APOL: Can Apollo Put the Past Behind It?

Mid Cap Watch List (Track at Marketocracy) and Large Cap Watch List (Track at Marketocracy) member Apollo Group, Inc. (APOL) reported fiscal 2007 financial results for its second quarter ended February 28, 2007 and announced it will be filing its overdue 10Q and 10K reports for recent quarters. With these filings, the Company will be current with the SEC on all required and delinquent periodic filings.

With the filings, the company is at least able to lift the cloud of uncertainty that surrounds companies that haven’t filed their financials. This includes the risk that it would lose its listing on the NASDAQ market. Since investors don’t like uncertainty (and often assume the worst) having the facts laid out for all to see is certainly an improvement. It also allows investors to evaluate the issues in question – after all, it could be that assuming the worst was the appropriate action. So let’s take a look:

Based on the independent review conducted by the Special Committee as well as Apollo Group’s internal review, the Company determined that 57 of the 100 total grants made during the period from 1994 through September 2006 used incorrect measurement dates for accounting purposes. The Special Committee also found no direct evidence that the grant date for any of the large management grants was selected with the benefit of hindsight.

The Company also identified four material weaknesses in internal controls over financial reporting, which it believes it has made significant progress in remediating as of February 28, 2007. The material weaknesses related to ineffective internal control over financial reporting include:

1. The granting of stock options and the related recording and disclosure of share based compensation expense;

2. The recording of allowance for doubtful accounts;

3. The recording of impairments for goodwill; and

4. The deduction of certain compensation expenses under the Internal Revenue Code.

As to issue 1, Apollo is in good (or bad) company, as many many companies messed up the way they accounted for stock based compensation over the last few years. We’ll focus on the last three, and in particular look at the specific adjustments the company is making.

The Company had four primary adjustments to its financial statements:

1. A cumulative pre-tax non-cash compensation expense of $52.9 million covering the period of 1994 through 2005. This is not insignificant. On an after-tax basis it equates to 1.7% of the company’s net income. That means that any earnings models based on the previous financial statements are likely overestimating net profit margin. For example, the net profit margin reported in 2006 was 17.7%, but should have been 17.4% based solely on this adjustment.

2. An accrual of $42.8 million, as of February 2007, for its best estimate with respect to potential tax liabilities, including interest and penalties, under IRS code 162(m). No dates are given to estimate the scope of this adjustment, but even if we assume that it was for a 10-year period it is significant. This adjustment would reduce net margins by a further 40 basis points.

3. An increase in the allowance for doubtful accounts of $38 million, $24 million of which relates to years prior to fiscal 2006. I have talked about Apollo’s bad debt expense before. Again, having reported too little of an estimate for bad debt in the past indicates that the historical margins are not good guides for the future. In this case, with more than a third of the charge applying to 2006 it is probably not something to spread over a long period. Using the $14 million adjustment to 2006 results in another 25-basis point adjustment to net margin.
4. A goodwill impairment charge of $20.2 million (non-cash) related to the Company’s September 1997 acquisition of the College for Financial Planning (”CFP”). The impairment charge implies that the company paid too much when it made the acquisition. The “non-cash” holds no water for me – they paid cash at some point, it just isn’t the current period. However, this was a fairly isolated event and goodwill is no longer amortized anyway, so I’m inclined to ignore this one for purposes of estimating profitability.

All in all, it looks like Apollo’s net profit margins as originally reported in recent years were overstated by a fairly significant amount – nearly a percentage point based on my estimate of the impact of the current restatements. Instead of the 17.7% reported it may be more like 16.7% in the future. Analyst estimates do not appear to have reflected this, at least not for 2007 (we estimate analysts were factoring in 17.3% margins for this year). And that helps explain why, despite the removal of uncertainty, the shares were trading lower after this announcement.

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