TWST: If you would, please start with a snapshot of your coverage universe.

Mr. Volshteyn: I cover nine names in the for-profit education sector. They range from smaller-cap names, such as American Public Education (APEI) and Grand Canyon Education (LOPE), to larger-cap companies such as Apollo Group (APOL). While these companies look similar to new industry observers, they have different business models, they serve different demographics, and they offer a full spectrum of degrees and programs.

TWST: What is your overall sentiment on the group right now and why?

Mr. Volshteyn: Over the last two years or so, the sector has been out of favor with investors for several reasons — regulatory problems, legislative uncertainty about upcoming laws, questions about aggressive marketing and questions about program quality. These are not new issues for the sector. I've been covering the sector for about seven years, and looking back at trends before that, you can see that industry challenges come in waves. The sector went through waves of regulatory changes in the 1990s and in the early 2000s, and every five to seven years, we see some substantial changes happen. We are in a period of change now.

As I mentioned, these businesses are diverse, and just because the for-profit schools share a common tax status, that doesn't mean they are all the same. There are good actors and there are bad actors. There are more attractive business models and less attractive business models. At the end of the day, we look at tuition as one of the most important differentiating factors. We like low-tuition names, and we don't like high-tuition names. It sounds very simple, but higher tuition is basically the reason why some institutions are more aggressive in marketing. High tuition also may lead to problems with regulatory measures, such as student debt repayment and default metrics, and weak student outcomes. While there are surely many complex issues in higher education, many concerns are significantly reduced for institutions with lower tuition. So it goes back to tuition, and it’s from that perspective that we look at the sector.

I also wanted to point out that there are strong secular drivers that should support the growth of institutions in this segment over the intermediate term. To achieve President Obama’s goal of leading the world in higher education completion, this country is going to need between 10 million and 20 million additional educated workers over the next decade. We think that for-profit institutions have an important role to play in achieving this goal. It cannot be achieved purely with state institutions given the current state budget challenges. We think that institutions that grow in a responsible manner with lower tuition and high focus on student outcomes will be successful.

TWST: In addition to the regulatory environment, how much of an impact are these companies facing in terms of more competition, any decline in enrollment and decreasing revenues?

Mr. Volshteyn: Surely, the sector has become a lot more competitive in recent years, particularly as traditional schools are entering the online space. When we look at the competitive landscape, competition comes from other for-profit schools, community colleges or other state-sponsored institutions, and private not-for-profit institutions. State institutions have seen budget challenges with their subsidies from their respective states. Private non-profit institutions have seen a decline in their investment fund returns. To substitute for shortfalls in these revenue streams, these institutions go after the high-quality, working adult population, which has traditionally been the main demographic of for-profit institutions. So clearly, we've seen indications of more intense competition online.

On-ground competition is a little more difficult to assess. Anecdotally, the landscape has become more competitive, but at the same time, working adult students tend to like the flexibility of online. So some of the pickup in on-ground enrollments may be a mix shift of traditional-age students who otherwise would have gone to a regular campus program, and now, because of the challenges with their parents’ finances, for example, have to get a job and attend school part time in the evening.

Outside of that, there are several other trends that we can observe in the industry. I mentioned a little bit about price sensitivity. When you look at the way students view the importance of tuition, it was one of, let's say, four or five important factors in their college-enrollment decision several years ago. I think at this point, tuition has become the number one or number two most important factor on most of the prospective students’ lists. Does a school have a good brand or reputation, number one, and two, is it acceptable tuition? This is a big change from what we've seen in the past, and as a result of this change, schools have to alter the way they market, the way they present their information and the way they deliver their outcomes. There are many operational changes that schools have to make to adhere to this shift.

Another trend that is interesting is what I call a “cyclical drag.” In the past, when we talked about enrollments in higher education, we would classify them as mildly countercyclical, so when the economy turns bad, enrollments go up slightly. Over the last year or year and a half, we have seen a trend where enrollments have become more procyclical, so with a relatively weak economy, enrollments are coming down because of lower demand. This phenomenon is new. It can probably be explained by the duration of this latest economic weakness, as folks just don't see a benefit of higher education in their workplace. Based on studies, we understand that many prospective working adult students see bachelor's degree graduates coming in to their workplaces and reporting to them. So why would they need a degree? Student loan aversion — and debt aversion in general — is a big theme in education spending currently. As these trends become more pronounced now, they result in weaker new enrollments.

Interestingly, based on the studies we have seen, negative publicity has a rather small impact on new enrollments. In the past, companies talked about negative media pieces on TV and in newspapers hindering enrollments. But looking at surveys done by Parthenon, which is a leading higher education consulting firm, it's just not the case. Most of the students don't read the publications that talk about for-profit higher education issues or don't watch programs that talk about these issues. In general, it seems that high college costs are top of mind for a lot of folks considering their college choices.

That said, while overall enrollments are weaker, schools with low tuition have better new enrollment metrics than the others, for all the reasons that we’ve discussed. Within the group, low-tuition providers’ new enrollments in 2011 were up 16% versus a decline of 6% for the higher-tuition providers. So this evidence of increased tuition sensitivity is very visible now and not unexpected.

TWST: Are any of the companies you cover changing their business models or strategies to cope with the challenges and doing so successfully?

Mr. Volshteyn: Recent operational changes have been concentrated in a few areas, such as admissions processes, compensation of admissions advisers, changes in marketing messages, increases in student services and support, and a more focused use of scholarships. In our coverage universe, we have seen a range of operational changes from relatively little to more substantial changes.

Most changes within the admissions processes were inspired by the new rules from the U.S. Department of Education, which prohibit any incentive compensation for admissions advisers and update a definition of what they consider to be a “misrepresentation of information.” Institutions with more conservative admissions practices going into this period of change such as American Public University or DeVry (DV) University did not have to make many admissions-related changes. Other institutions have instituted significant admissions changes, such as improving training and changing the way they structure teams of admission counselors. Some schools group admissions advisers with financial aid advisers and student services advisers on three- or four-person teams to better service their students.

One popular topic in the industry was instituting orientation programs. Just about every company in the group now has some form of orientation, where new students can basically “try before they buy.” Apollo has done it with a three-week, no-credit program, which gives a potential student a sense of what kind of time commitment and rigor they should expect in the regular program. Other institutions offer the first class for free, or another variation of this theme.

These programs have been very successful for several reasons. They are better for institutions, as these programs basically weed out students who are not able to succeed early on, so schools do not have to spend resources on these students. These programs are better for students, as those students who do not complete leave with no debt. They try before they buy. They don't have bad feelings toward the institution, and they are more realistic about the amount of effort college education would require.

Such orientation programs are a contrast to the prior state of things in the sector, when even if students did not like what they were getting or realized they did not have enough time to complete their studies, they would still be charged a portion of their tuition. Such charges would eventually result in higher bad debt expense for the institution as well as potential defaults on student loans. So these programs are better for everyone.

Some of the institutions focus a bit more on career services, and put more staff and more emphasis within their academic programs on job-related outcomes. Many institutions offer students training in very specific, job-related skills, either with specific pieces of software or certain types of equipment. As a result of their job-specific training, students graduate with a bit of a competitive advantage in the job market. Education Management (EDMC), for example, emphasizes portfolio development for their applied arts students. EDMC students often work on real design projects in class and can present diverse portfolios of their work well before graduation.

Another important trend in how companies deal with current challenges has been in the area of scholarships. While it is difficult for many of the for-profit institutions to lower their tuition due to existing rules, such as the 90/10 rule, they have been increasingly using what are called “success-based” or “completion-based” scholarships to attract high-quality new students and to retain strong existing students. Strayer (STRA) University, for example, offers around $1,000 per term for certain qualified students. The success of such scholarships is consistent with our view that the sector is very price sensitive. These scholarships are also likely to improve student persistence in these schools, but will also likely create some revenue pressure in the near term.

TWST: You said you like the low tuition names. Would you give us a couple of top stock picks?

Mr. Volshteyn: American Public Education and Grand Canyon Education are our top picks in the group. American Public Education is an institution whose tuition is about 20% lower than in-state tuition at many state institutions. Their heritage is in military student education, and over the last several years they have expanded into the civilian market. A lot of their students come on referrals, which we see as quite a positive sign of quality of education and a positive student experience. Approximately 60% of their military students and about 40% of their civilian students come on referrals from their friends, which is rare in this industry.

APEI is very impressive in the way they have been able to hold their tuition flat for about 10 years, despite rapidly escalating college costs everywhere else. APEI has highly qualified faculty who have been cited in numerous industry publications as thought leaders in the area of online learning and student outcomes.

Grand Canyon Education is another lower-tuition institution we like. Grand Canyon Education has a campus in Phoenix, and their tuition is on par with ASU and other local state universities. What's notable about their model is a recent shift from the more competitive and commoditized online growth toward more traditional-age students on their campus. While about 80% of their students are still studying online, their focus on the campus students in Phoenix builds their brand in the Southwest, improves student satisfaction, and eventually is likely to improve outcomes for students and regulatory metrics for the school.

The academic and employment outcomes for these students are quite favorable compared to their local competitors, particularly as LOPE’s lower tuition results in smaller median debt upon graduation and one of the lowest student loan default rates in the group.

All in all, lower tuition does not prevent schools from producing high-quality academic outcomes. We think that successful models in higher education offer relatively low tuition and remain lean on fixed costs. We recognize that institutions with significant legacy costs and high tuition will have to go through transformative changes to remain competitive.

TWST: It's earnings season now. Is there anything in particular you are keeping an eye out for? Is there anything you've heard thus far that's noteworthy?

Mr. Volshteyn: Clearly, the focus has been on the new enrollment performance. We consider new enrollments to be an indication of demand for these institutions. This season, we have seen disappointing new enrollment results at relatively higher-tuition schools, such as DeVry and ITT (ESI). We closely monitor the new enrollment trends for the group, looking for signs of an inflection point for companies that have been negative on new enrollments.

For lower-tuition schools, such as APEI and Grand Canyon, new enrollments decelerated but did not decline through this last cycle. For schools with new enrollment declines, such as Apollo, we are looking for indications of their inflection into positive territory based on the initiatives that they are putting in place.

Another metric we closely monitor is student persistence or retention. This metric is an indicator of how students are progressing through their programs. This metric is not only indicative of the demand for higher education, but also of the quality of instruction at a particular institution.

The third most important metric is revenue per student. Revenue-per-student growth reflects a combination of tuition increases or decreases, uses of discounts or scholarships as well as what we call revenue density. Revenue density reflects the impact of a mix shift between the part-time student population and full-time, online and on-ground, graduate and undergraduate. Naturally, changes in revenue per student will lead to changes in revenues. This metric showed signs of weakness for several companies this earnings season. For some, the student body has shifted to more of a part-time behavior, for others it was a mix shift toward online.

And finally, obviously, operating margin is always an important indicator of cost controls versus companies’ ability to continue investments in academic initiatives as well as sales and marketing. Particularly for companies with declining revenues, we want to see good evidence of cost controls along those lines.

TWST: Beyond the next quarterly earnings, what is your outlook for the group mid-to-long term?

Mr. Volshteyn: We estimate that new enrollments for the group are likely to inflect up at the end of this year, beginning of 2013. Total enrollments for the broader group are likely to inflect up at the end of 2013. So when we look at the more intermediate term, we expect the sector to return to positive mid-single-digit growth after this period of correction.

Over the next three to five years, we are looking at 2% to 7% enrollment growth, 4% to 9% revenue growth and 10% to 15% EPS growth. This is a three-to-five-year CAGR projection.

TWST: Is there anything else you’d like to discuss?

Mr. Volshteyn: I think a lot of investors want to understand the upcoming catalysts for this sector. I think there are two main catalysts. In the near-term, it would be the November elections. Clearly, the results of the elections will impact the regulatory and legislative structure for this industry. There are several possible election outcomes, and the potential impact to the sector will depend not only on who takes the White House but also on the composition of Congress.

The second catalyst is the job market. Once the job market improves, we will likely see more people considering going back to school, and demand for higher education will likely pick up on a lagging basis. We think that from the time that we see strong indications of job growth, we may see a pickup in demand for higher education several quarters later.

TWST: To wrap up, what advice would you offer investors today?

Mr. Volshteyn: My advice is to not treat all the companies in the sector the same just because they're grouped in the same bucket based on their tax status. Look at these institutions as individual businesses, not necessarily as a sector. There are more attractive models, and there are less attractive models in this group.

Do not get distracted by negative media, which is often just a recycling of the same news flow. Really dig into the fundamentals, understand management incentives and their commitment to quality education, dig into potential partnerships with corporations, look at their quality metrics and look at the fundamental drivers of these businesses.

And again, very simply put, low tuition is likely to lead to better long-term outcomes for students as well as for businesses in this industry.

TWST: Thank you. (MN)

Note: Opinions and recommendations are as of 08/06/12.

Jeffrey Y. Volshteyn

Vice President

JPMorgan Chase & Co.

270 Park Ave.

New York, NY 10017

(212) 270-6000