and that comes in really what I consider two areas. One is the leadership in our admissions departments is much more stable this year than we were in previous years and our rep turnover is improved significantly while we still have opportunities in both of those areas.

I really believe that's the positive results that I'm seeing, you know, from the group relative to better show rates, better conversion rates and obviously, better starts.

Sara Gubins - Merrill Lynch

Thank you.

Gary McCullough

Just one more thing on the starts side, online -- like a just give kind a OEG group, you know, like the academy, if you look at the academy, one of the dynamics is they are moving to versus having four starts a year, having eight starts a year.

So sometimes you'll see, you saw kind of the third quarter jump and the four, you know on October start might have been a little bit down, but if you -- because they have moved to more starts, there is a, kind of a change in their start calendar versus kind of what they have done.

I just wanted to make that clarification give an example of the academy that could change the trend on an October start.

Sara Gubins - Merrill Lynch

Great. Thank you. Mike, can you talk a little bit about your expectations for revenue per student trends in online? I understand why it's been so negatively impacted through the course of this year.

If you get off of probation for AIU, what's the expectation for what we'll see in terms of revenue per start, either declines or growth into next year?

Mike Graham

I think I'll let Steve handle it in more detail. Obviously, coming off the probation will take some time to rebuild the population and rebuild -- renew the brand. And you don't have the same dynamic of CTU with the 2 plus 2 programs and the different changes and the noise. So the baseline program and the programs are strong. Steve, I'll give you a chance to give more color.

Steve Fireng

Yes. There's -- in AIU if you, you know one of the dynamic of AIU pending a successful outcome is offering new programs, especially at the bachelor's and master's and also revising programs.

As you're aware during this probation period, AIU has been unable to add any new programs or substantially change any of their current programs that they offer today. So one of the strategies post probation that AIU is going to be able to do is be able to add programs and really center on those programs in the bachelor's and the master's degree level.

So we can kind of leverage those profit at those at those two-degree levels. So that's a big change that AIU will be able to do post probation.

Sara Gubins - Merrill Lynch

Great. Thanks. And then last quick question, what are your plans for price increases or any update on recent price increases across the group?

Gary McCullough

Sarah, this is Gary. At this point we don't have price increases planned for 2008. We are going through our 2008 planning cycle, which will conclude during this quarter. We'll be looking for opportunities for pricing as they present themselves. We'll take them. But at this point, we haven't planned anything.

Sara Gubins - Merrill Lynch

Great. Thanks a lot.

Gary McCullough

You're welcome. Thank you.

Operator

Your next question comes from the line of Chris Shutler with William Blair and Company. Please proceed.

Chris Shutler - William Blair and Company

Hi guys, good morning.

Gary McCullough

Good morning.

Chris Shutler - William Blair and Company

First question is on the AIU price decrease that put in last year. Just wondering, if you can give us some rough sense of what kind of decline in the average revenue per students we would have been talking about absent that price decrease.

Gary McCullough

So you're asking, if we would have kept the same pricing, if we would have experienced any revenue decline, keeping the same pricing?

Chris Shutler - William Blair and Company

Right. I guess I'm assuming, based on our calculations we are figuring average revenue per student in university was down around 20% in the quarter. Would that have been low single digits, high single digits, or double digits, if…

Gary McCullough

The only dynamic you would have had and it's probably about 4 to 5% of our associate degree students take a part-time program. So you would have -- you would have some impact on just the part-time population, if you didn't have just the price.

You know bear in mind also, though you also have AIU as you know less revenue days, which does have an impact on that. And you probably would not experience the increased retention that you would have got. So that might have offset, the RPS issues that you're experiencing.

Chris Shutler - William Blair and Company

Okay. So the, the mix shift at CTU is probably accounting for low single-digits in terms of the average revenue per student decline, is that fair?

Gary McCullough

You know part-time. Yes. The part-time option?

Chris Shutler - William Blair and Company

Yes.

Gary McCullough

Yes.

Chris Shutler - William Blair and Company

Okay. In terms of the school in discontinued ops, is there any opportunity in your view to co-late, I'm sorry, co-locate other schools maybe health or culinary under these schools?

Paul Ryan

Yes. There's an opportunity to do that, we'll be evaluating that those opportunities during the quarter.

Chris Shutler - William Blair and Company

Okay. And Gary can you talk about Gibbs for a minute. Just what kind of trends you're seeing at that school? I know the New York school still going through some regulatory issues but as you view that school, how was your opinion of all from when you first arrived to now?

Gary McCullough

I'm sorry. I can you say that again, I can barely hear you?

Chris Shutler - William Blair and Company

I apologize. Can you hear me now?

Gary McCullough

Yes. That's better.

Chris Shutler - William Blair and Company

Great. Just In terms of Gibbs I am just wondering if can you give us some sort of sense how you are thinking in that school has evolved from when you first arrived, Gary to now?

Gary McCullough

I think Gibbs is a fantastic brand and I have thought that since before I even arrived, so I start there. I think the question is or the issue is that we've had uneven performance across the business and I think again, the team that's been managing the business has done a good job of recognizing that of making cost changes, of making programmatic changes.

And so, what we're going to do at this point of time is sit down with the team understand where they are understand what else we could do there. We've been looking at a variety of markets where we would like to open schools.

You know, even in other programs like healthcare or like culinary and some other markets that the Gibbs school of existing are markets that have come up as markets would be interested in.

And so that's where we think there could be viability in co-locating but again, I'll look at the schools and I'll sit down with the team and look to go forward. I think they have made operational improvements that are terrific and we want to make sure that before we do anything radical that, we might regret over the long haul that, we really understand the story of Gibbs going forward. So I've got an open mind as it relates to the brand the disposition of the schools.

Chris Shutler - William Blair and Company

Okay. Fair enough. And then final question for Paul, maybe you could just comment. Health obviously saw some nice increase in starts in the month of October. Just what are the key drivers of growth in that division?

And how sustainable in your mind are they and are you bumping up into any sort of capacity constraints at this point? Thanks.

Paul Ryan

First of all, I'm very pleased and proud of what this team has been able to accomplish. Our lead flow continues and consistently continues to be in our favor. The nice thing that I mentioned a moment ago was the stability that we have in our leadership, both at the school division and in our admissions areas, as well as, our rep. That is a significant issue when I think a school gets into trouble.

So having stabilized that, I think the division team and the presidents of the schools have done a significant job in doing that. We, as we look forward and with our strategies, we continue to -- we will continue to put in some higher end programs that obviously generates interest in the schools, that will continue to afford us the opportunity to grow these schools.

From a capacity standpoint, that's knots really an issue may be in one school, I'm trying to think off the top of my head but not really. We have plenty of capacity in healthcare and that's a matter of scheduling, which the division team has worked with the schools this year to give us more efficiency.

That's why we're seeing margin improvements from a standpoint of our academic expenses, because we've taken a lot of linear programs and moved them into more modular programs to give us the opportunity to have more space to put either new programs or expand the population which the school currently has.

Gary McCullough

And to the point of the management team over 80% of the individual schools within that group experienced start growth in the month of October, which shows that it's not one school, it's across the board.

Chris Shutler - William Blair and Company

Okay. Great. Thank you.

Gary McCullough

Thank you.

Operator

(Operator Instructions) Your next question comes from the line of Jennifer Childe with Bear Stearns. Please proceed.

Jennifer Childe - Bear Stearns

Thanks. I felt like this has been asked a couple of times but perhaps not answered directly. When do you expect revenue per student within the university segment to bottom?

Mike Graham

You know, I think really the big bottom begins when we start beginning to see those. If you're talking about AIU it's really two things. It's when those students that increase the amount of associate degree students begin to graduate and begin to start going into the bachelor's degree students and I would tell you that's in the first half of 2008, when those students begin to increase.

So really the increase occurs when the associate degree growth starts moving into the bachelor's degree students. And then the reality of it is, is that we're working on a repositioning of the AIU brand and although it's too early to tell how long that is going to take in terms of turn that brand around.

We have a lot of strategies in the first half of the year to reposition it but we'll have to see how long it takes to rebuild that population.

Jennifer Childe - Bear Stearns

Shouldn't you be getting more of a tailwind from the anniversarying of the tuition cuts?

Mike Graham

You actually, you would if we wouldn't have had an increase as a percentage of our overall population in the associate degree. So you anniversaried out the current population but at the same time your percentage of your over all population in the associate degree program was increasing at the same time.

So I mentioned, you know going from 44% of our population to 55%. So that increase in a percent of population is actually going to offset some of the, that benefit you would get by anniversarying it.

Jennifer Childe - Bear Stearns

Okay. Maybe if I can just sneak in a related one. Now that CTU and AIU margins are, online are essentially equivalent as CTU becomes a bigger part of the overall mix and presumably that margin expands. Can we expect the overall online margin to improve?

Mike Graham

Yes. I mean, yes. Our expectation is, as CTU becomes a bigger mix, we've seen improvement at CTU Online this quarter. We feel like we can continue to see improvement at CTU in the coming months and as long as that, as long as that trend continues, we expect it is. You will see an increase in margins in the online businesses.

Gary McCullough

Jennifer, this is Gary. You're asking a very fair question. You know, we have seen the margin expansion of the CTU. We expect that we'll be able to leverage that, continue to grow CTU. At the same time, we absolutely have to address the eroding margins that we've seen at AIU.

And ideally, we'll see that begin to turn, as Steve mentioned, you know, as we get into the mid part of '08 when students who matriculate into the bachelor's degree program. So it's a fair question. I would say putting a date on it, I would tell you that I think it's the second quarter of '08. We'll really begin to see a turn as we go into mid-year.

Jennifer Childe - Bear Stearns

Okay. Thanks a lot.

Gary McCullough

Good question. Thank you.

Operator

As a reminder, ladies and gentlemen, that is one question per caller. Your next question comes from the line of Jeff Lee with Signal Hill. Please proceed sir.

Jeff Lee - Signal Hill

Hi. Good morning. We've talked about the drivers for the claims in average revenue at the university group. What's behind the declines in average revenue in the Culinary College and Health Education segment and then when you expect those drivers to dissipate?

Paul Ryan

I'm sorry? Culinary health.

Jeff Lee - Signal Hill

Yes.

Paul Ryan

I'm trying to frame the question. Could I have it again please?

Jeff Lee - Signal Hill

Yes. Sure. Now this quarter average revenue per student declining at Culinary Division about 2%, decline about 3.4% at the Health Education Group and then at the College group, we have a declining about 1%. What's behind those declines in average revenue per student?

Paul Ryan

The only thing that I - I've got to go back and look at that to be honest with you. I'm looking at culinary. I have not had any mix changes or any of those things in my revenue per student.

The only thing that could be bringing it down would be the Kitchen Academy group because of the startups that we've done. That is a little bit lower. It's a lower tuition, so that does have a slight impact on the RPS. That's it from the culinary.

Steve Fireng

Yes. On the college side, it's very simple. We've had a couple schools offer some part-time options for the students although it's on a very limited scale. There is a shift because student's demands and students desires have changed off of some part-time options. So some of the colleges have been able to use that part-time to assist in retaining students and recruiting students. That's really the smaller change, although it's a small change, that's really the change for the college division.

Paul Ryan

And then finally, from a health standpoint, I think its just more of noise. I think we're down 2%, but if you look last quarter in the second quarter we were up about 1%. So given the number of schools, population of different programs, its probably just noise in the mix.

Jeff Lee - Signal Hill

Okay. Great. Thank you.

Gary McCullough

Thank you. Jeff.

Operator

Your next question comes from the line of Gary Bisbee with Lehman Brothers. Please proceed sir.

Gary Bisbee - Lehman Brothers

Good morning guys. The question relates to the online business, and you've talked about this mix to associate's degree, just across both AIU and CTU. I believe, I guess I'm trying to gauge how and why you're confident that you can have an improved mix back towards the more expensive and higher margin programs in bachelor and graduate.

When I look across all of the big for-profit companies, obviously we're seeing a massive mix shift that follows associates that mirrors what you've seen and I think we've seen that at other companies.

It seems to me that the low cost associate programs seems to be for the industry very much the easiest place to grow today. How are you confident that's going to move back and help ultimately revenue per student margins?

Mike Graham

Well, two things. First of all, we have experience in moving our associate degree to bachelor's degree students at AIU. We've done it since inception and as we've noted before, approximately 50% of our associate degree graduates continue on to their bachelor's degree program, and so even though when that's fluctuate -- when the associate degree graduates have fluctuated up or down.

That percentage has remained relatively flat. We have put into same strategies that we've put into AIU at CTU and have a lot of confidence with the interest in talking to our current associate degree students at CTU and have a lot of confidence that we should over time have a similar percentage of associate degree graduates continuing on to bachelor's degree. So we have a very successful track record at AIU.

Operator

Your final question comes from the line of Corey Greendale with First Analysis. Please proceed.

Corey Greendale - First Analysis

Hi. Good morning.

Steve Fireng

Good morning.

Gary McCullough

Good morning.

Corey Greendale - First Analysis

I'm hoping this can pass for one question, but it's kind of a three-part on the university segment. The first part is on AIU Online starts. Steve, this quarter we entered the queue were up, excuse me, down 11%. Last quarter they were up 9%. Which of those more accurately reflects the direction of that business?

Steve Fireng

Well, I think it's you know, the overall. As I've said before, the third quarter was really the focus. We were getting ready for our visit and there was a lot of focus and emphasis in that. So I think, you kind of have to blend the two together to prior get more of an accurate.

You know over the kind of period of time, you know really right now it's focusing on resolving the final SACS recommendations and but bear in mind we did have, you know we continue to see some increases with -- in our October start for AIU as well.

Corey Greendale - First Analysis

Okay. And on the university segment margins, first of all is it fair to assume -- there's still a lower number of revenue-generating days at AIU, so revenue could still be down sequentially and margin could still be down sequentially there for that reason. Is that correct?

Steve Fireng

That's correct. If you look at our past history at AIU, you've seen the trend as the year progresses, based on the number of revenue days that the revenue and profit will go down as the quarter's progress throughout the year.

Corey Greendale - First Analysis

Okay. And on the groundside of the university segment, is that calculated -- those are losing a fair amount of money. What's causing that and what are the prospects for getting that into the black, just the on ground campuses?

Steve Fireng

Yes. There's kind of two different stories on the, we are talking about AIU first; they have been significantly impacted with their local representation on the AIU groundside. And getting ready for SACS, they have a lot of work to do. They put a lot of focus and energy resolving the SACS concerns and as our recent result, they did a wonderful job in resolving based on the visit.

So really the turn on the AIU side is rebuilding the representation and the brand positioning locally for those AIU grounds schools, because you have it kind of across the board.

You know, at CTU you have kind of a mixed bag, you have two things going on you have one that we're really kind of pushing the 100% online, even from the ground side, so you have kind of -- you have schools kind of talking about 100% online and hybrid and things like that.

And then we do have a couple schools that are doing very well. We have a couple schools that are not doing very well on the CTU groundside. So really it's focusing on those couple ground schools that are not doing as well as we would to, need them to do.

Corey Greendale - First Analysis

Thank you.

Operator

And ladies and gentlemen, that concludes our question and answer session for today. At this time, I would now like to turn the call back over to Mr. Gary McCullough. Please proceed, sir.

Gary McCullough

Thank you, all for participating on our call this morning. We appreciate your questions. I would just summarize by saying that we are working on building a strong foundation for the future of our company and doing that's going to take patience it going to take hard.

We'll need to collaborate more. We'll have to execute better than we have and frankly with we have to change the way we've operated. We're putting into place what I believe to be a strong, talented management team.

We've got a clearer plan of action for the future and we've got certainly the resources within our company necessary for us to achieve our potential.

I wanted to say that. I want to thank you again for your time and your interest in our company. With that, we'll conclude our call.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. That concludes the presentation. You may now disconnect. Have a good day.

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