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For-Profit Education and the Need for Leases on Balance Sheets September 12, 2010

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, Lease Accounting.
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September’s here, school is starting, out-of-work workers need retraining … and the for-profit education industry should be partying. Shareholders and managers of companies running places like University of Phoenix (APOL), Argosy University (EDMC) , Corinthian College (COCO), DeVry University (DV), Strayer University (STRA), and others should be having back-to-school beer busts. Events of this past summer, though, have dampened the industry’s prospects, and a sobering time is ahead.

Until recently, the industry had been on an expansion tear, as the unemployed and underemployed attempt to upgrade their credentials in a challenging job market. Fortune’s “100 Fastest-Growing Companies” lists DeVry (#46), Strayer Education (#74) and Corinthian Colleges (#79). This summer, though, the U.S. Department of Education announced that it wants to curtail access to federal funds for any for-profit education company where too many of its students don’t repay their college loans … particularly if the non-repayment is due to the fact that there’s no way their students can earn enough after graduation to make payments. As you might guess, the DOE action was prompted by its discovery that, in fact, this is the case for many companies in the sector. As a result, the future of these companies is suddenly in jeopardy. If their students can’t get government-supported student loans, enrollment will fall because many prospective students won’t be able to pay tuition. Fewer students will mean, of course, less revenue.

How will these companies fare? If you look at just their financial statements, you’d get the impression that the companies are so under-leveraged that they will easily be able to survive reduced revenue. The Apollo Group, owner of the ubiquitous University of Phoenix, with annual revenues of $4.8 billion and net income of $600 million, has only $350 million of long-term obligations. Another example: DeVry has annual revenue of $1.9 billion, net income of $280 million, and long-term obligations of only $106 million. A third example, particularly eye-catching: Strayer has annual revenue of $579 million, net income of $120 million and a measly $12 million of long-term obligations. All of these companies could pay off their long-term obligations, as shown on balance sheets, with only a portion of one year’s earnings.  Across the industry, financial statements make companies look strong.

Undoubtedly, some investors have bought the stock of for-profit companies thinking the companies offered a great combination of fast growth and strong financial structure … a combination that they could have known was too-good-to-be-true if only they had read the notes in the companies’ financial statements filed with SEC.

They would have, though, had to have read those notes very carefully … and thoughtfully … and knowledgeably … and not have overlooked the section on operating leases. The operating lease section is just one of many in the “Notes to Consolidated Financial Statements” included in 10-K submissions. These notes are generally intended to provide detailed information on the line items shown on the balance sheet and other financial statements. In the case of the operating lease section, however, information is about obligations that don’t appear as line items on the financial statements. Anyone without an accounting background could easily overlook the import of the section. And many probably have.

The truth is these for-profit education companies have hundreds of millions of dollars of operating lease obligations which are all “off-balance sheet” even though are as real as obligations like the bond debts which are “on-balance sheet”. In the case of Apollo, there are $757 million of future lease obligations … more than twice the amount of long-term obligations now shown on the balance sheet. At DeVry, future lease obligations total $579 million … more than five times the amount of long-term obligations shown. And at Strayer, future operating lease obligations total $218 million, which is … OMG! … more than 18 times (yes, that’s eighteen times, no decimal point is missing!) more than the amount of long-term obligations shown on the balance sheet.  (See Table A.)

Table A: Stats for Selected For-Profit Education Companies   (in $ millions unless otherwise noted, rounded to simplify presentation)

  APOL CECO COCO DV EDMC ESI STRA
Annual Revenue (1) 4,800 2,000 1,800 1,900 2,500 1,500 580
Annual Net Income (1) 600 210 150 280 170 350 120
Long-Term Liabilities (2) 350 200 400 100 1,930 175 12
Future Operating Lease Obligations (2) 760 725 635 580 1,140 185 220
Lease Obligations As % of Long-Term Liabilities 217% 362% 159% 580% 59% 106% 1833%

Note 1:  Last twelve reported months.   Note 2: Last annual 10-k report.

If these operating lease obligations were included on balance sheets, investors would get a much better idea of the financial structure of the companies. They would understand how these companies have funded their operations with operating leases, which is not necessarily bad, but it does mean that these companies are not as financially secure as financial statements would lead one to believe.  These leases represent high fixed expenses that put these companies at solvency risk should their revenue decline. If all leases were on the balance sheet, investors would understand that these companies are, in fact, highly-leveraged … via operating leases.

And while it is true that, in the case of a bankruptcy filing, a company may have the right to cancel leases such that, theoretically, operating leases are less set in concrete than are obligations like bonds, from a practical point-of-view, how can a company actually cancel leases and improve its situation?  Any wholesale canceling of leases would be tantamount to going out of business.  So while leases might, legally-speaking, be canceled, this is a mute point, practically-speaking.

And so we have a situation where the largest obligations of these for-profit education companies do not appear on their balance sheets even though balance sheets are supposed to provide a snapshot of a company’s financial situation, showing what it owns and what it owes. Balance sheets aren’t doing what they’re supposed to do. And while savvy stock analysts understand that lease obligations are not on the balance sheet but can be seen in the notes to the financial statements, even some of them probably don’t fully account for these obligations when evaluating companies.  And they probably don’t go out of their way to bring these obligations to the attention of investors when things are booming and they have a “buy” recommendation out.  For many reasons, obligations noted in footnotes just don’t carry the same weight as those seen on balance sheets. Out-of-site, out-of-mind.

So what should be done?

Well, what should be done is being done… albeit, belatedly. The FASB and the IASB are working together to create a new accounting standard for leases. The proposed standard is outlined in the Exposure Draft on Leases issued by the two accounting bodies in mid-August. The thrust of the new standard is that leases will go onto the balance sheet … as both a right-to-use asset and a lease liability … in an amount equal to the present value of likely lease payments. This proposal is open for comments until December 15, 2010, and the accounting boards plan on issuing the new standard by June 2011.

Many people aren’t enamored with the proposed new accounting. It is going to cause a lot of pain to companies in terms of the effort required to comply and has many implications that reach far beyond accounting, per se.  

The case of the for-profit education industry, though, shows how important lease-accounting change is if financial statements are to serve their function. This will become all the more clear if revenues of these for-profit companies decline, and one or more of them file for bankruptcy protection.  If this happens, the for-profit education sector will serve as “Exhibit A” in the argument for why leases should go on balance sheets.

Click here to read more posts about the new lease accounting.

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Comments»

1. Michael VanderGoot - September 13, 2010

Bob,

To add on to the impact of your analysis if it only includes the information on the last 10-k it most likely does not factor in the “likely” renewal obligations which will increase the amount of the long term liabilities even more.

2. Bob Cook - September 13, 2010

Michael,

Yes, you’re absolutely right. The amounts that go on the balance sheet are likely to be significantly higher than what is now shown in the 10-K. Now, all that is shown in the note is the ** minimum ** operating lease obligation. It is, instead, the ** likely ** obligation that will go onto the balance sheet … including lease payment obligations related to option periods that are likely to be exercised. It is not inconceivable that the actual number could be two to three times as much as I’ve shown above. Example: for a five-year lease that had only two years left to run when the 10-k released, only two years of rent would have been shown. But if that lease had, say, two consequetive options to renew for five years, then the amount that goes on the balance sheet would be 12-years worth of rent payments … fully 6x more!

3. Jeff Moskovitz - September 13, 2010

Hi Bob,

This is an interesting and well-written article about an issue that I’m sure most companies and analysts are pondering as we speak.

While I see the value in reporting operating leases on the balance sheet, your comment about bankrupt for-profit education companies serving as “Exhibit A in the argument for why leases should go on balance sheets” worries me. I’m afraid that this new standard may result in another example of the proverbial “tail wagging the dog.”

What I mean by that is, transactions and results should determine value, not the manner in which those results are reported. There are many who would argue that the application of fair value rules contributed, at least in part, to the housing meltdown of the past few years, primarily because of the uncertainty surrounding the valuation of various mortgage-backed securities.

Fundamentally, economically and substantively nothing will have changed between the day before the proposed standard on leases is implemented and the day after it is implemented. The only change (albeit a significant one) will be how these transactions are accounted for.

Changes in certain regulations (i.e the recent DOE crackdown on loan repayment) drive value because they do have economic consequences (to what extent, remains to be seen). But changes in the way we report financial information, assuming that the information is otherwise available to begin with (unlike an “Enron situation,” where relevant financial information was, for all intents and purposes, buried), shouldn’t result in the determination of value. Unfortunately, and as I think you may have intimated in your post, I’m afraid it will. If that be the case, then bankrupt for-profit education companies may be “Exhibit A” in the argument about why leases SHOULDN’T be reported on the balance sheet.

Just another point of view, for what it’s worth.

4. Bob Cook - September 14, 2010

Jeff,

Thanks for your thoughtful comment. On some things, reasonable men can, indeed, differ … and lease accounting appears to be one of them.

Bob


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