Wednesday, October 28, 2009

Apollo Group (NASDAQ:APOL): Colour on news - Overreaction?

Apollo Group (NASDAQ:APOL) is under pressure this morning after announcing its results and yet another SEC inquiry into its revenue recognition practices:

- Merrill Lynch/BAM is downgrading the stock to Neutral from Buy with a $73 target (unch)

- RBC Capital is downgrading APOL to Underperform from Sector Perform and lowering their target to $66 from $73.

- Morgan Stanley is downgrading APOL to Equal-Weight from Overweight.

The downgrades are what they are. I'm going to focus on the defenses and other comments:

- JP Morgan maintains their Overweight rating and $95 target noting that two most obvious areas of SEC review could be revenue impact of refunds and bad debt. In general, both of these areas use a relatively limited amount of “judgement”, thus perhaps limiting the exposure. They acknowledge that Apollo’s (and for-profit sector’s) business model is highly attractive from the cash flow perspective, as majority of cash is paid upfront and then recognized over the appropriate periods. Importantly, APOL’s cash flow from operations has consistently exceeded net income, (comprising 1.6x of net income in FY2009, for example), which also gives us some comfort on revenue recognition. Firm also notes that APOL’s revenues are shorter cycle (based on 5-9 week courses) which leaves less room for timing differences across reporting periods.

While JPM's review of similar inquiries in the for-profit industry (COCO in 2005) and other industries found individual cases of SEC inquiries, the outcomes varied widely. For example, COCO was forced to restate its revenue recognition for certain diploma programs with a limited impact on financials.

Apollo stated that the Enforcement Division of the SEC has started an informal inquiry into the revenue recognition practices. Management has not been able to identify specific items under review, but feels comfortable with the existing policies. Importantly, APOL's auditors have signed off on the 10K without qualification. JPM's research of similar inquiries in this and other industries found a wide variance of the possible outcomes and that resolution could take more than a year

Taking a longer-term approach. Before a retrenchment today, shares of APOL trade at 13x firm's revised CY2010 estimate of $5.48 vs. the sector’s average of 15x. They think that APOL is compelling given company's dominating market position, strong growth/margin balance, and more consistent execution. Their new Dec 2010 price target of $95 implies 16x FY2011 EPS of $5.80, and suggests NTM multiple expansion from the current level, but below historical levels.

- Piper Jaffray is maintaining their Overweight rating but are lowering target to $91 (from $108) saying that while the scope, duration, and outcome of the inquiry are unknown at this time, they understand Apollo's revenue recognition practices to be straightforward.

Based on past SEC inquiries in the education space, it is not uncommon for such inquiries to span several quarters, with little if any information flow. Given the uncertainty surrounding the outcome of the SEC inquiry, they expect APOL shares will likely be range bound over the next several weeks, but ultimately believe investors with a longer term investment horizon will be rewarded by owning the shares.

The company received notice from the SEC of the informal inquiry last week, and it is interesting to note that despite the SEC informal inquiry, Apollo filed its 10-K yesterday, signed by the company's auditor, Deloitte and Touche.

- UBS notes management announced the SEC recently began an informal inquiry into revenue recognition. While it is too soon to accurately assess the impact, they think it is likely to be small and so the sharp sell-off after market was likely overdone. UBS believes management is closing in on a settlement of the Qui Tam case. They think the $81mm reserve looks reasonable relative to the $1bb face value of the charge.

Q4 results were solid as starts, enrollment, revenue, margins, and EPS all beat UBS estimates, and bad debt was lower than expected. UBS maintains Buy and $120 target.

- CSFB wonders if the SEC is seeking clarity on how/when Apollo’s revenue recognition is impacted when an online student stops attending class or how it relates to the pace at which students “earn” Title IV student aid funds. They believe that the DOE is focused on a related issue that will be discussed in the upcoming negotiated rulemaking (negreg) regulatory review sessions. As such, they believe it is prudent to await more detail on the outcome of the DOE’s negreg process and on Apollo’s inquiry before speculating on the potential results of the inquiry.

Maintains Neutral and $65 target.

Notablecalls: This is not the first time the SEC has probed APOL's revenue recognition policies. Last time around, in 2008 the case ended in this:

The thing ended in: 'We have completed our review of your Form 10-K and have no further comments at this time.'

If you read the letter you can probably see there were no smoking guns found. This in turn makes the new inquiry (albeit informal) somewhat surprising. But I guess maybe DOE asked SEC to double check.

Anyway, I think the market may be somewhat overreacting to the SEC inquiry news here.

Would be buying on dips sub-$60 level.

PS: I discussed the APOL news with a trader that had done some prelim. work on it overnight and according to him the downgrades look silly.

'Even the analysts downgrading APOL this morning see only minor one-time expenses related to the inquiry (or in some cases even seeing the thing end in nothing) but they are still cutting their EPS multiples from 20x to 12x. This is silly.'


PPS: The stock was trading around $58-$59 while I wrote the comments but has taken off since then and is trading around $60-$61. Bit of a missed opportunity.


Kevin said...

Wild ride today for APOL

Opened @ $60.98
Hit low today of $56.63 @ 2:22PM
Currently @ $ 58.30
Shares o/s: 154,359,000

Volume today: 8,328,476
Volume yesterday when news broke: 24,251,600

I would'a thought with volume yesterday being
15% of total shares outstanding and 3 downgrades
the selling should'a been over.

bl said...

People don't like the possibility of fraud these days...Madoff,Galleon. Shorting seems to have been the case, imo.