Jim Chanos for Profit VALUEx Final

8/6/2019 Jim Chanos for Profit VALUEx Final

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2

Short Selling is:

� Essential

� Not the opposite of going long

� A large alpha-creating strategy

� Important to theoretical finance

� Non-regulatory ³watchdog´ functions



3

Short Selling: Some Recurring Themes

� Booms that go ³bust´

� Consumer fads

� Technological obsolescence

� Structurally-flawed accounting

� Selling $1.00 for $2.00



4

The Value Trap

� Stock looks ³cheap´

± Low P/E multiple

± Cash flow generation at the moment

� Business fundamentals in decline

± ³E´ under constant pressure

± Deteriorating free cash flow

� Structural issues

± Competition / obsolescence

± Regulatory changes



5

For-Profit Education : Classic Value Trap

� Stocks trading at ³cheap´ valuations

± Forward P/E multiples range from 4.6x to 14.2x1

± Trading at large discounts to 5 year average forward P/E multiples (11.1x - 27.8x1)

± Returns on assets comparable to best companies (Google, Microsoft, Coca-Cola, Apple)

� Free cash flow continues« for now

± Cash conversion rate over 100% (FCF / Net Income)

± Overall enrollment still growing

� ³All the bad news is out´

± Legislative scrutiny losing steam due to 2010 elections

± Regulatory rule ³events´ have occurred

Note: Based on Bloomberg estimates for APOL, BPI, CECO, COCO, DV, EDMC, ESI, STRA.



6

For-Profit Education: Are They Really ³Cheap´?

� Structural earnings issues - new Program Integrity Rules

± Incentive compensation

± State authorization

± Misrepresentation accountability

� Revenue pressure going forward

± Product sold not bought

± Aggressive compensation for student growth no longer allowed

± Total enrollment growth masks increasing slowdown in new student growth

± Traditionally high churn rates increase pressure to maintain enrollment

� Earnings leverage works both ways



7

Free Cash Flow Generation is a Fallacy

� Businesses funded by government largess

± Over 80% of revenues from federal government programs

± Asymmetry of risk for the federal government

± Risk is born by the taxpayer and the student (debt is not dischargeable)

� Timing of cash flow is a key element of free cash flow illusion

± Title IV rules allow cash draws in advance of students attending class

± Negative working capital model reverses benefit when growth turns negative

� Bill for high cost education comes due later

± Median debt levels of for-profit students far exceed debt levels for students inother sectors

± Disproportionate defaults come from the for-profit sector



8

Title IV Funding: Well Drying Up?

� Temporary exceptions to 90/10 rules set to expire

± $2,000 Stafford Loan exception expires in July 2011

± Private student lending will no longer benefit 90/10 as of July 2012

� Accreditor scrutiny is intensifying

± The Higher Learning Commission (³HLC´) is the regional accreditor for most for-profits

± Head of HLC called to testify before Congress twice in the last two years

± Department of Education continues to scrutinize the role of accreditors

± HLC is tightening its standards ± Bridgepoint Education forced to seek accreditationelsewhere

� Manage statistics to lower Cohort Default Rates (³CDRs´)

± ³Default management´ servicers push students into deferment or forbearance to lower CDRs

± Big jump from 2-year to 3-year CDRs suggest that default rates are heavily managed ± Provisioning rates on private loans indicative of future risk for students

� Military enrollments are being used to comply with 90/10

± Department of Defense (³DoD´) education funds count towards 10% in 90/10

± Recent hearings in the Senate regarding DoD funding for-profit education



9

Gainful Employment: Holding For-Profit Education Accountable

� Less stringent than the proposed rule, but still has teeth

� Students must maintain at least one of three metrics

± 35% Repayment rate,

± 30% Debt-to-discretionary income ratio,

± 12% Debt-to-total earnings

� The Department of Education estimates that 18% of for-profit programs will fail theGainful Employment test at least once in the next three years

� Fewer loopholes than appear on the surface

± Benefit from interest only loans limited to 3% of program total

± Real income data will be used to calculate earnings

� Schools required to disclose failure to comply with Gainful Employment



10

Adaptability of For-Profit Education: Marketing is theModel

� Marketing (not education) is thereal core competency

� Educational outcomesquestionable

± High churn model produces poor graduation outcomes

± Focus on growth worsensprospects for graduates due toincreased competition in their chosen field

� High cost relative to other formsof postsecondary education

� Can the value proposition reallybe changed?



11

ITT Educational Services (ESI): Prime Example of For-Profit Education Value Trap

� Looks ³cheap´ at first glance

± Forward P/E 7.8x1

± EBIT margins over 35%

± Cash conversion over 140% (FCF/Net Income)

� Structural earnings issues

± ITT¶s programs are considered expensive even in the for-profit universe

± New student growth has been negative for two consecutive quarters

� PEAKS Private Student Loan Program raises questions and enhances free cash flow

± PEAKS is an off balance sheet entity used to finance student debt

± ITT guarantees performance of the underlying PEAKS debt, yet does not consolidate it on itsbalance sheet

± PEAKS reserve rate appears to be substantially below historical default rates in the industry

� Regulatory pressure is increasing

± 2009 2-year Cohort Default Rate doubled year over year

± Securities and Exchange Commission has inquired about PEAKS

Note: Based on Bloomberg estimates.



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Thank You

VALUEx Vail 2011

Jim Chanos for Profit VALUEx Final

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