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.

With the end of the first quarter approaching, it is time to adjust the names in my Watch Lists. I will price all the new lists as of the close on Friday, June 29.

Today I present my planned updates to the Small Cap Watch List. There was a fairly high level of turnover to the list. 12 of the 24 names from the previous run made it to the current list, which was also 24 names. Performance-wise, the list created in March has returned an unweighted average return of 2.6% through June 28, with 80% of the stocks in positive territory. All of the money-losers from the previous list fell out of consideration.
So without further ado, the names on the chopping block from the previous list are: PW Eagle (PWEI), Insteel Industries (IIIN), Allied Defense (ADG - Annual Report), Hartmarx (HMX), Parlux (PARL), Hansen Natural (HANS), FirstFed Financial (FED), Young Innovations (YDNT), ITT Educational (ESI), Rent-a-Center (RCII), Valassis (VCI), and Travelzoo (TZOO). The castaways include four of the five money losers from the previous portfolio (HMX, PARL, YDNT and TZOO) as well as the biggest gainer (ESI).
The new list is:

I will continue to track both lists on StockPickr.

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.

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.

With the end of the first quarter approaching, it is time to adjust the names in our Watch Lists. We will price all the new lists as of the close on Friday, March 30. Today we present our planned updates to the Large Cap Watch List (Track at Marketocracy).

Though less than the Small Cap Watch List and Mid Cap Watch List (Track at Marketocracy), there was still relatively high turnover in this list. 14 of the original 33 names made the cut for the new list (which was trimmed to just 26 names.) Part of the reason for the turnover was to reduce overlap between the lists. One third of the Mid Cap Watch List (Track at Marketocracy) names appear on each of the Small Cap and Large Cap Watch List (Track at Marketocracy)s, but there is no longer any overlap between small and large.
So without further ado, the names on the chopping block from the previous list are:

3M (MMM); Continental (CTTAY.PK); Mitsui (MITSY); Anheuser-Busch (BUD); ConocoPhillips (COP); Helix Energy (HELX); IndyMac Bancorp (NDE - Annual Report); Barr Pharmaceutical (BRL - Annual Report); Quest Diagnostics (DGX); Public Storage (PSA); ITT Educational Services (ESI); Equifax (EFX); Rent-a-Center (RCII); Kroger (KR); Ricoh (RICOY); First Data Corp. (FDC); Expeditors International (EXPD); and Keyspan (KSE).

The new list is:

With the end of the first quarter approaching, it is time to adjust the names in our Watch Lists. We will price all the new lists as of the close on Friday, March 30. Today we present our planned updates to the Mid Cap Watch List (Track at Marketocracy).

As with the Small Cap Watch List (Track at Marketocracy), we were surprised at the amount of turnover in our screens. Only 7 of the original 29 names made the cut for the new list (which comes in at only 24 names.) Part of the reason for the turnover was to reduce the overlap between the Small Cap and Mid Cap Watch List (Track at Marketocracy)s. Now there is only one-third overlapping names rather than two thirds. Furthermore, given the level of outperformance we saw in the first quarter (actually just two months) and the fact that much of those gains were achieved early, perhaps the turnover is warranted.

So without further ado, the names on the chopping block from the previous list are:

Silgan Holdings (SLGN - Annual Report); Middleby (MIDD); Olin (OLN); Vector Group (VGR); Sanderson Farms (SAFM); Tesoro (TSO); Downey Financial (DSL); Waddell & Reed (WDR); Gamco (GBL); Apria Healthcare (AHG); Quest Diagnostics (DGX); ITT Educational Services (ESI); Equifax (EFX); Delhaize Group (DEG); Papa John’s (PZZA); Rent-a-Center (RCII); Cato Corp (CTR); Dassault Systemes (DASTY); Ingram Micro (IM); Energy East (EAS); South Jersey Industries (SJI - Annual Report); and American States Water (AWR).

The new list is:

We asked, but no one answered. So we are taking our own counsel and breaking our Watch List into three portfolios: Small Cap, Mid Cap and Large Cap. Each will be tracked against the relevant S&P index going forward from their collective inception date of January 31 (priced at the close of market trading that day.)

For your viewing pleasure, the Large Cap Watch List (Track at Marketocracy) (to be measured against the S&P 500) follows.

Astute observers will notice less overlap between this watch list and the names in the Small Cap Watch List and Mid Cap Watch List. This was not for lack of overlap, as the smallest S&P 500 name has a market capitalization of $600 million, which would allow for complete overlap with the Mid Caps if we chose. Instead we selected an arbitrary low of $2 billion for large-cap names, which cuts off five names that are actually in the S&P 500.
In addition, we will provide a “quick and dirty” analysis of each name, with a goal of one such analysis per day. As the name implies, the quick and dirty analysis will be incomplete. We are hoping you will join in the debate and fill the gaps in our analysis.

We asked, but no one answered. So we are taking our own counsel and breaking our Watch List into three portfolios: Small Cap, Mid Cap and Large Cap. Each will be tracked against the relevant S&P index going forward from their collective inception date of January 31 (priced at the close of market trading that day.)

For your viewing pleasure, the Mid Cap Watch List (Track at Marketocracy) (to be measured against the S&P 400) follows.

Astute observers will notice a significant overlap between the names in the Small Cap Watch List and this one. In fact, of the 29 names on the Small Cap Watch List (Track at Marketocracy), 19 are included among the 29 names in the Mid Cap Watch List (Track at Marketocracy). The main reason is that we ran our screens against the criteria in the relevant indices rather than the names in the indices. Since the largest market cap in the S&P Small Cap is $3.5 billion and the smallest market cap in the S&P Mid Cap is $600 million, there is room for a good deal of overlap if one is willing to accept it.

In addition, we will provide a “quick and dirty” analysis of each name, with a goal of one such analysis per day. As the name implies, the quick and dirty analysis will be incomplete. We are hoping you will join in the debate and fill the gaps in our analysis.