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Tickers in this Article: APOL, DV, CPLA
Capella Education Company (CPLA) reported third quarter 2012 earnings of 39 cents a share, surpassing the Zacks Consensus Estimate of 28 cents banking on better-than-anticipated new enrollment growth. However, the third quarter earnings were down 40.9% from the year-ago quarter due to year-over-year decline in revenues and margins. Despite solid results in the second and third quarters, management maintained a cautious outlook for the last quarter due to a challenging economic environment, increased competitive and pricing pressure, and possibility of quarter over quarter volatility.

Revenue and Enrollments in Detail

Quarterly revenues of $99.3 million moved past the Zacks Consensus Estimate of $98.0 million. However, revenues slipped 2.9% from the year-ago levels. The top-line decline was much narrower than management's expectation of a 3.5% to 4.5% decline.  Revenues benefited from the positive new enrollment growth.

Total active enrollment dropped 2.1% over the prior-year quarter to 34,989 students, lower than management's guidance of a drop in the range of 3.5%-4.5% due to new enrollment growth and solid learner re-registration rates. New enrollment grew 10.5% year over year despite tough market conditions. However, new enrollment growth was significantly better than management expectation to remain flat or grow slightly. Capella's strategic initiatives, continued innovation efforts and bringing forward some demand into the quarter drove new enrollment growth.

Also, the new enrollment growth was driven by the Master degree programs. Total enrollments declined 3.7% for Ph.D./doctoral degrees, 7.9% for the Master's programs and grew 6.9% for the Bachelor's programs. However, the Other segment jumped 135.7% year over year.

In order to improve overall enrollment growth and increase efficiencies, the company is moving away from a direct marketing aggregator channel to a brand-driven marketing strategy to build greater awareness and preference for Capella. The company is also working to build brand awareness for its university through mass media, social media and strategic relationships with employers. Further, the company has undertaken several initiatives to improve student success rates. It is also creating innovative learning technologies, which will meet the needs of working adults. We believe that positive new enrollment growth in the third quarter is a clear indication that these operational initiatives are paying off.

Costs and Margins

Instructional cost of services increased to $44.4 million in the third quarter of 2012, up 4.4% year over year primarily due to the addition of Resource Development International Ltd, the company's strategic investments and increased impairment and depreciation charges. Marketing and promotional costs also increased to $32.9 million, up 2.1% year over year, spurred by higher advertising expenses.

Adjusted operating income came down 44% to $8.3 million, whereas operating margin contracted 620 basis points to 8.3%, due to higher bad debt expenses. However, operating margin was better than management expectation of a range of 5% to 6% driven by better revenue, shift of some marketing expenses into the fourth quarter, and efficiency improvements.

Dull Fourth Quarter Outlook

Management expects a 3.5%-4.5% year-on-year decline in revenues for the fourth quarter of 2012 as they anticipate a decline in total enrollment. Total enrollment is expected to decline between 4.0% and 5.0%, while new enrollments are expected to remain almost flat in the fourth quarter of 2012.

The total enrollment outlook for the fourth quarter is somewhat muted as some new starts were brought forward into the third quarter and due to management expectation of a lower persistence rate in the quarter. Despite witnessing positive new enrollment growth in the third quarter, management believes it will take a number of quarters before total enrollment growth turns positive.

For the fourth quarter of 2012, Capella expects operating margin to be in the range of 13.5% to 14.5%. The expected operating margin is down from 17.2% in the prior-year quarter due to revenue decline and higher investments in marketing, learner success strategy and increased bad debts.

Marketing and promotional expenses are expected to remain similar to prior-year quarter levels. General and administrative expenses are expected to increase slightly year-over-year primarily due to diversification-related expenses and increased bad debt.

Our Recommendation

We currently have a Neutral recommendation on Capella. The stock carries a Zacks #3 Rank (a short-term 'Hold' rating).

We are encouraged by the solid back-to-back quarterly results from Capella in the second and third quarters. We believe that Capella's brand-driven marketing strategy as well as initiatives to improve learner success rates, despite hurting margins in the near term, bode well for the company's long-term growth. Further, continuous innovation and efforts to update courses will boost enrollments. We believe that Capella is performing better than many larger peers like DeVry, Inc. (DV) and Apollo Group (APOL). However, the muted fourth quarter outlook concerns us. We would like to remain on the sidelines until we have greater confidence that the improvement in enrollment growth is sustainable.

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