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We have downgraded our rating on Capella Education Company from Neutral to Underperform on a weak outlook for the year.

Capella’s first-quarter 2012 earnings of 82 cents per share were down approximately 15% from adjusted earnings of 97 cents per share in the first quarter of 2011 due to top-line and margin decline. However, the first quarter earnings surpassed the Zacks Consensus Estimate of 78 cents. Quarterly revenues of $109.4 million fell 1.8% from $111.4 million in the year-ago quarter due to a decline in new enrollment. However, revenues exceeded the Zacks Consensus Estimate of $105.0 million.

The company has been witnessing volatile enrollment growth since the last few quarters. In 2011, and in the first quarter of 2012, the company witnessed declining new enrollment growth which in turn hurt total enrollments, revenues, cash flows and profitability. Enrollment growth was affected by tough overall market conditions.

In order to improve overall enrollment growth, 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. However, these initiatives have not significantly improved enrollments yet and management does not expect to see any positive enrollment growth for the rest of 2012. This strategy is hurting margins due to increased marketing and promotional spend.

In the second quarter too, the company is expecting a 1%–2% year-on-year decline in revenues due to an expected total enrollment decline between 6% and 7% and new enrollment decline in the high single digits. Operating margins are also expected to be down from the prior-year level. In fact, the company does not expect to see positive enrollment growth in any quarter of 2012 and believes achieving its operating goal of at least 15% annual operating margins is challenging in 2012. The weak outlook is the principal reason behind the downgrade.

Moreover, the highly regulated nature of postsecondary education in the US also remains a consistent overhang. The regulations and policies of the Department of Education, state education agencies, and the accrediting agencies change frequently. Changing regulatory requirements are taking a beating on enrollment growth for most education companies like ITT Educational Services Inc. , DeVry Inc. , Apollo Group Inc. , Universal Technical Institute Inc. and many more.

Capella derives a significant portion of its revenues from federal student financial aid programs, referred to as Title IV programs, which are administered by the Department of Education. A significant percentage of the company’s students rely on the Title IV program funds to meet the cost of their education.

Educational institutions are increasingly under the scanner due to the rise in abuse of Title IV funds.  The Department of Education has proposed that an educational program could only qualify for Title IV funds if it helps in achieving gainful employment, which includes the criteria of loan repayment rate and debt-to-income ratios. Educational institutions are now being asked to submit information relating to recruitment procedures and the use of student grants.

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