TWST: How did the education group fare from a business perspective in 2008, as the economy slowed?

Mr. Urdan: As the economy slowed, we saw this group really accelerate both in terms of the demand for the product and in terms of the leverage that it was able to generate in the income statement. That momentum seems to be continuing even into this year.

TWST: It seems contrary. What drove it in a decelerating or deteriorating economy?

Mr. Urdan: I think that in general, in a tough economic climate, prospective students become more interested in investing in themselves. It happens up and down the spectrum. At the vocational level, it's pretty straightforward. If there aren't $10-an-hour jobs at the mall, it looks a lot more appealing to go and study medical assisting or automotive technology so that you can get a high- paying hourly wage job. At the high end, it still applies. So if you are looking to complete your BA or get a Master's and you are either worried about your employment or facing unemployment, that's the time you get really serious about trying to beef up your resume. So typically in down cycles, we see students coming back to school. The thing that is an accelerant to that is the fact that in this downturn, the media environment is really deteriorating rapidly. So that means that education companies, which still have money to spend on media, are able to acquire media less expensively and their dollars are going a lot farther. So we are getting both the benefit in terms of increased demand as well as more leverage at the operating margin line. The double effect is very positive.

TWST: How about on the other side of the coin? There is more demand, but is there pressure on how to pay for school at this point with the economy going down?

Mr. Urdan: I think the Title IV programs that offer federal guaranteed loans to students are pretty solid and the politicians have worked hard to make sure that there has not been any kind of a gap there. But the private financing market is much tougher and the standards that the private lenders are using are rising in real time much as they are in other areas of consumer lending. And so what we've seen in the group is that a number of the companies that do have a gap between what Title IV covers and the full cost of tuition have had to get into the business of lending to their own students. That's not something investors like to see, but the positive aspect is it makes them very competitive for prospective students because that's not a benefit typically that state-funded institutions or even more elite not-for-profit undergraduate institutions can generally offer. So the fact that companies in the group are willing to provide student financing just enhances their appeal.

TWST: Is government funding being cut back or is that likely to be cut back, given what's going on?

Mr. Urdan: Not at all; in fact, just the opposite. The House version of the stimulus bill includes two measures that explicitly increase student funding. One is an increase in the average size of the Pell Grant by $500, which was largely expected. The other, which is not included in the Senate's version of the bill, is a proposed increase in the Stafford loan limit by $2,000. If the final bill passes with the latter provision, it means $2,000 less the students have to fund out of pocket or borrow elsewhere. It generally brings down the cost of the total education for those students because Stafford loans come at a lower rate of interest. But if it passes, this ought to move a lot of these school companies either entirely or largely out of the lending business and that is something that investors will be happy to see.

TWST: What's going on with these public entities in terms of pricing? Are they able to put through price increases?

Mr. Urdan: It goes school by school, I think. The schools that have a big gap that needs to be financed are a little less interested in raising their prices in this environment. Other schools that are priced already underneath the Title IV loan limits are putting through bigger price increases. So far, it hasn't seemed to harm enrollment either way, but interestingly, the bar is going up as well. So what we are seeing among private universities and public universities is those institutions have to raise their prices as well because of the fiscal pressures that they are under. The state schools are getting fewer subsidies from the state governments because tax dollars are low, so they have to turn more to fees and tuition to cover their costs, and even independent not-for-profit institutions have taken a real hit to their endowments. So in some cases, those institutions are either having to spread financial aid dollars around more widely among more students in this climate, which has the effect of raising their net prices. So the overall environment still provides an effective pricing umbrella for the for-profit schools.

TWST: Is the gap widening between private versus public cost?

Mr. Urdan: No, not so much, I think we've seen that divide narrow as state budgets have increasingly been pressured and public institutions have had to rely more and more on student fees, and that trend is continuing even in this recession. So even though everybody is raising their prices to some degree, the public institutions have to raise them even more. So you are actually seeing a leveling off. I think the other thing that's starting to happen that's interesting in the for- profit space is that you are starting to see more price-based competition and this is especially happening in the online marketplace, where historically, before online came along, most for-profit schools didn't really compete head to head. You had occasional circumstances where two schools might be in the same market going after the same student, but for the most part they stayed out of each other's hair. Now, in the online marketplace, it's a common pool and everybody is competing for the same types of students, and we are starting to see new entrants emerge that are competing on price. You've got American Public Education (APEI) that has a very distinct point of view about price and they have a price that is, for their similarly accredited Associate, Bachelor's and even Master's programs, significantly below their competition and they are hoping to really make some headway with that disruptive pricing model. So this is, I think, a new development, especially in the online realm, that's going to be very interesting to watch.

TWST: As you look at the industry, are we continuing to see these public companies or for-profit companies grow or, given the economy, are they pulling back a little?

Mr. Urdan: No. As I alluded to earlier, you are seeing the unit volumes rise, you are seeing the revenues per student, consisting of pricing and mix, increasing as well. There is acceleration taking place. Recently ITT Education (ESI) reported very strong numbers, we had Apollo (APOL) two weeks before that report very strong numbers as well. I think, as we go through this fourth quarter reporting season, we are seeing acceleration from what were already very big third quarter numbers. It's really a countercyclical industry; this is the time when these companies are growing. This pace of growth isn't going to last forever, but for now, a weak economy is good for the group and it's good for the stocks.

TWST: What's been the impact on the companies in this space throughout this financial crisis?

Mr. Urdan: We talked about the financing, so obviously students' lack of access to financing has had an impact. Eighteen months ago there was easy money for private student loans, just as there was in other areas of the economy, and that has shut down. The biggest impact has been on those companies that are in a position of needing to lend to their students, either because they generally serve students with low credit scores, or their students aren't the type to be able to take advantage of corporate reimbursement dollars. Those companies are bearing a cost associated with consumer financing. They have higher bad debt expense and their free cash flow has taken a hit, but even with those headwinds, it's not impeding their growth. It's just an added cost and that's certainly a function of the economy. But aside from that, the effects on the group from the weaker economy have all been positive. I think some skeptics and short sellers have been focused on the idea that this economic situation is so difficult that students might be reluctant to borrow at all. So even if the funds are available to them, whether they are guaranteed by the government or not, folks are not going to be willing to go into debt in order to purchase this product. That day may come, but we certainly aren't seeing that now. It seems pretty clear, based on the results that we've seen through the fourth quarter of 2008, that students really believe in the value proposition and the ROI of investing in a degree and they are willing to borrow if they can.

TWST: Earlier you touched on the fact that the companies are lending more. Is that because of interest or because they need to?

Mr. Urdan: They are serving students who really don't have access to credit. Some of the companies have students who are still able to borrow from third- party lenders, but they have a lot of students who aren't able to because they don't have the credit scores or they don't have the credit history. For the most part, at the diploma and Associate degree end of the spectrum, you are serving students that are really looking to improve their earning power, so the only way that they can enroll those students is if they lend the piece that they can't get from government-backed loans. At the other end of the spectrum, companies like Capella (CPLA) and Apollo and Strayer (STRA) are providing higher-level degree programs to a higher-end customer who might have access to credit. In that circumstance, however, those students generally don't need to borrow because they are able to tap into corporate reimbursement dollars. And so far, the corporate reimbursement market has held up reasonably well. We've done a fair amount of work in this area talking to a number of different companies in a number of different industries and the story so far seems to be that this is a program, even among companies that are retrenching and laying employees off, that is difficult to cut. For large companies, offering this benefit has become a cost of doing business. If you are a Fortune 2000 company, you really have to have a tuition reimbursement benefit to offer your employees. There are exceptions of course (Sprint recently terminated its tuition reimbursement program), but for the most part, the benefit seems to be surviving.

TWST: What does it do to the balance sheet risk for these companies?

Mr. Urdan: Lending diminishes one of the strong qualities of the group, which is its free cash flow. So to the extent that third-party lenders are not supplying funds at the start of each semester, it reduces the free cash flow that companies typically report. The bulk of student funding is still coming from lenders through government guaranteed loans and that cash does come in at the beginning of the semester. So there is still positive free cash flow for the most part, but it's not what it used to be and so that's a negative aspect. Of course, if some of the provisions in the House version of the stimulus bill pass, that situation will be reversed to a large extent and that will be $2,000 per student that the companies won't have to lend that they will get through the Title IV program.

TWST: So there's a little additional risk, but nothing meaningful.

Mr. Urdan: At some level there is risk, of course, because they are loaning this money to the students and they may or may not get paid back. In general, however, the companies are taking a pretty hefty discount in recognizing that revenue right at the beginning. Skeptics are concerned that the discounts that they are taking, which are up to 50% in some cases, may not be sufficient. That is, once the companies start to collect the funds and this hasn't even really happened yet because typically the loans don't start to come due until six months after the student graduates they may find that even a 50% discount in this economy is not sufficient. We'll have to see. So yes, there is some risk associated with those revenues and whether they'll be collected or not, but my view is that it is a limited risk. The companies have a fair amount of experience with these students and with their habits. Generally speaking, if a student graduates successfully and secures a job, s/he pays the loan back. So its fair to think that the defaults might rise, and it's fair to think that the companies might not be getting it exactly right in terms of the discounts that they're taking, but in the context of that student still being profitable to them and still having most of his or her tuition financed through the Title IV loans, where there is no risk to the company, it's a manageable amount of risk.

TWST: Some of the companies in this space had embarked on overseas expansion. Is that still going on?

Mr. Urdan: There is nothing that has happened recently. It's a big part of Apollo's story and they have capital and so they continue to talk a good game, but they haven't bought anything in a while and may be feeling more protective of their cash. So it's fair to think that that activity has slowed down. But everybody is still insisting that it's an important part of their strategy.

TWST: Do we have any evidence or history on what happens in these overseas education markets as economies slow?

Mr. Urdan: We are watching that, it will be interesting to see. Mostly the overseas schools are private pay and there are really not a lot of government programs or loans, so that would suggest that we might expect to see some weakness. It depends on the market. In China, which has its one-child policy, you have this phenomenon of six adults one set of parents and two sets of grandparents focused on the betterment of one child and you have a culture where education is highly prized. So the means and the desire to fund the child's education and give them a leg up in a weak economy remains still firmly in place. So that's a situation where we don't expect to see much incremental weakness. But in other countries, within Latin America, for example, which have been very fast-growing, you don't have the same kind of dynamic in those cases. You tend to have larger families and there aren't as many resources and so in those countries we very well might start to see a slowdown. For a company like Apollo that has domestic business that's roaring and has a fair amount of capital and access to credit, that could make it a good time for them to become more acquisitive.

TWST: Are you likely to see a pickup in M&A activity?

Mr. Urdan: Companies are guarding their cash a bit more, but on the other hand, maybe prices are coming down. So we will have to see what transpires.

TWST: We've got a new Administration in place. What is that likely to do to the regulatory environment here?

Mr. Urdan: We are waiting to see. Arne Duncan, head of the Department of Education, is very much a K-12 person. He doesn't have a strong background in the postsecondary arena, so we are waiting to see who gets the deputy slot for postsecondary education and what that person's stance has been historically toward the for-profit sector. In general, Republicans have been a bit more positive toward the for-profit group, but I think that the group in general has made a lot of strides in recent years with both parties in showing them how much it serves a traditionally underserved, minority population. It's really a group that caters to folks who haven't had access to higher education typically and so it fits right into a lot of the themes of the Administration. We'll have to see. Certainly, the measures in the stimulus package are positive. Those will be positive for the group. We are in the middle of a rulemaking process for the Higher Education Act passed last year by Congress, through which the law gets translated into specific regulations. That process will be interesting to watch to see whether the Department of Education takes a harder line or not with respect to for-profit schools. So far the new Administration is neutral to positive. If we get somebody who has been a real foe of the for-profit group into that deputy slot, then things could get worse.

TWST: As you talk with investors, what do you find to be the interest level in this space?

Mr. Urdan: Very high. There is new money coming in all the time. Investors new to the group generally want to avoid the companies that are lending to their students. That's sort of an extra layer of risk and complexity that new investors don't really tend to bite off at the beginning. But on the flip side, there is also new hedge fund interest looking for names to sell short. So I think the volatility is likely to increase even as new money comes in. Longs and shorts are duking it out over Apollo. Apollo had a lawsuit filed in December and the shorts jumped on that. Now the lawsuit has been pulled away, but maybe it will come back. So there is a lot of activity for sure, but in general the education stocks are one of the few sectors in the market right now that is working and it is seen as defensive. You still have a lot of investors that are so nervous based on what's gone on in the market, they are quick to take gains. People have an urge to grab gains and run, and part of what we are doing every day is persuading people to stay invested because the momentum in this space hasn't started to peter out yet.

TWST: What was the basis for the Apollo lawsuit?

Mr. Urdan: There was class action filed on behalf of students who dropped out within the first 30 days of enrollment. The company had returned their Title IV funds back to the lender. And these students feel entitled to the student loans and would prefer to owe the lender rather than the company. The contention is that Apollo did this in order to avoid seeing its cohort default rates on Title IV loans rise. I am not too concerned about the lawsuit itself but the response to the lawsuit, I think, is very interesting. There has been a very big response to it and it's a part of the general dynamic in the group. There are a lot of folks who may have a more shallow understanding of how everything works. There is a strong desire for short sellers to try to jump on the stocks that have done well. So they were inclined to seize on the lawsuit and make hay with it. I am less concerned about the suit and the cost to the company of the suit than I am about what it portends in terms of volatility. We may be entering a new phase of greater headline risk. The stakes are high for the group right now and so there are going to be people looking to jump on the negative.

TWST: What are you telling investors to do at this point?

Mr. Urdan: We like the group. Momentum is continuing. I think the advertising market is continuing to deteriorate. Student demand seems to be solid; we are seeing acceleration in the few earnings reports we had so far for the fourth quarter. What I say to people is, if you feel like it's time to take money off the table in education, then you also have to feel like it's time to start buying media stocks, because as long as the advertising climate continues to deteriorate, the environment is only going to improve for this group. I think that this prospective legislative change in the stimulus bill could have a real impact and is not fully appreciated yet across the group.

TWST: Who is on your favorite list?

Mr. Urdan: We like Apollo. They have a lot of attributes that operate well in this environment. They have got a big associate program online that is priced underneath the Title IV loan limits. They have a lot of marketing clout and are a beneficiary of lower advertising rates. They have been able to put through a big price increase in their Axia business, which should contribute to big earnings growth this year. It is not sustainable, but it is going to look pretty impressive over the next several quarters as they have 25% plus earnings growth. We think it's Apollo's time right now. We also like ITT Education. They have had a big run, but I think they are going to really be the biggest beneficiary of this prospective Stafford loan increase and until that's fully in the stock, I think there is a fair amount of upside from this level. The stock might go as high as a $160.

TWST: Where is it now?

Mr. Urdan: It is $124 right now. So I think there is a lot of "run room" there still. You also have some terrific secular growth stories in the market still. I mentioned American Public Education having a really low disruptive price in the marketplace and they are growing off of a very small base. So I think that is going to be your classic growth stock over the next several years. The last one is Corinthian Colleges (COCO), which operates in the vocational segment and really benefits from countercyclicality. Corinthian has room for margin expansion as they begin to fill excess capacity in their schools. They have the potential to go from an operating margin in the mid-single-digit range up to about 15% over the next few years. Strong top-line growth with that kind of margin expansion should really drive above average earnings growth for that story.

TWST: How about the other side of the coin? Is there any company that worries you in this space?

Mr. Urdan: I think Universal Technical Institute (UTI) is overvalued right now. They are seeing a positive turn in their business, but they are not seeing anything near the strength that other businesses are seeing, and they have a lot of excess capacity. They added capacity right at the top of the market. So they've never really filled their capacity and investors, I think, that like this name are thinking in terms of an earnings power story, imagining what earnings would be if they filled up all that excess capacity. But I don't believe it's clear the UTI can ever fill all that capacity. I think that there is growth there now, but I think it's not going to come at the pace that the bulls expect, and they are going to end up being disappointed on that one. Career Education (CECO) is probably a great story over the next couple of years, but on a near-term basis, I think they are still struggling with different pieces of their business. Their culinary business is contracting. That is one area of education that does not do as well in recession. And their art and design business is also contracting. They are trying to figure out how to lend to their students and they are being very cautious. They don't have the confidence there. They have some businesses that are doing well, but they are either not big enough, as in the case of the health business, or they are not growing as fast as others are growing, as in the case of their online business. So I feel like it's premature to dive into that one, although the valuation is low. I just don't see that there is really a near-term catalyst in that one.

TWST: Thank you. (TJM)

Note: Opinions and recommendations are as of 2/2/09.

TRACE A. URDAN Signal Hill Capital Group, LLC 343 Sansome Street Suite 950 San Francisco, CA 94104 (415) 364-0365