Element Solutions Inc (ESI) Q3 2012 Earnings Report, Transcript and Summary

Greetings, ladies and gentlemen, and welcome to the ITT Educational Services 2012 Third Quarter Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. Joining us today from the management of ITT Educational Services, we have Kevin Modany, Chief Executive Officer and Chairman; and Dan Fitzpatrick, Executive Vice President and Chief Financial Officer. Before we begin, ITT Educational Services Inc. wishes to remind you that this conference call may include forward-looking information. Actual results may differ from the information presented during this call. For additional information, please review the section on forward-looking information contained in today's news release or in the company's public filings with the Securities and Exchange Commission. Thank you. Mr. Modany, you may begin.

Thank you, operator. Good morning, ladies and gentlemen, and thank you for joining us on our conference call to review our 2012 third quarter results. Dan Fitzpatrick, our Executive Vice President and Chief Financial Officer, is on the call with me this morning. We'll spend a little more time this morning on our prepared remarks, as we have a lot of information that we'd like to cover. However, we expect to provide you with about 30 minutes for your questions during the Q&A session at the conclusion of our prepared comments. I'll begin by providing you with a quick overview of the topics we'd like to address this morning. We will provide some color on the enrollment results for the third quarter as well as our thoughts on the enrollment outlook for the final quarter of 2012. Then, we'll provide you with our typical update on a few of the other key third quarter operating metrics for the business including student retention, year-over-year graduation information and graduate employment measures. Next, we'll provide an update on our strategic plan. It's here we will spend a little additional time today, as we hope to provide insight into how we're thinking about our business over the long term, taking into consideration sector changes over the past couple of years. We will discuss our current thinking on topics such as perspective student behavior, program costs, student value proposition and more. Dan will conclude our prepared remarks by providing additional color on the financial results reported in this morning's press release as well as an update on our risk share agreement under the private student loan programs. Then, we will open the lines for your questions. Before we begin reviewing the third quarter results, we should note that we will not provide an outlook on the business for 2013 in our call this morning. However, we do expect to review our 2013 internal goals for the key operating and financial metrics in our January 2013 earnings call. With the agenda for the call out of the way, let me begin with the review of our 2012 third quarter marketing and advertising results. Advertising expense decreased 17% in the third quarter of 2012 compared to the same prior year period, as we continue to adjust our spending in an effort to generate efficiencies in our student enrollment process. The reduced advertising spend generated an increase in perspective student increase in the third quarter of 2012 compared to the same period in the prior year. However, once again, we experienced a decrease in the rate at which student applications converted to new students, resulting in the 15.8% decline in new student enrollments. At this point, we'd like to give you a little bit of color on the enrollment results by program and/or school starting. In the third quarter of 2012 compared to the same period in the prior year, new student enrollment decreased approximately 36% in graphics design and criminal justice related programs, combined; decreased approximately 12% in our 3 core associate degree programs in the drafting, network administration and electronics disciplines, combined; increased approximately 16% in our Breckinridge School of Nursing and Health Sciences programs; and increased approximately 29% in our School of Business programs. Further, new student enrollment in our online programs of study in the third quarter of 2012 declined at almost twice the rate of our resident programs of study compared to the same period in the prior year. Looking ahead to the academic period that will begin in December 2012. As of October 22, 2012, applications for the academic period that begins in the fourth quarter of 2012 for programs offered by ITT Technical Institute were approximately 9% less than the number of applications received as of the same point in 2011 for the academic period that began in the fourth quarter of 2011. At this point, based on current enrollment trends, the lack of visibility and predictability of the conversion rate of student inquiries into new student enrollments and other related information, we cannot provide any specific predictions regarding when we may return to year-over-year growth in new student enrollment. As we noted in our July 2012 earnings call, we initiated efforts to better convey the value proposition of the investment in a career-based education for graduates of ITT Technical Institute. We have various communication campaigns directed toward individuals who have indicated an interest in pursuing their studies at our institution. However, clearly, we have additional work to do on this and/or redoubling our efforts in that regard. We continue to see a strong interest in our programs of study, as indicated by year-over-year increases in the number of students inquiring about our programs of study. However, our challenge is related to converting those student inquiries into new student enrollment continuum. Thus, we intend to focus our efforts on more effectively conveying to students the dynamics associated with the value proposition of an investment and an education at ITT Technical Institute. I will speak to those efforts more specifically a little later on in this call. At this point, I'd like to provide a brief update on the 2012 third quarter student retention data. We experienced a year-over-year decrease in the total number of graduates in the 3 months ended September 30, 2012, compared to the same period in the prior year, as we began to see the impact from prior quarter's year-over-year declines in new student enrollment on our total graduate counts. However, the year-over-year decline in total graduates during the third quarter of 2012 was less than the 15.7% year-over-year decline in total student enrollment as of June 30, 2012, and as a result, had a negative impact on student persistence as of September 30, 2012, compared with the same point in the prior year. Student retention in the 3 months ended September 30, 2012, declined slightly compared to student retention in the same academic period in 2011. We believe that student retention was negatively impacted by the rollout of new courses that are part of our 7-quarter associate degree programs of study, which were introduced initially at a material number of the ITT Technical Institute campuses in the academic period that began in September 2011. We have historically experienced a slight decline in student retention in new courses that we offer until our faculty gained greater experience teaching the new content. As such, we believe that we may experience the same new course impact on student retention for the next several quarters. 56% of the course registrations in the academic quarter that ended in September 2012 were in new courses compared to 14% in the same academic period in 2011. As a result of the changes in the number of graduates, and student retention metrics in the third quarter of 2012, our persistence rate declined 170 basis points to 69.8% as of September 30, 2012, compared to 71.5% as of the same date in 2011. At this point, I'd like to review our graduate employment metrics. The graduate employment rate of our 2012 employable graduates as of October 22, 2012, was approximately 350 basis points lower than the graduate employment rate of our 2011 employable graduates as of the same date in 2011. However, the average annual salary reported by our 2012 employed graduates as of October 22, 2012, was approximately 2.7% higher than the average annual salary reported by our 2011 employed graduates as of that same date in 2011. Updating our geographic expansion efforts, we began operations at one new ITT Technical Institute in the third quarter of 2012 in Pensacola, Florida. Counting the new campus that began operations in the third quarter, we had a total of 147 campuses and 3 learning sites in operation as of September 30, 2012. We don't expect to open any additional new locations in the remainder of 2012, which means that we will have opened 6 new locations in the current year. We continue to evaluate additional technology and health care-related programs that offer the potential for attractive returns on investments for future graduates. We'll speak to specific areas of interest for our future programmatic expansion efforts a little later on in our prepared remarks. During the second quarter of 2012, we obtained all the necessary regulatory authorizations to begin offering online programs in business administration at the associate bachelor and master degree levels at Daniel Webster College. The school has begun enrolling students in the new online business programs, but that enrollment did not have a material impact on our enrollment results in the third quarter of 2012. Further, we believe that these new online programs will have an immaterial impact on our consolidated operating and financial results for the foreseeable future. That said, we intend to seek approval to offer additional online programs of study at DWC in the future. Any new programs that we seek approval to offer will be in disciplines that we believe offer graduates the potential for a solid return on their educational investment. Moving on, we would now like to talk a bit about our strategic planning. As has been our custom this time of year, we have been conducting a comprehensive review of our business in evaluating the trends and the relevant data points as we plot the future course of our business. It is common knowledge that the proprietary post-secondary education sector has experienced a lot of change and volatility over the past several years, and that change has substantially influenced the way we think about our business today and into the future. We believe that we'll continue to experience additional change in the near term, and it is prudent for us to consider potential regulatory and legislative changes that may occur in the future in our strategic planning. As we've mentioned earlier on the call, we continue to experience a strong demand for our programs of study. We believe that is in part due to the relevancy of the programs that we offer and the fact that our programmatic expansion efforts have historically been governed by student outcome considerations and more specifically, the student value proposition. Thus, we expect that our future programmatic expansion efforts will focus on science and more specifically, health sciences, technology and engineering-related disciplines because of the projected levels of job growth and starting salaries in those disciplines. We believe that our strong brand name combined with a focus on program disciplines that offer good student value proposition will favorably position us going forward. As we review our business and consider how we should position ourselves for the future, we do not believe that we need to reengineer our approach to generating perspective student demand. Generating student inquiries for our programs of study, while always a key focus area for any post-secondary institution, is not our current challenge. However, our strategic planning process has led us to conclude that the continued economic disruption, coupled with the publicity regarding the rising cost of higher education, has negatively impacted the conversion of student inquiries to new student enrollments. Thus, we have begun to test several changes to our communications with prospective students in an effort to positively impact conversion rates. In several markets, we have very recently modified the content of our recruitment communications related to the student value proposition. This content change is intended to more deliberately and clearly inform prospective students of their individual estimated net program cost, which is the program cost less estimated grants, scholarships and benefits that may be available to each prospective student. We believe that the estimated net program cost is a key element in calculating potential return on an educational investment and that this information is, and will continue to be, an important data point in a prospective student's educational decision-making process. Currently and historically, when a prospective student visits a campus to obtain additional information about our programs of study, we communicate the total estimated cost of the selected program without analyzing what estimated grants, scholarships and benefits may be available to the student to reduce his or her program cost. While the overwhelming majority of our students receive a grant, scholarship and/or benefit that reduces their total cost of attendance at our institution, we have not estimated and/or communicated these redemptions to prospective students during the initial recruitment process. Over the past 3 years, the amount of institutional scholarships, grants and benefits available to our students have increased significantly, but we have not attempted to proactively communicate the availability of these awards as part of our recruitment communications. Thus, in our initial on-campus conversation with a prospective student, we do not discuss the student's estimated net program cost. The new recruitment communication campaign that we initiated in the fourth quarter of 2012 at select campuses includes a student-specific estimate of grants, scholarships and benefits for which a prospective student may qualify, and we'll provide each prospective student with an estimate of his or her net program cost, which we believe will enable the student to better evaluate the value proposition of an investment in an education at ITT Technical Institute. In the initial test, we will also be increasing the amount of institutional scholarships that we will award eligible students who qualify. If the test proves to be effective, we would anticipate rolling out the revised recruitment communications campaign to all ITT Technical Institute campuses throughout 2013. And if this occurs, we believe that it could have a positive impact on our operating and financial results in future periods, but it is impossible for us to predict that impact at this time. As a result, we're unable to provide any outlook with respect to our 2013 operating results. I want to further note that by increasing the amount of scholarships as part of this test, we believe the prospective students in the test markets will be able to materially reduce, and in many cases, eliminate their need for private student loans to pay for their program cost. While it's far too early for us to predict the effectiveness of the new recruitment communications campaign or the potential impact on our operating and financial results with any degree of certainty, we believe that it could have a positive impact on our overall conversion rates and cause a corresponding increase in expenses as a result of higher institutional scholarship amounts. As is typically the case for our organization, we expect that we will determine the success of this initiative on the basis of the ROI to the institution. Now before I hand it over to Dan for some additional color on the financial results reported this morning, I would like to provide a brief update on our efforts to arrange for third-party private loan options for our students. Depending on the result for the new recruitment communications campaign and increased institutional scholarships that we are testing, our students' need for private student loans could change materially. Today, however, we can say that conversations are ongoing with regard to the creation of a new third-party private student loan program for our students. Having private student loan programs available to our students remains a strategic initiative, but our strategic planning has impacted the priority of this initiative and as a result, the ultimate timeline for its completion. We hope to be in a position to provide you with more information regarding private student loan matters in our January 2013 conference call. While our project plan anticipates the availability of a new private student loan program beginning in the fourth quarter of 2012, the results of the test of our new recruitment communication campaign could significantly alter this plan. Also, let me just try to proactively address a question that may arise as a result of our discussion of the testing of our new recruitment communications campaign and the related increase in institutional scholarships and the potential rollout of those changes systemwide should they prove to be effective. If we were to eliminate the need for our students to access private student loan programs, we believe that we would remain in compliance with the 90/10 Rule with approximately 85% of our revenue in 2013 being derived from federal student financial aid programs. Lastly, on this topic, we should note that our long-term strategic planning also includes consideration of other avenues that we can pursue to enhance our compliance with the 90/10 Rule in the long term. At this point, I'd like to turn the call over to Dan, who will provide an update on a few financial matters.

Thanks, Kevin. First, I'd like to provide a few brief comments on the financial results that we released this morning. Revenue per student increased 3.5% in the 3 months ended September 30, 2012, compared to the same period in the prior year primarily because of the continued impact of the rollout of the new programs at a portion of our schools as Kevin mentioned earlier. Moving onto scholarship and award activity for the quarter. In the 3 months ended September 30, 2012, our students received approximately $16.6 million in scholarships and awards compared to approximately $22.5 million in the third quarter of 2011. The decrease was the result of a 15.7% year-over-year decline in total student enrollment as of June 30, 2012, compared to June 30, 2011, as well as the reduction in some of the awards that have been made available to students in prior periods towards the end of their programs of study. The reduction in the institutional scholarships and awards is indirectly tied to the testing of the new recruitment communication campaign that Kevin discussed. If the test is effective and expanded to all additional locations, we would expect to have the amount of the awards granted to students during the last few quarters of the programs of study would be reduced, and these amounts would be reallocated to institutional scholarships that would be awarded to students more evenly throughout their programs of study. That said, the reduction in the total amount of scholarships and awards granted to our students in the third quarter of 2012 contributed to increases in accounts receivable and corresponding our bad debt expense in the quarter. Days sales outstanding increased 11.8 days to 26.1 days as of September 30, 2012, compared to 14.3 days as of the same date in 2011. Bad debt expense as a percentage of revenue increased 350 basis points to 7.3% in the 3 months ended September 30, 2012, compared to 3.8% in the 3 months -- in the same period in 2011. The year-over-year increases in DSO and bad debt expense were due to an increased use of internal financing for our students resulting from a decrease in the amount of funds received from private student loan programs available to our students in the third quarter of 2012 compared to the third quarter of 2011 and the reduction of institutional awards previously mentioned. We expect that bad debt expense will be in the range of 5% to 6% for the full year 2012. At this point, I'd like to talk about the loan repayment performance of the third-party private student loan programs where we provide a guarantee under risk share agreements. The repayment performance to date of private student loans has been lower than our original projections, and the charge-off rates have been higher as reflected in the contingent liability that we've recorded in connection with our guarantees under these agreements. As of September 30, 2012, our recorded liability for various claims and contingencies was approximately $44.3 million, the substantial majority of which pertained to our guarantee arrangements under the risk share agreements. In the third quarter, we increased our contingent liability associated with their risk share agreements by approximately $3 million. Approximately $5.3 million of the recorded liability was included in other current liabilities, and approximately $39 million was included in long-term liabilities on our consolidated condensed balance sheet as of September 30, 2012. As we noted in previous public communications, in certain reporting periods, there have disruption in servicing of a portion of the private student loans, which we believe has negatively impacted the repayment performance of those private student loans. That said, we cannot predict with any certainty as to the extent which servicing disruptions may affect the repayment performance of those loans in the future or whether other servicing disruptions will occur in the future. Additionally, it's not yet clear as to whether the variance in repayment performance is solely the result of servicing disruptions or whether it's indicative of a broader change in borrower repayment behavior. We are currently analyzing initiatives that we may decide to take in an effort to improve the performance of the private student loans under the risk share agreements. However, we cannot assure you to the extent that those initiatives can be implemented or their effectiveness in improving the repayment rates in the private student loans. Of course, we continue to monitor the loan performance data as it becomes available to us, and we will adjust our contingent liability appropriately based upon current information. Now moving on to review of the outstanding balance under our line of credit. As of September 30, 2012, the outstanding balance under our $325 million revolving credit facility was $140 million. As reporting in the earnings releases morning, we have revised our 2012 internal goal for EPS from a range of $8 to $9 to an adjusted range of $8 and $8.10. The new student enrollment results in the third quarter of 2012 were the primary reason for the adjustment of our internal 2012 EPS goal to the low end of the range. Our strategic planning efforts have included complete and thorough review of our operating model and specifically, our cost construct. In light of the landscape in enrollment results, we have identified potential efficiencies in our business model that we believe could be realized through various business initiatives that could be implemented in 2013. We have begun to implement these initiatives and believe that the majority can be implemented in 2013. We do not believe, however, that the full impact of these initiatives would be realized in our financial results until at least 2014. While we believe that we have historically operated one of the most efficient organizations in this space, we are cognizant of the changing landscape of higher education, and as a result, we need to be more diligent in our efforts to operate our business efficiently as possible. We believe that the more efficient we are, the more effective we'll be at driving higher levels of student outcomes. So executing on these initiatives will be a focus for our organization in the fourth quarter and 2013. Lastly, we should note that the efficiency initiatives I just discussed did not include any campus closures. We continue to monitor the performance of our campuses on an ongoing basis and will not hesitate to adjust the number of our campuses should we believe it to be operationally and financially appropriate to do so. However, we do not have any immediate plans to make material changes to the number of our campus locations. And with that, I'd like to hand the call back over to Kevin.

Thanks, Dan. At this time, I'd like to ask the operator to open the lines, so we can entertain your questions.

[Operator Instructions] Our first question comes from Jeff Volshteyn at JPMorgan.

In your strategic review, when you look at the average net program cost, what is an average number that you're coming up with? And what level of scholarship does that include?

Well, we're not getting into the specifics just yet on that, Jeff, but generally what you're looking at is a communication of a cost today that is roughly in the range of about $45,000, let's say, for an associate degree program. That communication of a net program cost, we believe, on average will go to about $27,000. That's not to say that, that difference is all increased expense or increased scholarship because we're already providing a significant amount of scholarship. There are already significant amount of grants received by our students. A large percentage of those students, roughly 65% to 70% of them participate in the Pell program, so the incremental component is much smaller. And again, we're not giving the details on that. But I would just give you a range of the communication differences between what we're saying today to a student and what we will say on average as a part of this test.

Our next question comes from Sara Gubins at Bank of America Merrill Lynch.

Based on what you're seeing in terms of applications and conversions so far, do you think it's reasonable to think that the start declines get worse in the fourth quarter versus the third? And also if you could give us some examples of cost-cutting initiatives and maybe magnitude given that it's not coming from campus closures?

Sure. Two things there. The first question with regard to fourth quarter enrollment and whether we think the year-over-year comparisons could get worse, at this point, Sara, we're not projecting that. We would not project the fourth quarter would be worse. It does not look like we're going to be able to get flat or over prior year at this point just based on the trending that we're seeing. But it looks like it will not be at the current levels in terms of year-over-year. We were 15.8% down in the third quarter. It looks like we can do better than that but again, not yet getting to the point of being flat or positive on prior year. The second part of the question I believe related to cost cutting and whether or not we can give specifics. And I speak in generalities here. Generally, the cost-cutting initiative opportunities going forward are in and around our student services process areas, just the way in which we process transactions if I can describe it in a more generic sense. Now we think there are opportunities for us to implement some technologies in those areas that, a, should make us more efficient in the way in which we serve our student needs but I think probably even more importantly, make us more effective, as we look at some of the operating metrics that we judge ourselves by and the quality of service that we provide in terms of communication and support to our students. We think we can actually increase those with the use of technology while being more efficient. So it's generally in and around that area. If we were to estimate an annualized impact at this point, I would say it's probably in the $50 million range just based upon some early preliminary work we've done to try to size the opportunity.

The next question comes from James Samford at Citigroup.

Just wanted to sort of broadly speaking about margin trends. I mean, it looks like based on your guidance, you're looking for another 1,000 basis points of margin deleverage in Q4. Where -- how quickly can you stop the bleed in terms of cost cutting? And are we really talking about a 2014 kind of stabilization of margins given some of the plans that you have right now?

Well, we're not giving any specific guidance over and above what we provided for 2012, and obviously, you come back into what that means from a cost and revenue and margin perspective. We do think there are opportunities for us to manage that cost construct, but at the end of the day, this is about the leveraging. And we are seeing deleveraging right now. We've been able to manage that deleveraging a bit, I would say, from a cost perspective, as we look at fourth quarter, even versus third quarter. If you adjust for seasonality, I think we're going to see a similar type level of cost. What we hopefully will see as we start seeing a decline in the rate of year-over-year new student enrollment changes that we'll start to see an improvement and a change in the total enrollment. So total enrollment on a year-over-year basis, we should be able to close that gap as we move forward. But as you've mentioned, it does take time for that to play itself out. Again, we're going to be mindful of costs. We're going to manage our costs as efficiently as we can, but it's going to take us a little bit of time to turn the enrollment trend. Once we do, we see a significant amount of leverage on every incremental student at this point. We're probably looking at upwards of 90% of each one of the incremental revenue dollars working its way down to the bottom, to the operating line. So -- and I think we're probably managing it on the deleveraging side at about $0.60 if you do the math. So we've got some opportunity to close that gap, and I think we will. And again, we're going to be as efficient as we possibly can going forward and have identified some additional opportunities over and above what you're seeing in the current numbers to enable us to do that.

Our next question comes from Corey Greendale at First Analysis.

On the kind of strategic plan side, I guess 2 things. First of all,, obviously, there's a big difference between a $45,000 cost and a $27,000 cost, but the $27,000 is still above what students can get at community colleges. So what gives you confidence that, that will make the difference? And secondly, I realize it's too early to say what the impact would be if you do rollout enough scholarships that you wouldn't need the third-party private loans anymore, but I was hoping you could just at a high level talk us through kind of what the impact would be on revenue, cost, bad debt, that sort of thing.

Sure, Corey. With regard to our confidence in our test and in the ultimate outcome, I don't think we can give you any assurances one way or the other as to what will happen here. I think it's reasonable to expect that there is some level of price elasticity in post-secondary education today. We may not have seen that as recent as 5 years ago, but it exists today. To what degree? I don't know that anyone has good data on that. We've certainly done the research, and there are some data out there but nothing that I would say is appropriate to use in this particular scenario. And we have not tested this. So it's hard for me to give you any specific information as to the level of elasticity and the type of demand conversion increases we could potentially see as a result of that change in pricing. That's why we're testing it, and we'll see what the test shows us. But again, intuitively, you would think that the elasticity exists and some level of price reduction in terms of the way we communicate it, which here it is substantial. I think you would agree it's substantial, should have some level of increased impact on the conversion of what we're seeing for being very strong demand. I would -- now we don't position ourselves to compete with community colleges and we never have. And we're not trying to do that with this initiative. We are trying to demonstrate to students the value proposition more clearly and communicate that to them with a higher degree of transparency, and hopefully, that will enable them to make a good decision and see that there's an opportunity here for a very strong return on their investment. So it's a change in communication. And again, I don't know that we can, absolutely with a high degree of confidence, tell you what will ultimately happen as a result of this. The second part of the question was revenue impact and the rollout of the test. Since we won't see much of that in 2012 because the test schools -- it's about 15% of our schools where we're testing this right now. It's not going to have a big impact on the fourth quarter, and we're not providing any guidance on '13 just yet. So I'm going to stop short of providing any color on that. But as soon as we get some good data, get a good sense of what the impact is, we're able to correlate the results and project forward a potential impact one way or the other, we'll communicate that to the market and again, probably communicate or communicate it and include it in our 2013 guidance that we expect to provide in our January call.

Our next question comes from Gary Bisbee at Barclays.

Two questions if I could. The first one, it sounds to me like the right thing to do to consider this. I wonder why you don't just cut price. You're still going to have the blist price in some of the DOE disclosures. You've got a lot of room on 90/10. It would clean up the accounting with less lending to students and make the net income much closer to cash flow. It just seems to me like it would be cleaner and you'd probably get a bigger boost. And then the second question, would just love a little more color on the weaker repayment performance. Can you give us a sense how much that's been? And if that trend continues ultimately, have you reserved enough? Or what does it mean for the financials?

Thanks, Gary. I think that's a great question in terms of how we think about pricing and the communication of that pricing. And certainly, we spent a fair amount of time on this, and a significant amount of time, I should say, more than a fair amount, looking at it and analyzing the different approaches that we could take to it. And we feel as if we've taken the best approach where we customize that pricing communication to the student. So we feel like this is going to give us the best return dynamic for the institution and also be as transparent as possible to students. Right now, we feel like this is the way to go. Obviously, we're going to test it. We're going to collect some data, and we'll see what happens. But right now, we think like this is -- we feel like this is the best approach to go with. And ultimately, the result, if it works out, we will get the same result that you talked about. I mean it does clean up some of those issues that are out there hanging and certainly, would present a situation where this would be a cash business at the end of the day. The net income would principally be all cash. So we still think we get to those same points, and based upon the research that we've done, we think that this customized pricing per student is likely going to give us the optimal result. But again, the test will tell, and we'll adjust accordingly. In terms of the private lending and the repayment, I think what the -- recording of the reserves, obviously the repayment rates haven't been where we wanted them to be. I wouldn't say that we've seen any material degradation in that. It hasn't really changed materially. It's just not where we want it to be. And so I guess, with today's communication, we're basically saying we want to step up the monitoring and do everything that we can to try to impact the results here. But again, we've not seen a major negative change in the trending. Again, it's just not where we want it, and that's evidenced by the accrual that we have. The accrual we have on the books today contemplates that trending and contemplates our expectation over the lifetime of the program. So that all goes into your accrual analysis and went into our estimating process that led to the current accrual and the adjustment in the reserve for the current quarter.

Our next question comes from Paul Ginocchio at Deutsche Bank.

Two maybe questions. Just could you talk about the average internal loan balance or private loan balance of students, when graduating with recently? And then second is there -- could -- can you give us any update to your free cash flow guidance or free cash flow for the fourth quarter?

Sure. In terms of debt balances, we talked about this a little bit, maybe about a year or so ago when gainful employment was one of the prominent topics of discussion. We had seen prior to, let's say, the 2011 year graduate balances, median balances around 30,000, the debt balances. With the scholarships that we had put forth and the increased level of scholarships that continue through to today, those balances have come down to about 26,000 or 27,000, the median debt. That's a rough average based upon our analysis of the graduate debt data that we have available to us. Now that's just the most current information we have. Of course, if the test proves effective and we do increase institutional scholarships, that could be impacted further. So we'll, have to continue to analyze that and see what the impact is. In terms of free cash flow -- yes, go ahead, Dan.

No, I -- the free cash flow, we really haven't changed the guidance or not the guidance but how we've talked about in the past. We talked about a range of $50 million to $75 million this year, and that's still the expectation at this point.

Free cash flow is a non-GAAP metric. That's -- is reconciled on our website, so we are obligated to say that.

The next question comes from Kelly Flynn at Credit Suisse.

I just wanted to ask you about the private loan agreement. Last quarter, I think you used the language preliminary agreement and I think perhaps talked about documentation stage. Can you just clarify whether or not you still have that preliminary agreement and what, in fact, has changed since last call on this front?

Sure, Kelly. Nothing has changed. Non-binding term sheet is still in play. Discussions are ongoing. Documentation processes ongoing. The only thing that has changed is as we think about our strategic planning and look at the future of the business, we are changing the way in which we communicate pricing as I discussed in the prepared remarks. So nothing's changed on the private lending front. Our strategic planning process and our decision to go forward with this communications campaign has not been influenced at all by our ability to secure private lending. That has absolutely nothing to do with it. There's no lack of interest there. We've -- again, discussions are ongoing. This is a separate and an exclusive decision relative to strategic planning and really relates to our review of a very strong level of demand for our brand, our widely recognized brand and the decline in the conversion of that demand to new students and for reasons that based on our research, we believe relate to the introduction of price elasticity and the post-secondary market. So it's really related to that strategic planning, but nothing has changed on the private lending front at this point other than what we've said in the prepared remarks. Our strategic planning has informed our thinking in that regard, and it's changed the priority of that initiative for the organization and likely will change the timing of it. But aside from that, nothing has changed.

Our next question comes from Peter Appert at Piper Jaffray.

So, Kevin, maybe I'm just not understanding this, but in the context of what would -- could be, I guess, effectively pretty significant price reductions, I don't see how that doesn't translate into some further significant pressure on margins. What am I missing?

Well, I think what we're talking about today is the way in which we communicate our pricing construct to students. And today, we basically communicate a gross price, and tomorrow, we want to make sure that we incorporate a discussion of net pricing. So that's a big change relative to what's already out there in the terms of grants, scholarships, benefits, awards to students. We are saying that there could be an increase in the level of institutional scholarships that go along with this. So there could be a cost associated with it. However, if in fact this proves to be an effective communication strategy, there is the possibility that, that strong level of demand that we keep talking about in terms of the number of inquiries that we're seeing from prospective students, the conversion of that demand could increase as a result of this. If in fact our research is correct in that, the reason for the decline in conversion has something to do with price elasticity. So we changed that communication. We may see an improvement in the conversion, and the conversion rate on a strong demand could drive a higher level of units or students that enter our system and therefore, give us an opportunity to positively impact the bottom line. So there is a cost certainly included with additional institutional scholarships, but it could be more than offset by a potential corresponding increase in conversion rate. That's basically what we're saying. And then in the prepared remarks we said, the ultimate success of this initiative will be determined by an ROI. And it's simple math in that regard. So it absolutely presents an opportunity for some upside for us, but again, the test will tell. We will run the test in the 20 or so markets. We'll collect data, and we'll see what it shows us against the baseline, and then we'll be able to project forward what the expected impact is of this initiative. And that will then lead to a communication of our 2013 expectations. But hopefully, that description gives you a little more color on how we're thinking about it and how it could have a very positive impact on the business.

Our next question comes from Jeff Meuler at Robert W. Baird.

The question that's getting asked, but can you, I guess, just try to compare the economics of this new model that you're piloting relative to the economics to you of the model you've been operating of on-balance-sheet lending over the last couple of quarters because I get that it'll be lower revenue per student. But if we look at your bad debt expense, it seems like you're probably already charging off a lot of that revenue. And then if we look at your cash flow, you're not getting paid up front. So I guess if you could just compare and contrast the economics of the 2 different models.

No, Jeff, that's absolutely correct. I think you're thinking about it the right way. And again, we're going to stop short of giving specifics on 2013 guidance, which I would have to get into if I got into the specific numbers that we're looking at as we analyze this. But certainly, you have to take into consideration the bad debt expense that we are recording as a result of having on-balance-sheet financing for our students. Also the scholarships, institutional scholarships that we're providing, those dollars, that funding pool that already is included in our financial statements and the results that we're reporting basically gets reallocated. So we reallocate that and do it in a way that enables us to provide a better picture to the student relative to the value proposition. Over and above that, there is potentially a slight increase in those expenses if we increase the institutional scholarships. So there's a -- and again, I'm just speaking generally here. I'm not giving dollar numbers. But there could be a slight increase in that expense over and above what is currently bad debt and what is already recorded as scholarships. We would do that and continue to do it and expand it throughout the network of our campuses if, in fact, it generated a positive return in terms of the number of students that converted as a result. So -- and you're thinking about it correctly. We're thinking about it the same way. And we'll provide a little more specifics when we get in our January call when we start talking about 2013 outlook. But hopefully, you all can appreciate it's very difficult for us to do that until we actually collect some data from this test to see the degree of price elasticity that exists in the marketplace and how our prospective students react to this change in communications.

Our next question comes from Jerry Herman at Stifel, Nicolaus.

I appreciate the comments about demand levels being high, but the shortness or the declining conversion rates, it -- isn't that -- where are they falling out? And I guess my question is, are they in fact falling out because of price? And if it is price, isn't that enough evidence to make the move? And maybe just to expand the question a little bit more than that, from a shareholder perspective, the stock seems to already be reflecting a very heavy discounting effect. And I'm wondering strategically if there's something that you guys have thought about that would enhance not only the value to the student but also to the shareholder?

Thanks, Jerry. I appreciate that. The first question being kind of where we think people fall out of the process, and if you go back the last couple of years and we just say from lead to start, we're seeing degradation in each one of the major steps in the process. But principally, where we've seen the majority of the decline is between a student application and a student start. And that for us, an application is when a student actually physically comes to our campus, tours the campus and initially receives specific information about tuition costs. That's the first time we really get into that. And up to this point, prior to the test, we have always communicated a gross tuition cost there. So -- and there's more detail that goes into this, but generally speaking, we're seeing that degradation from the time in which they first receive a communication of costs and when they start. And yes, there is a good bit of anecdotal information that suggests that's pricing. We've also done surveying as others have done. But there is really no specific statistically valid data that could support it as a price issue and as the existence of elasticity of price in our current model. It isn't overly complicated or difficult for us to test this and collect some data. We'll be able to do that in a relatively short period of time. And so once we collect that data, then we can better expand the initiative and better execute on this, and it gets the best result for us and for our students and ultimately, for our shareholders. So we're thinking about it that way strategically. We'll adjust accordingly based on the information we get from the test, but I think this is the right thing to do. All data points are suggesting this is the right thing. We want to substantiate that data with some very specific statistically valid information. But again, it seems to be the right thing to do for all constituents involved here and ultimately, will drive higher levels of returns for our shareholders. We believe that if we see the right kind of correlation between the change in price and the conversion of demand.

Our next question comes from Trace Urdan at Wells Fargo Securities.

Kevin, I wondered if you could talk about the -- whether you're going to be testing a range of scholarships at the various schools and whether there's going to be any variability in terms of which programs they're offered to or which degree levels they may be offered to?

Sure, Trace. From the discipline perspective or type of degree, we're not really using this scholarship/communications campaign initiative as a way to move student decision making. We have made some decisions on programmatic disciplines, as we've communicated in previous calls, where we don't see the right level of outcome. So if we don't see the right employment level, if we don't see the right salary level, we've made those changes exclusive of anything we're trying to do in terms of converting demand. So the scholarships will be available to all programs that are being offered at the schools or all disciplines, I should say. At this point, it's focused on the associate degree level student, but that doesn't mean that we wouldn't expand it to bachelors as well. We have a separate scholarship program that we apply to our bachelor students. That we'll continue to keep in place right now, and that has been in place for quite some time. Depending upon the results that we see with the program at the associate level, it could very well be expanded to the bachelor level. But at this point, it's all disciplines, and it's associate degree level students only at this point. But again, based on results, that could change.

Our next question comes from Thomas Allen at Morgan Stanley.

Two part question. First, x bad debt, 3Q costs were down substantially on a sequential basis. Was that seasonality all the lower marketing spend? Or did you take other costs out of the system already? And then the second part, last call, I believe you said that you were going to increase marketing slightly in the second half of '12, and you said that in 3Q, you cut it substantially. What drove that decision?

Sure. In terms of just a general discussion of costs and what's happening in the quarter, certainly the marketing expense reduction on a year-over-year basis is reflected in that total cost reduction, but we did adjust other costs. We are being very mindful of the current environment, very mindful of our cost construct and have been adjusting our costs accordingly. And that's on all fronts, on all levels of the business. We're a service business, so when we adjust costs, that also means personnel, and we've adjustments there. We've got a pretty established construct in terms of the staffing levels at our school relative to the student census. And we've been applying that. Obviously, we've seen declines in total enrollment, and accordingly, we've been adjusting our staffing levels. And you're seeing some of that reflected in the total cost. When you think about the marketing spend and the fact that there was an anticipation of an increase in spend, we've done a great job. The team has done a fantastic job in managing that spend and getting us a better result with fewer dollars. And so we've seen a pretty substantial decline, 17% on a year-over-year basis in the current quarter. That's reflective of the changes in mix that are generating good returns for us, that are generating good conversions to the application, which is really how you need to judge a marketing or advertising spend. Can you convert somebody to the point where they will come to your physical location? And we're getting good results in that regard. Looking into the fourth quarter, we'll probably see another decline in marketing spend, probably not to this degree, quite frankly, that we saw in the third quarter, but in the fourth quarter, we expect to be down year-over-year. And again, that's just a part of what we're seeing as the result of a mix change there. And then other cost adjustments that we mentioned, some of the optimization efforts, we'll start to see some of that bleed in, not a bunch in the fourth quarter but definitely into 2013 to where we get to the end of the year. We hope that we have all of those optimization initiatives fully executed and in effect and reflective in the financial results.

Our next question comes from Timo Connor at William Blair.

At the schools where you're testing out the net cost reduction, what kind of reaction or questions are you getting from existing students? And then how would this -- how might that impact how you think about tuition levels for existing students?

I appreciate the question. I'll have to say that it's relatively recent in the implementation. Literally, we're talking about a week, not even a full week quite frankly. So the ink's not yet dry on the paper here, and the feedback at this point is probably not relevant. But nothing unexpected. I think we need another week or 2 before we can really start thinking about it, but it's just very, very early on in the process. So unfortunately, I don't have a lot of good color I can give you on that regard.

Well, I guess, quick follow-up, so what -- does any of this change how you're thinking about tuition levels for existing students? Any other changes that you're talking about for net cost reductions for new students?

I think you mean for current students, and what we're talking about doing here is really changing this construct across the entire census. So it's not just for new students, as our students are -- basically this is -- the change is initiated by the packaging process, so when a student comes through and gets packaged, they get packaged when they initially start, and then they get repackaged 9 months later. And so as students are repackaged, they'll be repackaged with this new construct in play. So it'll sort of work its way through the system if, in fact, it's successful. So with the current schools that have it, they're working with students and any students that are existing that are getting repackaged.

[Operator Instructions] And our next question comes from Paul Ginocchio at Deutsche Bank.

Kevin, I just wanted to go back to my previous question. I didn't ask you correctly. Just I'm looking for recent grads and students about to graduate, what their average loan balance is for just ITT internal loans and PEAK are all private loans. Just what's the balance of all those, so we can better -- excluding the federal loans?

Yes, thanks, Paul. Unfortunately, we don't break out that detail because of the NDAs that we have in place with the various third-party lenders, so it's -- yes, we're not able to give that kind of information unfortunately. You probably could back into it a little bit. I would just say this much that the majority of the students are going to fully exhaust all of their Title IV before they would ever enter into a private lending program. So you could take some rough estimates, 85% -- 80% to 85% of the students are associate degree level. You can look at the availability of lending for Title IV programs for the Stafford loan. See what that cap is in our typical student profile as an independent student. So that'll kind of aid in your thinking in that regard. And then you can kind of back into it in terms of that $26,000 to $27,000 median number that is all inclusive. But again, we can't speak to the specifics of what it is for just the third-party programs due to the non-disclosure agreements.

And one very minor point, the -- we really don't have any internal institutional loans. So if somebody did not get a private loan, it is just credit. It's not been formalized into an interest-bearing loan.

Our next question comes from at Alex Paris with Barrington Research.

Just a clean-up question or 2. I did called away from this call, so I might have missed it. But did you comment at all on plans for share purchases. I noticed that you didn't repurchase anything in the third quarter. Yet, you repurchased 3 million shares for the first 2 quarters. And then the second question is related to revenue per student. Should we anticipate a similar increase in the fourth quarter? That's all.

Thanks, Alex. So we did not comment on either of those, so allow us to do that now. Our fourth quarter -- or let's just say the 2012 revised internal goals that we provided this morning do not include any additional share repurchases. And then from a revenue per student perspective, we talked before about our expectation that for the full year, we expect to end in the range of around 3%. And we continue to think that, that'll be the case for the revenue per student.

That's all the time we have for questions today. I would like to turn the conference back over to Kevin Modany for closing remarks.

Operator, thank you, and thank you, everyone, for your time today. We appreciate your questions and look forward to talking to you in our January 2013 conference call. Thank you again. Have a great day.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.