Apollo Group Needs an Accounting Refresher

On Thursday afternoon, Apollo Group (APOL) demonstrated stunningly why I didn’t buy Apollo’s apparent earnings momentum. The stock is now down more than a third since that article, compared with a 1.5% decline in the S&P 500. Given the sharp decline, I’d lighten up on any short position, but I still wouldn’t touch this stock with a 10-foot pole. I see no reason the stock couldn’t drop another 25%.

One thing about the stock plummeting is that it brought some of the valuation metrics I previously considered out of whack into more reasonable territory. The P/E, even considering downward revisions, should now be close to that of the overall market. The free cash flow yield is a more impressive 7.4%, provided you don’t count acquisitions as functionally equivalent to capital expenditures.

But these valuation metrics rely on the financial numbers reported by management, which in my opinion now requires a leap of faith on the part of investors.

For example, last month I commented on a persistent increase in bad debt expense as a signal that earnings quality was getting shaky. Now, according to their earnings release, “the Company reviewed the components of bad debt expense and identified certain items that should have been classified as discounts or refunds (reduction of tuition revenue) rather than bad debt expense. Had the Company reclassified these items in the second quarter of fiscal 2007, the amounts reported for net revenue, and bad debt expense would have been $5.2 million lower. On a comparable basis, bad debt expense as a percentage of net revenue, increased approximately 30 basis points from 3.5% in the second quarter of fiscal 2007 to 3.8% in the second quarter of fiscal 2008.”

So now, instead of higher expenses, we get lower revenue. The impact on earnings is the same, but it raises some questions. Like, how is it that management doesn’t know the difference between a refund and a bad debt?

This is even more astounding because in the February 2007 quarter Apollo concluded an independent review of its financial results and was able to file its overdue 10K and 10Q reports. This review resulted in $154 million in various charges, yet somehow missed the distinction between a refund and bad debt? Please.

Earnings quality is showing no sign of improving, either. The accrual ratio measures the difference between cash earnings and accounting earnings. The closer to zero, the more reliable I consider the earnings to be. Apollo’s have been all over the map, and if anything the ratio is becoming more volatile.

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Sources: Zacks Research Wizard and Apollo Group, compiled by William A. Trent

The reason for the sudden reversal in the direction of accruals this quarter was the $168.4 million accrual for estimated damages stemming from the securities class action lawsuit. This accrual reduced earnings but not cash flow in the February quarter, and is expected to reduce cash flow (but not earnings) in a future quarter.

Most analysts are treating the $168.4 million as a one-time charge. However, given the stock’s performance after the report, I wonder if we won’t be seeing these securities class action lawsuits on a recurring basis.

Disclosures: At time of publication, William Trent has no positions in the companies mentioned.

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Comments

[Solomon]

The reclass is not the main issue with the stock, though perhaps indicative of sloppy management.

APOL is over-valued on a P/E and cash flow basis, has a rising cost structure, and facing higher student acquisition costs and slowing enrollment growth due to reduced availability and higher cost of student loans.

The result, lower expected earnings and a lower multiple - sellers outnumber buyers and the stock has fallen dramatically.

That's what the shorts thought before the recent conference call. What is the incremental call, here?

Seems like the sector and market want to bounce off lows here. APOL noted on the call that they have material buy-back availability in their stock repurchase plan.

Comparable, STRA announced it's earnings date of on 4/30/08 pre-market, with a 10 am eastern time conference call. Expected EPS $1.58 vs. $1.30 prior year.

Look for more indications of stress on student borrowers in form of bad debt, fewer student loans, more loans above limits, slowing enrollment growth.

In related news, CIT and Northstar announced exits from the student loan business today.

Analysts and current institutions are defending the stock with positive comments, but lowering price targets. Executives are net sellers of their shares and exercised options.

If STRA evidences this weakness in student enrollment growth, expect to see APOL and other sectors companies' shares under pressure.