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.

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

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

This article is a reprint of my February 19, 2008 RealMoney column

Apollo Group (APOL) is one of the largest private providers of higher education services. Through the University of Phoenix and other subsidiaries, Apollo serves more than 300,000 enrolled students at more than 100 campuses, using a mix of traditional and online educational services.

Over the last month, analysts have been increasing their earnings estimates for Apollo. For the August 2008 fiscal year, estimates have risen from $2.80 three months ago to $2.97 today. The estimates for 2009 have grown from $3.25 to $3.40 over the same period. As a result of this momentum in earnings, Apollo’s Zacks rank was recently upped to 1, which puts the company among the top 5% in terms of earnings momentum.

Byron Wien thinks Apollo is worth playing on the thesis that “a lot of people will be laid off and they’ll be trying to improve their skills.” But that makes an implicit assumption that those students will be able to pay their bills. Last year, Apollo, ITT Educational (ESI) and Corinthian Colleges (COCO) all reported rising bad debt expenses, and the trend has not abated.

Bad debt expense for the first quarter of 2008 as a percentage of revenue was 4.2% compared to 3.5% a year ago. Management also identified “certain items that should have been reported or should have been classified as discounts or refunds, that is, as a reduction of revenue, as opposed to a charge to bad debt expense in prior quarters.” This would have made the prior year number 2.9%, so the deterioration is from 2.9% to 4.2%.

Apollo’s associates degree programs are growing at a far faster rate than their bachelor’s degree program, which contributes to the bad debt issues and may contradict Wien’s thesis that higher growth will be coming from professionals looking to enhance their skills.

As to those rising earnings estimates, it’s hard to put too much faith in them when I see their quality. The accrual ratio, which measures the difference between cash earnings and accounting earnings, ideally should hover around zero. Apollo’s is all over the map, and the trend appears to be getting worse.

Source: Zacks Research Wizard, compiled by William A. Trent

At 23x current year earnings and 13.3x book value (compared to an industry average of 3.5) Apollo hardly looks cheap by traditional valuation measures. Apollo’s free cash flow over the last 12 months was $540 million, which amounts to a 4.9% free cash flow yield. Although the paltry Treasury yields currently available result in a favorable comparison, I think there are other names with similar cash flow yield and growth profile but with higher earnings quality.

On the conference call, management noted that “during the first quarter, we didn’t repurchase any of our Class A stock. As I just discussed, with the creation of Apollo Global, our potentially deep pipeline has grown significantly and we are busy evaluating the best use of our capital to create long-term value for our shareholders.” Could that be code for, “the stock is too expensive right now?”

I’m no technician, but Apollo has dropped through several moving averages recently and what looked like decent support at $70. If it drops through the 200-day (currently around $64-65) all bets could be off.

Disclosures: None

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

Mid Cap Watch List (Track at Marketocracy) and Large Cap Watch List (Track at Marketocracy) member Apollo Group, Inc. (APOL) reported financial results for the third quarter ended May 31, 2007. The Company also announced that its Board of Directors (”Board”) authorized the repurchase of up to $500 million of Apollo Group Class A common stock.

Consolidated revenues for the three months ended May 31, 2007, totaled $733.4 million, which represents a 12.2% increase over the third quarter of fiscal 2006. Total degreed enrollments grew by 12.2% year-over-year to 311,100.

Net income was $131.4 million, or $0.75 per diluted share (174.6 million weighted average shares outstanding), compared to $131.5 million, or $0.75 per diluted share (174.5 million weighted average shares outstanding) for three months ended May 31, 2007 and 2006, respectively.

For some reason Apollo still finds it necessary to break out the results as though stock based compensation did not exist (what I call Unaccepted Accounting), despite the fact that the consensus estimate of $0.67 apparently is on the basis of earnings reported under Generally Accepted Accounting Princples. Revenues were also ahead of analyst expectations, which helped the shares rally after the report was issued.
With revenues rising double-digit but earnings actually down, it is clear that costs are rising faster than sales. Bad debt expense continues to rise, which the company attributes to “a shift in the Company’s student mix.” Clearly the mix has shifted (to students who are not paying their bills) but the company has not presented a clear justification for admitting students who cost more than the incremental revenue they generate.

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.

Mid Cap Watch List (Track at Marketocracy) and Large Cap Watch List (Track at Marketocracy) member Apollo Group (APOL) announced that two of its board members will be resigning as soon as the company catches up on its regulatory filings.

Apollo Group, Inc. (Nasdaq:APOL) today announced the resignations of Hedy Govenar and John Blair from its Board of Directors, effective immediately after the Company files its delinquent financial reports, which are expected no later than May 25, 2007.After such reports are filed, Ms. Govenar and Mr. Blair will serve on the Board of Directors for University of Phoenix and Western International University, respectively, both wholly-owned subsidiaries of Apollo Group.

“Hedy Govenar and John Blair have been critical assets to Apollo Group, and we value their long-term dedication to the Company,” said Brian Mueller, President of Apollo Group. “We look forward to continuing to work with them in their new roles and will appreciate their contributions to our subsidiaries.”

Ms. Govenar has been a director of the Company since 1997, and Mr. Blair has served as director of the Company since 2000.

Neither Ms. Govenar nor Mr. Blair advised the Company of any disagreement with the Company on any matter relating to its operations, policies or practices. “We expect,” said Mr. Mueller, “that upon completion of the filing of our financial reports we will soon be able to complete our due diligence work on the various candidates for replacement of these Board members.”

We aren’t sure what to make of this one. We are always somewhat skeptical of board or executive departures. In this case it is somewhat complicated by the fact that there are two members resigning (which we don’t like) but they will both be staying on, albeit in apparently diminished roles.

Corinthian Colleges (COCO) reported earnings:

Comparing the third quarter of fiscal 2007 with the same quarter of the prior year:

* Net revenue was $250.5 million versus $250.3 million.

* Total student population was 68,175 versus 69,403.

* Total student starts were 24,457 versus 24,647.

* Operating income was $18.6 million compared with operating income of $19.8 million. Excluding severance expenses of $1.2 million, Q3 07 operating income was $19.8 million, flat with the same quarter of the prior year.

* Net income was $12.0 million compared with $14.7 million.

* Diluted earnings per share were $0.14 versus $0.17, in line with the Company’s previous guidance of $0.14 - $0.16. Excluding severance expenses of $0.01 per share, diluted earnings per share were $0.15 in Q3 07.

Analysts were expecting the company to earn $0.14 on $253 million in revenue. COCO’s decline in enrollments contrasts with some of its peers, such as Small Cap Watch List (Track at Marketocracy) and Mid Cap Watch List (Track at Marketocracy) member Apollo Group (APOL) or Large Cap Watch List (Track at Marketocracy) member ITT Educational Services (ESI). However, it does share a less favorable metric with those peers:

Educational services expenses were 56.7% of revenue in Q3 07 versus 55.1% in Q3 06. The increase was mainly the result of higher occupancy and bad debt expenses. Bad debt expense was 4.8% of revenue in Q3 07 versus 4.0% in Q3 06.

The company issued EPS guidance of $0.12-$0.13 for its fourth quarter, which ends in June. The consensus expectation had been for $0.14.

Small Cap Watch List (Track at Marketocracy) member ITT Educational Services, Inc. (ESI) reported earnings:

ITT Educational Services, Inc. (NYSE: ESI), a leading provider of technology-oriented postsecondary degree programs, today reported that Earnings Per Share (”EPS”) in the first quarter of 2007 increased 46.7 percent to $0.66 compared to $0.45 in the first quarter of 2006. Revenue in the three months ended March 31, 2007 increased 15.8 percent to $204.2 million compared to $176.3 million in the first quarter of 2006.

Analysts were expecting the company to earn $0.54 on $198 million in revenue. Guidance was also strong:

[CFO Daniel] Fitzpatrick closed by noting, “The fundamentals of our business remain extremely strong and, as a result of our operational and financial performance during the first quarter of 2007, we are raising our internal goal for 2007 EPS from the range of $3.17 to $3.21 to the revised range of $3.40 to $3.50.”

Consensus estimates were already slightly above management’s guidance, at $3.22. Still, not all was coming up roses:

Fitzpatrick said, “Bad debt expense as a percentage of revenue increased to 2.3 percent in the three months ended March 31, 2007 compared to 1.4 percent in the same period during 2006. We believe that our bad debt expense will remain within our historical range of 1.0 and 3.0 percent of revenue. Days sales outstanding was 4.3 days as of March 31, 2007 and 5.0 days as of March 31, 2006.”

Bad debt was one of the earnings quality concerns we developed when we reviewed the 10K. Even if management claims it is within historical ranges, the truth is it is still rising. It is also, apparently, an industry-wide phenomenon. Investors should keep a close eye on collections going forward.

Mid Cap Watch List (Track at Marketocracy) and Large Cap Watch List (Track at Marketocracy) member Apollo Group. (APOL) issued the following statement in an 8K SEC Filing:

The Company previously disclosed that it intended to file by April 30, 2007, its Quarterly Report on Form 10-Q for the fiscal quarter ended May 31, 2006, its Annual Report on Form 10-K for the fiscal year ended August 31, 2006 and its Quarterly Reports on Form 10-Q for the first and second fiscal quarters ended November 30, 2006 and February 28, 2007, respectively. While the Company has made significant progress toward the completion of its delinquent reports, it will not be in a position to file by such date. The Company expects to file its delinquent reports as soon as possible and no later than May 25, 2007, the last day of the temporary exception period granted to the Company by the Nasdaq Listing and Hearings Council.

We noted recently that Apollo’s students have been late paying their tuition bills.  Perhaps they are learning by example. The check, and the 10-Q, are presumably in the mail.

When we recently reviewed the 10K report for ITT Educational Systems (ESI), we said there were some earnings quality concerns. Among them were “Doubtful accounts – reserve nearly doubled despite a decline in total receivables.” Apparently that is an industry-wide problem, according to this article from Reuters.com:

Apollo Group Inc. (APOL) said on Monday it expected to raise its allowance for doubtful accounts and associated bad-debt costs by about $38 million as it works to complete its delayed quarterly financial report.

The for-profit education provider also said Nasdaq had granted it an extension to file its quarterly financial report.

The allowance increase follows a review of the company’s write-offs in the fiscal years 2000 to 2006 that concluded Apollo’s previous allowance for doubtful accounts was understated.

Apollo said of the $38 million, $24 million relates to years prior to 2006. Bad-debt expense would be reflected in a restatement of its results.

The allowance for doubtful accounts is not the actual bad debt expense a company incurs, but rather an estimate of it. Accounting rules require that expenses be recognized at the same time as revenues, but the bad debts will not be known until several months after the revenue is earned. The estimate, in allowance for doubtful accounts, makes the match.

If the estimate is reasonably close everything is working according to plan. Any differences due to bad debts being either higher or lower than the estimate will be adjusted on the balance sheet rather than the income statement.

However, because it is an estimate there is the potential for the estimate to not be reasonably close. This could occur due to misfortune, poor estimating skill or management attempts to manage reported earnings per share. Investors can monitor the amount charged to the allowance as a percentage of accounts receivable or sales. If the company is accruing less than normal, it will inflate their earnings in the current period.

ITT Educational is a current member of our Small Cap Watch List (Track at Marketocracy), and Apollo is on the Mid Cap Watch List (Track at Marketocracy) and Large Cap Watch List (Track at Marketocracy).

This case is a little different. They will be adding to the allowance, which reduces the current period earnings. But since the adjustment reflects prior year results it means they were reserving too little before - and that earnings forecasts based on the company’s prior profitability levels are probably too optimistic.

Small Cap Watch List (Track at Marketocracy) member ITT Educational Services (ESI) is up more than 20% year-to-date on the back of strong earnings and guidance given in January. We reviewed the recently issued 10K and came away with a few concerns over the quality of those earnings.

Summary: ITT Educational Services has provided career-oriented education programs since 1969 under the “ITT Technical Institute” name. It is a leading for-profit provider of postsecondary degree programs in the United States. As of December 31, 2006, it was offering diploma, associate, bachelor and master degree programs to approximately 47,000 students through 87 institutes and nine learning sites of those institutes located in 33 states. All institutes are authorized by the applicable education authorities of the states in which they operate and recruit, and are accredited by an accrediting commission recognized by the U.S. Department of Education (“ED”).

Income statement analysis

Sales growth - Revenue increased $69.8 million, or 10.1%, to $757.8 million in the year ended December 31, 2006 compared to $688.0 million in the year ended December 31, 2005

Unit vs. dollar – Sales gain resulted from a 5.0% increase in tuition rates in March 2006, a 5.2% increase in total student enrollment at December 31, 2005 compared to December 31, 2004, and a 10.8% increase in new student enrollment in the year ended December 31, 2006 compared to the year ended December 31, 2005.

Revenue recognition - Tuition revenue is recorded on a straight-line basis over the length of the applicable course Other - In 2006, we indirectly derived approximately 61% of our revenue determined on an accrual accounting basis (or 57% determined on a cash accounting basis as defined by the ED’s regulations) from the federal student financial aid programs. Changes to these programs or ITT’s eligibility could have an adverse impact on revenues. (See lawsuits).Seasonality - Revenue higher in third and fourth quarters because more new students enroll in June (23% of all new students in 2006) and September (34% of all new students in 2006) following high school graduation. Costs are not affected by the calendar, so margins are better in the third and fourth quarter as well.

Earnings quality

Capitalization of expenses - Direct costs incurred relating to the enrollment of new students are capitalized using the successful efforts method. Direct marketing costs subject to capitalization include salaries and employee benefits of recruiting representatives and other direct costs. Successful efforts is the ratio of students enrolled to prospective students interviewed. The higher the rate of interviewed students who enroll, the greater the percentage of our direct marketing costs that are capitalized. Direct marketing costs on the balance sheet totaled $46,706 at December 31, 2006 and $39,705 at December 31, 2005, less accumulated amortization of $25,078 at December 31, 2006 and $22,215 at December 31, 2005. If the costs were expensed as incurred, operating income would have been $4.1 million (2.3%) and earnings per share would have been $0.06 lower in 2006.

Operating margins – Have been remarkably consistent over the three years, as illustrated by the common size statement in the table below. Only legal charges in 2004 resulted in a significant anomaly. Cost of educational services as a percentage of revenue decreased to 47.1% in 2006 from 47.7% in 2005, primarily due to a decrease in compensation and benefit expense arising from the freeze of our pension plans and greater efficiencies.

Year Ended December 31,

Net margins – net profit has not grown significantly but earnings per share grew due to nearly 10% reduction in share count.

Stock options – reduced net income by $1.9 million in 2006 compared to 2005 due to adoption of SFAS 123R.

Pensions – froze pension plan. The 8% discount rate and maximum 70% equity allocation implies an expected return on equity investments of at least 9.3%, which under current market conditions is probably aggressive.

Anomalous tax rates - Accruals were close to actual cash taxes in 2004 and 2005 but company paid only $44 million in 2006 compared to an accrual of $71 million.

Balance sheet analysis

Asset depreciation schedule – high end of equipment and software ranges may be aggressive, but generally no concern.

Debt load and maturity schedule - $150 million drawn from credit facility in 2006, compared with no debt the prior year.Pension funding – fully funded

Doubtful accounts – reserve nearly doubled despite a decline in total receivables.

SPEs and other off-balance sheet items - $100 million in future operating lease obligations

Cash flow analysisOperating cash flow and net income trends – both rising, and cash flow higher than net income in all periods.

Free cash flow and net income trends – $107 million in 2004, $108 million in 2005 and $121 million in 2006.

Capital investment relative to depreciation – running at about double, suggesting FCF could increase by $20 million on a no-growth/maintenance basis. Given the $3.2 billion enterprise value, this implies a 4.3% free cash flow yield.

Cash taxes paid relative to tax accrual – Accruals were close to actual cash taxes in 2004 and 2005 but company paid only $44 million in 2006 compared to an accrual of $71 million. This means earnings reported to shareholders were significantly higher than earnings reported to the IRS. While this could signal efficient tax management, it could also be a sign of low earnings quality.

Footnotes

Legal issues – Civil lawsuit alleges that ITT “violated the False Claims Act, 31 U.S.C. § 3729, et seq., by knowingly making and using false records and statements relating to, among other things, student recruitment, admission, enrollment, attendance, grading, testing, graduate placement, programs of study and course materials in order to fraudulently obtain student loans and tuition from the federal government.”

Growth indicators

The company’s growth strategy includes geographic expansion, acquisitions and expanded program offerings. One key risk is that attracting additional students could reduce the overall applicant quality, which could have a negative reputational effect. As it is, the company reports in its 10K that “approximately 76% of the Employable Graduates (as defined below) from our institutes’ programs during 2005 either obtained employment by April 30, 2006, or were already employed, in positions that required the direct or indirect use of skills taught in their programs of study” and that “reported annualized salaries initially following graduation averaged approximately $28,000.”

Peers include Apollo Group, Inc. (APOL), Capella Education Company (“CEC”), Career Education Corp. (CECO), Corinthian Colleges, Inc. (COCO), DeVry, Inc. (DVY), Laureate Education, Inc., Lincoln Educational Services Corporation, Strayer Education, Inc. and Universal Technical Institute, Inc.