By Damion Rallis - Senior Research Associate
Last week's bad news at for-profit education company Apollo Group Inc. (NASD:APOL) started with a weak earnings report that included the announcement of job cuts and school closures and then ended with a steep share price drop. While we are loath to lean on such facile sentiments as "we told you so," sometimes a reminder is in order. At GMI Ratings, we have been evaluating Apollo Group Inc poorly for so long-having fallen to a "D" in August 2010 and then an "F" in February 2012-that it seems that Apollo is running out of road to drive on. As of our latest assessment, Apollo Group is signaling significant risks across two of our rating models:
GMI Ratings' Litigation Risk model has also been flashing warning signs about Apollo Group for some time. Having been in High Risk territory for many years, the company currently has a 5.1% probability of Class Action Litigation occurring within the next 12 months. This places them in the 6th percentile of all companies in North America, indicating higher shareholder class action litigation risk than 94% of all rated companies in this region.
In its earnings report released last Tuesday, the company announced that its net revenue for the fourth quarter of fiscal year 2012 totaled $996.5 million, which represents an 11.0% decrease compared to the fourth quarter of fiscal year 2011. The decrease was due principally to lower enrollment at the company's flagship institution of learning and main subsidiary, The University of Phoenix; for the quarter, University of Phoenix Degreed Enrollment decreased 13.8% to 328,400 and New Degreed Enrollment decreased 13.7% compared to the fourth quarter of fiscal year 2011.
Apollo Group went on to report that it would "reengineer business processes and refine its delivery structure" in order to cut operating expenses by at least $300 million by fiscal year 2014. The plan to save costs includes closing 115 University locations, consisting of 90 learning and resource centers and 25 campuses. As part of this significant reduction, approximately 800 employees will lose their jobs. Curiously, in the same announcement, the company revealed that it had entered into an agreement with The Carlyle Group and closed the purchase of Carlyle's remaining 14.4% non-controlling ownership interest in Apollo Global, Inc. for $42.5 million in cash, plus other contingent payments. No reason is given for the buyout and we can only speculate-in the absence of full disclosure and in the context of other bad news-that Carlyle Group, like the market, got cold feet. In chorus with these announcements, Apollo Group's share price opened the week at $28.67 and closed on Friday at $20.39, a reduction of nearly 30%. To further illustrate how far it has fallen, Apollo's shares traded as high as $58.29 over the past year and about $90 in January 2009.
GMI Ratings has been highlighting the investment risks of the For-Profit Education industry for some time, having published a November 2011 report entitled "ESG and Fiduciary Risk: The For-Profit Colleges" and another this past July on the two-year investigation led by Senator Tom Harkin called "For-Profit Colleges: Senate Investigation Highlights Risky Investment Profile of Socially Objectionable Business Models." Among the conclusions that can be drawn, the entire for-profit education sector is heavily dependent on federal financial aid monies, which can account for as much as 91% of a firm's revenues. The industry has also been facing a number of regulatory and reputational challenges. A number of companies have faced litigation over their recruitment practices: Apollo itself paid $78.5 million in 2009 to settle a whistleblower lawsuit alleging that it had violated rules against paying admissions counselors incentive pay based on total students recruited.
In addition, critics have alleged that many for-profit schools provide substandard education to their students, leaving them with poor job opportunities and leading to high rates of default on federally guaranteed student loans, whose cost is ultimately borne by taxpayers. In 2010, the Government Accountability Office conducted an investigation of 15 for-profit colleges, uncovering a number of fraudulent and deceptive practices. In 2011, the Department of Education tightened oversight of the industry, with new rules including requirements for schools to report on the percentage of their graduates that are repaying loans and the average income of graduates in relationship to their loan burden. The thresholds that schools must meet on each of these metrics in order to retain eligibility for federal funding are relatively low, and a number of the industry's critics remain concerned that they will not adequately address its problems. The industry has struggled to attract students ever since government scrutiny revealed high student debt loads and low graduation rates. New federal rules that threatened to cut away financial aid if debt loads remained high were introduced in 2011, forcing colleges to change the way they enrolled students and focus more on the quality of education.
Apollo Group was founded in 1973 by former humanities professor John Sperling and is by far the largest and most influential of the for-profit college firms. Mr. Sperling, though 90, continues to serve as Chairman, and Mr. Sperling's son, Peter, who joined the company in 1983, is also a director. Apollo's Class A shares, which are publicly traded, have no voting rights. The voting Class B shares are entirely owned by company management and related trusts. In evaluating controlled companies the single most important consideration for investors is the extent to which the controlling shareholders have organized and manage the company for their own benefit. In the case of Apollo, father and son John and Peter Sperling, through their voting trusts, control 100% of the Class B voting stock and 13% of the non-voting stock, effectively removing the company from the market for control. Directors on Apollo's board are not independent, as all directors are elected by a separate class of stock that is entirely owned by the Sterling family. There is no meaningful separation between the board and management at Apollo, as only the Sperlings can elect the board. Moreover, four of the 13 board members are executive directors.
As the industry continues to tank, the Sperlings continue to cash out at an alarmingly high rate. Since October 2010, when the company's share price opened at $51.40, John and Peter Sperling have sold over 8.1 million shares for an aggregate price of over $367 million. In the meantime, shareholders have seen stock prices drop more than 60% over the same two-year period. While there have been no allegations that these sales were improper, it is noteworthy that the Apollo Group is currently under investigation by the SEC for insider trading in the past.
In October 2010, Apollo announced it had received an SEC request for information regarding its "insider trading policies and procedures." According to a New York Times article, the Sperlings were suspected of tying certain of their stock sales to specific developments in the U.S. Department of Education investigation into the financial aid practices at the University of Phoenix. According to that article, the Sperlings sold nearly 1.1 million shares in late January 2009, shortly after the department notified the company of student complaints about disbursements of student loans. The article said they sold another 2.1 million shares in July 2009, soon after the company may have received a draft of the department's findings. Similarly, in April 2012, the company revealed yet another request from the SEC for documents and information relating to certain stock sales by company insiders and the filing of its 8-K on February 28, 2012 in which Apollo announced that new degreed enrollment growth at University of Phoenix was less than previously expected. At this point, unless your last name is Sperling, there's very little reason to say invested in a company that definitely is heading in the wrong direction.
Clearly, we are not alone with this opinion. A recent article from Seeking Alpha made the following point: "One of the largest legal scams in the country is beginning to unwind - it will take years, and the lobbyists for this industry will push back hard with intermittent success but the scamsters have been outed and the future is clear." The New York Times goes on to point out that not only is the industry tanking, but upon taking a closer look at the numbers, there is no doubt that more and more students will avoid such choices as the University of Phoenix based on the calculated risk of the tuition fees: "Students at for-profit colleges make up 13 percent of the nation's college enrollment, but account for about 47 percent of the defaults on loans. About 96 percent of students at for-profit schools take out loans, compared with about 13 percent at community colleges and 48 percent at four-year public universities."
Finally, for its part, the executives at Apollo Group have already begun to wander down that familiar path of management speak and hyperbole; during the company's conference call last week to discuss its disappointing financial results, CEO Gregory W. Cappelli said that despite the fact that it had "certainly been a challenging year for both Apollo Group and our industry as a whole for reasons you know well" that the company has "been building a stronger Apollo, squarely positioned to innovate and possibly influence the future of higher education." He went on to say that the company was "building the formula that can put America back to work." Statements like this are hard to swallow especially given "two-thirds of Apollo's associate-degree students leave before earning their degree," according to the New York Times. Furthermore, CFO Brian L. Swartz goes on to point out that, ironically, the company has reduced its total headcount by approximately 20%, excluding faculty, since the beginning of fiscal year 2011. No matter the endgame at Apollo Group, we are clear in our evaluation of the company and, without any sense of irony, continue to view the company with very high long-term sustainability risk.