UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

(Mark One)
ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2004
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from             to
Commission file number     1-13144

 

ITT EDUCATIONAL SERVICES, INC.

(Exact name of registrant as specified in its charter)

 

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.                              Yes      o      No      ý

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).                              Yes      ý      No      o

 

45,937,076

 

Number of shares of Common Stock, $.01 par value, outstanding at September 30, 2004

 

 

ITT EDUCATIONAL SERVICES, INC.

Carmel, Indiana

 

Quarterly Report to Securities and Exchange Commission

September 30, 2004

 

PART I

FINANCIAL INFORMATION

 

Item 1.  FINANCIAL STATEMENTS.

 

INDEX

 

Consolidated Statements of Income (unaudited) for the three and nine months ended September 30, 2004 and 2003
Consolidated Balance Sheets as of September 30, 2004 and 2003 (unaudited) and December 31, 2003
Consolidated Statements of Cash Flows (unaudited) for the three and nine months ended September 30, 2004 and 2003
Consolidated Statements of Shareholders’ Equity for the three months ended March 31, 2004, June 30, 2004 and September 30, 2004 (unaudited) and the year ended December 31, 2003
Notes to Consolidated Financial Statements

 

1

 

ITT EDUCATIONAL SERVICES, INC.

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

(unaudited)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Revenues		$	157,945		$	134,382		$	450,606		$	378,213
Costs and Expenses
Cost of educational services		75,033			69,681			229,536			210,463
Student services and administrative expenses		43,771			39,495			130,265			113,417
Special legal and other investigation costs		9,837			—			25,143			—
Total costs and expenses		128,641			109,176			384,944			323,880
Operating income		29,304			25,206			65,662			54,333
Interest income, net		959			551			2,316			1,549
Income before income taxes		30,263			25,757			67,978			55,882
Income taxes		11,803			9,916			26,512			21,514
Net income		$	18,460		$	15,841		$	41,466		$	34,368
Earnings per common share (basic):		$	0.40		$	0.35		$	0.91		$	0.76
Earnings per common share (diluted):		$	0.39		$	0.34		$	0.89		$	0.75

 

The accompanying notes are an integral part of these financial statements.

 

2

 

ITT EDUCATIONAL SERVICES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

 

		September 30, 2004			December 31, 2003			September 30, 2003
		(unaudited)						(unaudited)
Assets
Current assets
Cash and cash equivalents		$	166,702		$	168,273		$	159,749
Restricted cash		—			8,496			—
Short-term investments		145,719			63,938			37,912
Accounts receivable, net		14,041			9,398			9,943
Deferred and prepaid income tax		4,842			2,906			2,950
Prepaids and other current assets		5,572			3,635			4,409
Total current assets		336,876			256,646			214,963
Property and equipment, net		92,515			81,503			78,910
Direct marketing costs		13,813			10,844			10,470
Investments		3,275			13,467			6,455
Other assets		989			810			811
Total assets		$	447,468		$	363,270		$	311,609
Liabilities and Shareholders’ Equity
Current liabilities
Accounts payable		$	48,148		$	36,543		$	41,297
Accrued compensation and benefits		17,499			16,986			13,925
Other accrued liabilities		29,866			18,444			16,146
Deferred revenue		136,094			130,364			110,087
Total current liabilities		231,607			202,337			181,455
Deferred income tax		4,814			4,691			2,714
Minimum pension liability		7,012			7,012			8,041
Other liabilities		3,020			3,106			2,582
Total liabilities		246,453			217,146			194,792
Shareholders’ equity
Preferred stock, $.01 par value, 5,000,000 shares authorized, none issued or outstanding		—			—			—
Common stock, $.01 par value, 150,000,000 shares authorized, 54,068,904 issued and outstanding		540			540			540
Capital surplus		58,866			52,688			49,838
Retained earnings		260,241			221,400			199,956
Accumulated other comprehensive (loss)		(4,263		)	(4,263		)	(4,888		)
Treasury stock, 8,131,828, 8,638,535 and 8,798,609 shares, at cost		(114,369		)	(124,241		)	(128,629		)
Total shareholders’ equity		201,015			146,124			116,817
Total liabilities and shareholders’ equity		$	447,468		$	363,270		$	311,609

 

The accompanying notes are an integral part of these financial statements.

 

3

 

ITT EDUCATIONAL SERVICES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Cash flows provided by (used for) operating activities:
Net income		$	18,460		$	15,841		$	41,466		$	34,368
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,920			4,787			13,708			15,800
Provision for doubtful accounts		2,803			1,482			7,704			5,024
Deferred taxes		(52		)	(1,006		)	(1,812		)	(4,452		)
Increase/decrease in operating assets and liabilities:
Short-term investments		(6,895		)	(7,687		)	4,448			5,796
Accounts receivable		(5,524		)	(3,103		)	(12,347		)	(5,994		)
Direct marketing costs		(887		)	148			(2,969		)	139
Accounts payable and accrued liabilities		732			1,094			23,453			32,518
Prepaids and other assets		1,308			1,188			(2,116		)	1,625
Deferred revenue		13,573			15,060			5,730			7,090
Net cash provided by (used for) operating activities		27,438			27,804			77,265			91,914
Cash flows provided by (used for) investing activities:
Facility and land purchases		(1,837		)	(3,766		)	(8,635		)	(21,069		)
Capital expenditures, net		(6,134		)	(5,046		)	(16,085		)	(11,057		)
Proceeds from maturities of held-to-maturity investments		87,420			—			146,622			—
Purchase of held-to-maturity investments		(127,888		)	(24,492		)	(222,659		)	(24,492		)
Net cash provided by (used for) investing activities		(48,439		)	(33,304		)	(100,757		)	(56,618		)
Cash flows provided by (used for) financing activities:
Purchase of treasury stock		—			—			—			(28,726		)
Exercise of stock options		4,376			9,037			13,425			22,142
Net cash provided by (used for) financing activities		4,376			9,037			13,425			(6,584		)
Net increase (decrease) in cash, cash equivalents and restricted cash		(16,625		)	3,537			(10,067		)	28,712
Cash, cash equivalents and restricted cash at beginning of period		183,327			156,212			176,769			131,037
Cash, cash equivalents and restricted cash at end of period		$	166,702		$	159,749		$	166,702		$	159,749

 

The accompanying notes are an integral part of these financial statements.

 

4

 

ITT EDUCATIONAL SERVICES, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(In thousands)

 

		Common Stock					Capital Surplus			Retained Earnings			Compre- hensive Income			Accumulated Other Compre- hensive Income (Loss)			Treasury Stock					Total
		Shares		Amount															Shares		Amount
Balance as of December 31, 2002		54,069		$	540		$	40,393		$	184,409					$	(4,888	)	(8,986	)	$	(131,430	)	$	89,024
Exercise of stock options										(21,867		)							1,425		35,906			14,039
Tax benefit from exercise of stock options							12,295																	12,295
Purchase of treasury stock																			(1,078	)	(28,726		)	(28,726		)
Issue treasury stock for board of directors plan																			1		9			9
Comprehensive income:
Net income for 2003										58,858			$	58,858										58,858
Other comprehensive income, net of tax:
Minimum pension liability adjustment													625			625								625
Other comprehensive income													625
Comprehensive income													$	59,483
Balance as of December 31, 2003		54,069		540			52,688			221,400						(4,263		)	(8,638	)	(124,241		)	146,124
For the three months ended March 31, 2004 (unaudited):
Exercise of stock options							150			(2,029		)							285		6,114			4,235
Tax benefit from exercise of stock options							4,259																	4,259
Net income										9,026														9,026
Balance as of March 31, 2004		54,069		540			57,097			228,397						(4,263		)	(8,353	)	(118,127		)	163,644
For the three months ended June 30, 2004 (unaudited):
Exercise of stock options							28			(74		)							21		394			348
Tax benefit from exercise of stock options							207																	207
Net income										13,980														13,980
Balance as of June 30, 2004		54,069		540			57,332			242,303						(4,263		)	(8,332	)	(117,733		)	178,179
For the three months ended September 30, 2004 (unaudited):
Exercise of stock options							257			(522		)							200		3,364			3,099
Tax benefit from exercise of stock options							1,277																	1,277
Net income										18,460														18,460
Balance as of September 30, 2004		54,069		$	540		$	58,866		$	260,241					$	(4,263	)	(8,132	)	$	(114,369	)	$	201,015

 

The accompanying notes are an integral part of these financial statements.

 

5

 

ITT EDUCATIONAL SERVICES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2004

(Dollar amounts in thousands, unless otherwise stated)

 

1.                                       Basis of Presentation

 

We prepared the accompanying unaudited consolidated financial statements in accordance with generally accepted accounting principles for interim periods.  In the opinion of our management, the financial statements contain all adjustments necessary to present fairly our financial condition and results of operations.  Certain information and footnote disclosures, including significant accounting policies, normally included in a complete presentation of financial statements prepared in accordance with generally accepted accounting principles, have been omitted.  The interim financial statements should be read in conjunction with the audited financial statements and notes thereto contained in our Annual Report on Form 10-K as filed with the Securities and Exchange Commission (“SEC”) for the year ended December 31, 2003.

 

2.                                       Summary of Certain Accounting Principles and Policies

 

Stock Options.  We adopted and our stockholders approved the ITT Educational Services, Inc. 1994 Stock Option Plan and the 1997 ITT Educational Services, Inc. Incentive Stock Plan, and we also established the 1999 Outside Directors Stock Option Plan (collectively, the “Plans”).  We have adopted the disclosure only provisions of Statements of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation. ” Accordingly, no compensation cost has been recognized in the financial statements for the Plans. We have elected, as permitted by the standard, to continue following the intrinsic value based method of accounting for stock options consistent with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees. ” Under the intrinsic method, compensation cost for stock options is measured as the excess, if any, of the quoted market price of our common stock at the measurement date over the exercise price.

 

If compensation costs for the Plans had been determined based on the fair value of the stock options at grant date consistent with SFAS No. 123, our compensation costs would have increased and our net income and earnings per share could have been reduced to the proforma amounts indicated below:

 

			Three Months Ended September 30,						Nine Months Ended September 30,
			2004			2003			2004			2003
Net income as reported			$	18,460		$	15,841		$	41,466		$	34,368
Deduct:	Total stock-based employee compensation expense determined under the fair value based method for stock options, net of tax		(2,233		)	(1,389		)	(6,294		)	(3,880		)
Proforma net income			$	16,227		$	14,452		$	35,172		$	30,488
Earnings per share:
Basic as reported			$	0.40		$	0.35		$	0.91		$	0.76
Basic proforma			$	0.35		$	0.32		$	0.77		$	0.68
Diluted as reported			$	0.39		$	0.34		$	0.89		$	0.75
Diluted proforma			$	0.35		$	0.31		$	0.75		$	0.66

 

6

 

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

 

		Three Months Ended September 30,				Nine Months Ended September 30,
		2004		2003		2004		2003
Risk free interest rates		3.8	%	3.1	%	3.3	%	2.7	%
Expected lives (in years)		5		5		5		5
Volatility		59	%	57	%	58	%	57	%
Dividend yield		None		None		None		None

 

Contingent Liabilities.  We are subject to litigation in the ordinary course of our business.  When we are aware of a claim or potential claim, we assess the likelihood of any loss or exposure.  If it is probable that a loss will result and the amount of the loss can be reasonably estimated, we record a liability for the loss.  The liability recorded includes probable and estimatable legal costs associated with the claim or potential claim.  If the loss is not probable or the amount of the loss cannot be reasonably estimated, we disclose the claim if the likelihood of a potential loss is reasonably possible and the amount involved is material.

 

3.                                       New Accounting Pronouncements

 

In December 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 132 revised (“SFAS No. 132R”), “Employers’ Disclosures about Pensions and Other Postretirement Benefits.”  The provisions of SFAS No. 132R do not change the measurement and recognition provisions of SFAS No. 87, “Employers’ Accounting for Pensions,” SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.”  SFAS No. 132R adds interim period and annual financial statement disclosures.  See Note 8, which presents the additional interim disclosures required by SFAS No. 132R.

 

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.”  FIN 46 clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements” to certain entities in which the equity investors do not have either a controlling financial interest or sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties.  FIN 46 is effective for variable interest entities in which companies hold a variable interest. We do not hold variable interests in variable interest entities and, therefore, FIN 46 does not have an impact on our financial condition or results of operations.

 

In January and May 2004, the FASB issued two staff positions with respect to the application of SFAS No. 106 on the accounting and disclosure requirements related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“Drug Act”).  The Drug Act affects postretirement health care benefits that companies may provide to their employees.  We do not provide any postretirement health care benefits to our employees, and, therefore, those staff positions do not have an impact on our financial condition or results of operation.

 

In June 2004, the FASB’s Emerging Issues Task Force (“EITF”) issued EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.”  EITF 03-1 provides further guidance on the meaning of other-than-temporary impairment and its application to debt and equity securities in accordance with Accounting Principle Board (“APB”) No. 18, “The Equity Method of Accounting for Investments in Common Stock,” and SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.”  EITF 03-1 is effective for all reporting periods beginning after June 15, 2004.  Until further guidance is provided by the FASB, we are unable to determine the effect, if any, that EITF 03-1 will have on our financial condition or results of operations.  See Note 5 for additional disclosures regarding our investments.

 

4.                                       Special Legal and Other Investigation Costs

 

Consistent with our accounting policy for contingent liabilities (pursuant to which we accrue probable legal costs associated with a claim or a potential claim), we recorded a charge of $9,700 in the three months ended March 31, 2004 and $3,000 in the three months ended June 30, 2004 for estimated legal costs associated with the investigation of us being conducted by the U.S. Department of Justice (“DOJ”), the inquiry initiated by the SEC into the allegations being investigated by the DOJ, and the securities class action and shareholder derivative lawsuits filed against us, certain of our current and former executive officers and each of our Directors (collectively, the “Actions”), as described below in Note 10.  We regularly evaluate the reasonableness of our estimate of the probable legal costs associated with the Actions and make any adjustments considered necessary.  As a result of our most recent review of this estimate, we recorded an incremental charge of $8,005 for legal costs associated with the Actions during

 

7

 

the three months ended September 30, 2004.  During the nine months ended September 30, 2004, we were billed $14,595 of those legal costs.  We believe that it is probable that we will incur at least $20,705 in legal costs related to these matters.  Due to the uncertainty regarding the outcomes of these matters, however, we cannot estimate the maximum amount of costs that we could potentially incur with respect to these matters.  In accordance with the financial accounting standards for loss contingencies, we have accrued what we believe to be a reasonable estimate of costs that is probable we will incur.  If our estimate proves to be inadequate, however, it is possible that we could subsequently be required to record a charge to earnings which could have a material adverse effect on our results of operations.

 

We incurred non-legal costs related to the Actions in the amount of $1,832 during the three months ended September 30, 2004 and $4,438 during the nine months ended September 30, 2004.  Those costs were expensed as incurred and primarily included fees charged by our independent registered public accounting firm for the performance of extended audit procedures as a result of the Actions, costs to create an electronic database of all documents seized in connection with the DOJ investigation and other non-legal costs related to the Actions.

 

5.                                       Investments

 

Investments with original maturity dates of less than 90 days are included in cash and cash equivalents and are recorded at cost, which approximates market value.  Investments classified as trading securities that have maturity dates in excess of 90 days at the time of purchase are recorded at their market value and are included in short-term investments.  Investments classified as held-to-maturity include investments that are recorded at their amortized cost.   Short-term investments have maturity dates within one year following the balance sheet date.  Non-current investments have maturity dates between one and three years following the balance sheet date.

 

The cost of securities sold is based on the first-in, first-out method.  All of our investments are in marketable debt securities.

 

		As of September 30, 2004									As of Dec. 31, 2003									As of September 30, 2003
		Trading securities			Held-to-maturity			Total			Trading securities			Held-to-maturity			Total			Trading securities			Held-to-maturity			Total
Cash and cash equivalents		$	166,702		$	—		$	166,702		$	168,273		$	—		$	168,273		$	159,749		$	—		$	159,749
Short-term investments		8,899			136,820			145,719			13,347			50,591			63,938			19,910			18,002			37,912
Non-current investments		—			3,275			3,275			—			13,467			13,467			—			6,455			6,455
		$	175,601		$	140,095		$	315,696		$	181,620		$	64,058		$	245,678		$	179,659		$	24,457		$	204,116

 

As of September 30, 2004, there were no gross unrealized losses on our trading securities.

 

6.                                       Property and Equipment

 

During the three months ended September 30, 2004, we purchased two parcels of land for $1,837 on which we intend to build facilities.  During the nine months ended September 30, 2004, we purchased four parcels of land for $4,850 on which we are building or intend to build facilities, and we purchased one of our facilities for $3,785 that we previously leased under an operating lease agreement.

 

7.                                       Earnings Per Share

 

Earnings per common share for all periods have been calculated in conformity with SFAS No. 128, “Earnings Per Share.”  This data is based on historical net income and the average number of shares of our common stock outstanding during each period.

 

		Average Shares Outstanding
		(in thousands)
		Three Months Ended September 30,				Nine Months Ended September 30,
		2004		2003		2004		2003
Basic		45,871		45,119		45,735		44,988
Diluted		46,743		46,415		46,759		46,126

 

8

 

The difference in the number of shares used to calculate basic and diluted earnings per share represents the average number of shares assumed issued under our stock option plans less shares assumed to be purchased with proceeds from the exercise of those stock options.  Outstanding stock options that have exercise prices greater than the average market price of our common shares (706,000 shares at September 30, 2004 and 1,000 shares at September 30, 2003) have been excluded from the calculation of our earnings per common share, because the effect would be antidilutive.

 

8.                                       Employee Pension Benefits

 

The net periodic benefit costs for the ESI Pension Plan (“Pension Plan”) and the ESI Excess Pension Plan (“Excess Plan”) are as follows:

 

		For the Three Months Ended September 30,						For the Nine Months Ended September 30,
		2004			2003			2004			2003
Service cost		$	1,765		$	1,470		$	5,295		$	4,410
Interest cost		570			444			1,710			1,334
Expected return on assets		(550		)	(393		)	(1,650		)	(1,177		)
Recognized net actuarial loss		250			249			750			745
Amortization of prior service cost		(25		)	(22		)	(75		)	(66		)
Net periodic pension cost		$	2,010		$	1,748		$	6,030		$	5,246

 

In January 2004, we contributed $6,700 to the Pension Plan.  In July 2004, we contributed $2,000 to the Pension Plan, which fulfilled all of our remaining contribution requirements in 2004.  The Excess Plan is a non-qualified, unfunded retirement plan and, therefore, we do not currently plan to make any contributions to it in 2004.

 

9.                                       Letter of Credit

 

During the nine months ended September 30, 2004, we provided a $7,000 irrevocable standby letter of credit to one of our insurers to secure the surety bonds issued by that insurer which are required as part of our normal course of operations by various education authorities that regulate us.  The letter of credit is collateralized by our investments.  As of September 30, 2004, the total face value of those surety bonds was $11,319.

 

10.                                 Contingencies

 

We are subject to litigation in the ordinary course of our business. When we are aware of a claim or potential claim, we assess the likelihood of any loss or exposure.  If it is probable that a loss will result and the amount of the loss can be reasonably estimated, we record a liability for the loss.  The liability recorded includes probable and estimatable legal costs associated with the claim or potential claim.  If the loss is not probable or the amount of the loss cannot be reasonably estimated, we disclose the claim if the likelihood of a potential loss is reasonably possible and the amount involved is material.

 

Among the legal actions currently pending is United States ex rel. Dan Graves and Susan Newman v. ITT Educational Services, Inc., et al.  This action is a qui tam action that was filed on November 5, 1999 in the United States District Court for the Southern District of Texas by two former employees (“relators”) on behalf of themselves and the federal government (the “Qui Tam Action”).  The Qui Tam Action alleges, among other things, violations of the False Claims Act, 31 U.S.C. § 3730, by us, one of our employees and our registered public accounting firm in connection with how we compensated our sales representatives. The relators seek various forms of recovery on behalf of themselves and the federal government, including: (a) treble the amount of unspecified damages sustained by the federal government; (b) a civil penalty of up to $10 for each violation of the False Claims Act; (c) double back pay for Susan Newman; and (d) attorney’s fees, costs and interest.

 

A qui tam action is a civil lawsuit brought by one or more individuals (a qui tam “relator”) on behalf of the federal or state government for an alleged submission to the government of a false claim for payment.  A qui tam action is always filed under seal and remains under seal until the government decides whether to intervene in the litigation.  Whenever a relator files a qui tam action, the government typically initiates an investigation in order to determine whether to intervene in the litigation.  If the government intervenes, it has primary control over the litigation.  If the government declines to intervene, the relator may pursue the litigation on behalf of the federal or state government and, if successful, receives a portion of the government’s recovery.

 

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On May 25, 2001, the DOJ declined to intervene in the Qui Tam Action. On March 31, 2002, the court dismissed all of the claims against all of the defendants for failure to allege facts sufficient to support the claims and gave the relators 20 days to file an amended complaint. The relators filed an amended complaint on April 22, 2002 against all of the defendants. On March 31, 2003, the court issued a final judgment in the Qui Tam Action dismissing with prejudice all of the relators’ claims against us and all of the other defendants for failure to state a claim.  On April 28, 2003, the relators filed a notice of appeal to the United States Court of Appeals for the Fifth Judicial Circuit.  The oral argument before the appellate court on the relators’ appeal occurred on October 4, 2004.  On October 20, 2004, the appellate court affirmed the district court’s judgment that dismissed with prejudice all of the relators’ claims against us and the other defendants in the Qui Tam Action.

 

On February 25, 2004, federal agents executed search warrants at our corporate headquarters and at ten of our 77 ITT Technical Institutes nationwide.  On that same date, our Directors and executive officers and some of our other employees each received a federal grand jury subpoena that was issued, along with the search warrants, by the U.S. District Court, Southern District of Texas, located in Houston, Texas.  The search warrants and subpoenas seek broad categories of documents, including documents containing information relating to our figures and rates for placement, retention, graduation and attendance, recruitment and admissions materials, student grades, graduate salaries, transferability of credits to other institutions, and personnel records.  Although no formal charges have been filed, we believe that the DOJ is investigating claims alleging, among other matters, falsification of records relating to student attendance, grades and academic progress and graduate job placement statistics, and fraudulent misrepresentations regarding the transferability of credits.  We, our Directors and our executive officers are continuing to work with the DOJ to resolve its investigation.  The costs that we have incurred in connection with the DOJ investigation have had a material adverse effect on our financial condition and results of operations, and there can be no assurance that the ultimate outcome of the DOJ investigation will not have a further material adverse effect on our financial condition and results of operations.

 

On March 4, 2004, we were notified by the Fort Worth, Texas regional office of the SEC that it has initiated an inquiry into the allegations being investigated by the DOJ as described in the preceding paragraph.  We are cooperating with the SEC in its inquiry.  There can be no assurance, however, that the ultimate outcome of the SEC inquiry will not have a material adverse effect on our financial condition or results of operations.

 

In October 2002, the Office of the Attorney General for the State of California (“CAG”) informed us that it had initiated an investigation of our ITT Technical Institutes in California.  We believe that the CAG’s investigation is in response to one or more qui tam actions filed against us under the state and/or federal False Claims Acts.  The CAG has not asserted any claims against us, and we have not been informed of the specific matters that the CAG is investigating.  Based on the information that the CAG has requested, however, we believe that the CAG is investigating, among other matters, whether one or more of our California ITT Technical Institutes:

 

•                  falsified records relating to student attendance, grades and academic progress;

•                  falsified student grade point average calculations used to qualify students for financial aid under the State’s Cal Grant Program; and

•                  retaliated against employees who may have complained about those alleged acts.

 

We are cooperating with the CAG in its investigation, and we have been conducting our own investigation of the same matters.  While we cannot assure you of the ultimate outcome of the CAG investigation, based on the results of our investigation to date, we do not believe that the CAG investigation and any qui tam actions that may be associated with the investigation will have a material adverse effect on our financial condition, results of operations or cash flows.

 

On August 19, 2004, a consolidated complaint in a securities class action lawsuit was filed against us and 10 of our current and former Directors and executive officers in the United States District Court for the Southern District of Indiana under the following caption: City of Austin Police Retirement System, Individually And On Behalf Of All Others Similarly Situated v. ITT Educational Services, Inc., et al.  This action is a result of the Court’s June 18, 2004 order to consolidate 13 separate securities class action lawsuits filed from February 26, 2004 through April 23, 2004.  The consolidated complaint alleges, among other things, that the defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “1934 Act”), and Rule 10b-5 promulgated thereunder, by engaging in an unlawful course of conduct, pursuant to which the defendants knowingly or recklessly engaged in acts, transactions, practices and courses of business to conceal adverse material information about our financial condition, and that this conduct operated as a fraud and deceit upon the plaintiffs.  The complaint also alleges that the defendants made various deceptive and untrue statements of material facts and omitted to state material facts necessary in order to

 

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make the statements made, in light of the circumstances under which they were made, not misleading to the plaintiffs, causing the plaintiffs to purchase our securities at artificially inflated prices.  The putative class period in this action is from October 17, 2002 through March 8, 2004.  The plaintiffs seek, among other things, an award of unspecified compensatory damages, interest, costs, expenses and attorney’s fees.  All of the defendants intend to defend themselves vigorously against the allegations made in the complaint.  There can be no assurance, however, that the ultimate outcome of this or other actions (including other actions under federal or state securities laws) will not have a material adverse effect on our financial condition or results of operations.

 

On or about April 29, 2004, a consolidated complaint in a shareholder derivative lawsuit was filed against five of our current and former executive officers, 10 of our current and former Directors and PricewaterhouseCoopers LLP (“PWC”), our independent registered public accounting firm, in the Superior Court of Hamilton County, Indiana under the following caption: In Re ITT Educational Services, Inc. Derivative Litigation.  This action is a result of the Court’s March 30, 2004 order to consolidate two separate shareholder derivative lawsuits filed on or about February 27, 2004.  The consolidated complaint alleges, among other things, that:

 

•                  certain individual defendants breached a fiduciary duty by selling our common stock and misappropriating our information;

•                  all defendants breached their fiduciary duties to us, abused their ability to control and influence us, grossly mismanaged us, caused us to waste corporate assets and were unjustly enriched; and

•                  PWC breached a duty of care and professional competence to us and breached its contracts with us.

 

The consolidated complaint seeks unspecified damages, extraordinary equitable and/or injunctive relief, disgorgement of profits, benefits and other compensation, costs and attorneys’ fees.  All of the individual defendants intend to defend themselves vigorously against the allegations in the complaint.

 

On September 7, 2004, a shareholder derivative lawsuit was filed against five of our current and former executive officers, 10 of our current and former Directors and PWC, in the United States District Court for the Southern District of Indiana under the following caption: Alaska Electrical Pension Fund Derivatively on Behalf of ITT Educational Services, Inc. v. Rene R. Champagne, et al.  The complaint alleges, among other things, that the defendants caused us to violate state and federal education finance laws and regulations by falsifying our student records and federal securities laws by falsifying our accounting, auditing and financial reporting between October 2002 and April 2004.  As a result, the complaint alleges, among other things, that the individual defendants:

 

•                  breached and/or aided and abetted in the breach of:

•                  a duty to disseminate accurate information about us;

•                  fiduciary duties of care, candor and loyalty to us and disclosure to our shareholders;

•                  a duty to test, oversee and monitor our system of internal controls, governance procedures and disclosure procedures; and

•                  a duty to ensure that our internal controls, governance procedures and disclosure procedures were functioning in an effective manner and in compliance with Pub. L. 107-204, 116 Stat. 745 (2002);

•                  abused their ability to control and influence us;

•                  grossly mismanaged us;

•                  committed constructive fraud;

•                  will be and have been unjustly enriched at our expense; and

•                  violated Section 10(b) of the 1934 Act and Rule 10-5 promulgated thereunder by:

•                  disseminating or approving false statements that they knew or recklessly disregarded were misleading;

•                  failing to disclose material facts necessary in order to make those statements not misleading; and

•                  misappropriating our proprietary information.

 

In addition, the complaint alleges, among other things, that PWC:

 

•                  violated Section 10(b) of the 1934 Act and Rule 10b-5 promulgated thereunder by:

•                  disseminating or approving false statements that it knew or recklessly disregarded were misleading; and

•                  failing to disclose material facts necessary in order to make those statements not misleading;

•                  was negligent and committed accounting malpractice by failing to conduct its audits of our 2002 and 2003 fiscal year financial statements in accordance with generally accepted accounting principles, generally accepted auditing standards and SEC rules;

•                  aided and abetted the individual defendants’:

 

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•                  breach of fiduciary duties to us;

•                  abuse of their control of us; and

•                  gross mismanagement of us; and

•                  violated their duty of candor to our shareholders.

 

The complaint seeks unspecified damages, extraordinary equitable and/or injunctive relief, punitive damages, costs and expenses, attorneys’ fees, pre-judgment interest, an order directing the defendants to account for all damages caused by them and all profits, special benefits and unjust enrichment they obtained, and an order directing us to reform and improve our corporate governance and internal control procedures.  All of the individual defendants intend to defend themselves vigorously against the allegations in the complaint.

 

Although the derivative actions are brought nominally on behalf of us, we expect to incur defense costs and other expenses in connection with the derivative lawsuits, and there can be no assurance that the ultimate outcome of these or other actions will not have a material adverse effect on our financial condition or results of operations.

 

On July 7, 2004, we received a derivative demand letter pursuant to Del. Ct. Ch. R. 23.1 on behalf of a purported shareholder demanding that our Board of Directors commence a civil action against each of our current directors, one former director and four of our current and former executive officers to recover for our benefit the amount of damages sustained by us as a result of the misconduct alleged in the letter.  The misconduct alleged in the letter is similar to the type of misconduct alleged against the individual defendants in the consolidated shareholder derivative lawsuit described above.  The demand letter indicates that the purported shareholder named therein will commence a shareholder’s derivative action on our behalf, if our Board does not commence an action as demanded therein within a reasonable period of time.  We have informed the purported shareholder that, because of other events, we have been conducting an extensive investigation of the same matters referred to in the demand letter and will consider what, if any, claims should be brought against any of the individuals identified in the letter after our investigation is completed.

 

The current and former executive officers named in one or more of the securities class action and shareholder derivative lawsuits and derivative demand letter described above include: Gene A. Baugh, Rene R. Champagne, Clark D. Elwood, Eugene W. Feichtner, Martin A. Grossman, Thomas W. Lauer, Kevin M. Modany and Omer E. Waddles.

 

Certain of our current and former officers and Directors are or may become a party in certain of the actions described above. Our By-laws and Restated Certificate of Incorporation obligate us to indemnify our officers and Directors to the fullest extent permitted by Delaware law, provided that their conduct complied with certain requirements. We are obligated to advance defense costs to our officers and Directors, subject to the individual’s obligation to repay such amount if it is ultimately determined that the individual was not entitled to indemnification. In addition, our indemnity obligation can, under certain circumstances, include indemnifiable judgments, penalties, fines and amounts paid in settlement in connection with those actions.

 

As previously disclosed, on March 4, 2004, our Board of Directors appointed a Special Committee of independent Directors.  The Special Committee has completed its investigation relating to the conduct and integrity of our senior management.  In late June 2004, the Special Committee reported to our Board of Directors that it had found no evidence that our senior management had engaged in any violations of our policies and procedures or any wrongful or criminal conduct related to the matters that are the subject of the DOJ and CAG investigations and the securities class action lawsuit described above.  The Special Committee also reported that when allegations of possible violations have been brought to the attention of our senior management, we have investigated those allegations and our senior management has taken appropriate action when responding to those allegations and any violations found.

 

Item 2.                       MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

This management’s discussion and analysis of financial condition and results of operations should be read in conjunction with the same titled section contained in our Annual Report on Form 10-K as filed with the SEC for the year ended December 31, 2003 for discussion of, among other matters, the following items:

 

•            Cash receipts from financial aid programs

•            Nature of capital additions

•            Seasonality of revenues

 

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•            Components of income statement captions

•            Federal regulations regarding:

•                  Timing of receipt of funds from the federal student financial aid programs under Title IV of the Higher Education Act of 1965, as amended (the “Title IV Programs”)

•                  Percentage of applicable revenues that may be derived from the Title IV Programs

•                  Return of Title IV Program funds for withdrawn students

•                  Default rates

•            Private loan programs

•            Repurchased shares of our common stock

•            Minimum pension liability

•            Our hybrid education delivery model, pursuant to which certain program courses are taught in residence on campus and others are taught online over the Internet (the “Hybrid Delivery Model”)

 

Among the factors that could cause our actual results to differ materially include the Actions, as described in Note 10 of the Notes to Consolidated Financial Statements set forth elsewhere in this report.  The effects of the DOJ investigation of us could result in monetary fines or penalties or other sanctions imposed on us, including our loss of eligibility to participate in student financial aid programs, that could materially adversely affect our financial condition and operations.  The results of the SEC inquiry into the allegations being investigated by the DOJ could result in the restatement of our financial statements, monetary fines or penalties or other sanctions that could materially adversely affect our financial condition and operations.  The results of the securities class action and shareholder derivative lawsuits filed against us, if adversely determined, could have a material adverse effect on our financial condition and results of operations.

 

Critical Accounting Policies and Estimates

 

This management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in conformity with generally accepted accounting principles.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses and contingent assets and liabilities.  Actual results may differ from those estimates and judgments under different assumptions or conditions.

 

We believe the following critical accounting policies affect our more significant estimates and judgments used in the preparation of our consolidated financial statements.  These policies should be read in conjunction with Note 1 of the Notes to Consolidated Financial Statements contained in our Annual Report on Form 10-K as filed with the SEC for the year ended December 31, 2003.

 

Property and Equipment. We include all property and equipment in the financial statements at cost and make provisions for depreciation of property and equipment using the straight-line method.  Estimated useful lives generally range from three to ten years for our furniture and equipment, three to 14 years for leasehold improvements, 20 to 40 years for the buildings and three to eight years for capitalized software.  Changes in circumstances, such as changes in our curricula and technological advances, may result in the actual useful lives of our property, equipment and capitalized software differing from our estimates.  We regularly review and evaluate the estimated useful lives of our property and equipment and capitalized software.  Although we believe our assumptions and estimates are reasonable, deviations from our assumptions and estimates could produce a materially different result.

 

Recognition of Revenues. Tuition revenues are recorded on a straight-line basis over the length of the applicable course.  If a student withdraws from an institute, the standards of most state education authorities that regulate our institutes, the accrediting commission that accredits our institutes and our own internal policy limit a student’s obligation for tuition and fees to the institute depending on when the student withdraws during an academic quarter (“Refund Policies”).  The terms of the Refund Policies vary by state, and the limitations imposed by the Refund Policies are generally based on the portion of the academic quarter that has elapsed at the time the student withdraws. The greater the portion of the academic quarter that has elapsed at the time the student withdraws, the greater the student’s obligation is to the institute for the tuition and fees related to that academic quarter.  We record revenues net of any refunds paid as a result of any applicable Refund Policy.  On an individual student basis, tuition earned in excess of cash received is recorded as accounts receivable, and cash received in excess of tuition earned is recorded as deferred revenue.

 

The cost of the textbooks is amortized on a straight-line basis over the applicable course length and the deferral of textbook costs is recorded in prepaids and other current assets.  Academic fees (which are charged only one time to students on their first day

 

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of class attendance) and admission processing fees (which were charged only one time to students upon being evaluated for admission to their programs of study) are recognized as revenue on a straight-line basis over the average course length of 24 months.  If a student withdraws from an institute, all unrecognized revenue relating to his or her fees, net of any refunds paid as a result of any applicable Refund Policy, is recognized upon the student’s departure.

 

More than 95% of our revenues represent tuition charges and less than 5% of our revenues represent bookstore sales and student fees.  The amount of tuition earned depends on the cost per credit hour of the courses in the program, the number of courses in the program, how long a student remains enrolled in the program, how many program courses a student takes during each period of enrollment in the program, and the total number of students enrolled in each program.  Each of these factors is known at the time our tuition revenues are calculated and is not subject to estimation.

 

Direct Marketing Costs. Direct costs incurred relating to the enrollment of new students are capitalized using the successful efforts method. Direct marketing costs subject to capitalization include salaries and employee benefits of recruiting representatives and other direct costs less admission processing fees. Successful efforts is the ratio of students enrolled to prospective students interviewed. The higher the rate of interviewed students who enroll, the greater the percentage of our direct marketing costs that are capitalized.  We amortize our direct marketing costs on a cost-pool-by-cost-pool basis over the period that we expect to receive revenue streams associated with those assets.  The direct costs subject to capitalization are readily quantifiable and are not subject to estimation.  The amortization method is based on historical trends of student enrollment and retention activity and is not subject to significant assumptions.  We regularly evaluate the future recoverability of these deferred costs.

 

Contingent Liabilities.  We are subject to litigation in the ordinary course of our business. When we are aware of a claim or potential claim, we assess the likelihood of any loss or exposure.  If it is probable that a loss will result and the amount of the loss can be reasonably estimated, we record a liability for the loss.  If it is probable that we will incur legal costs associated with a claim or potential claim, we (a) accrue the amount of legal costs that can be reasonably estimated, (b) regularly evaluate the reasonableness of our estimate and (c) make adjustments thereto that we determine to be appropriate.  If the loss is not probable or the amount of the loss cannot be reasonably estimated, we disclose the claim if the likelihood of a potential loss is reasonably possible and the amount involved is material.  See Note 4 of the Notes to Consolidated Financial Statements set forth elsewhere in this report regarding the estimated legal costs associated with the Actions.

 

New Accounting Pronouncements

 

In December 2003, the FASB issued SFAS No. 132 revised (“SFAS No. 132R”), “Employers’ Disclosures about Pensions and Other Postretirement Benefits.”  The provisions of SFAS No. 132R do not change the measurement and recognition provisions of SFAS No. 87, “Employers’ Accounting for Pensions,” SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.”  SFAS No. 132R adds interim period and annual financial statement disclosures.  See Note 8 of the Notes to Consolidated Financial Statements set forth elsewhere in this report, which presents the additional interim disclosures required by SFAS No. 132R.

 

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.”   FIN 46 clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements” to certain entities in which the equity investors do not have either a controlling financial interest or sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties.  FIN 46 is effective for variable interest entities in which companies hold a variable interest. We do not hold variable interests in variable interest entities and, therefore, FIN 46 does not have an impact on our financial condition or results of operations.

 

In January and May 2004, the FASB issued two staff positions with respect to the application of SFAS No. 106 on the accounting and disclosure requirements related to the Drug Act.  The Drug Act affects postretirement health care benefits that companies may provide to their employees.  We do not provide any postretirement health care benefits to our employees and, therefore, those staff positions do not have an impact on our financial condition or results of operation.

 

In June 2004, the EITF issued EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.”  EITF 03-1 provides further guidance on the meaning of other-than-temporary impairment and its application to debt and equity securities in accordance with APB No. 18, “The Equity Method of Accounting for Investments in Common Stock,” and SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.”  EITF 03-1 is effective for all reporting periods beginning after June 15, 2004.  Until further guidance is provided by the FASB, we are unable to determine the

 

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effect, if any, that EITF 03-1 will have on our financial condition or results of operations.  See Note 5 of the Notes to Consolidated Financial Statements set forth elsewhere in this report, which presents additional disclosures regarding our investments.

 

Results of Operations

 

The following table sets forth the percentage relationship of certain statement of income data to revenues for the periods indicated.

 

		For the Three Months Ended September 30,				For the Nine Months Ended September 30,
		2004		2003		2004		2003
Revenues		100.0	%	100.0	%	100.0	%	100.0	%
Cost of educational services		47.5		51.9		50.9		55.6
Student services and administrative expenses		27.7		29.3		28.9		30.0
Special legal and other investigation costs		6.2		—		5.6		—
Operating income		18.6		18.8		14.6		14.4
Interest income, net		0.6		0.4		0.5		0.4
Income before income taxes		19.2	%	19.2	%	15.1	%	14.8	%

 

The following table sets forth our total student enrollment:

 

		2004				2003
Total Student Enrollment as of:		Total Student Enrollment		Increase Over Prior Year		Total Student Enrollment		Increase Over Prior Year
March 31		38,192		18.2	%	32,313		4.3	%
June 30		38,810		16.0	%	33,443		6.0	%
September 30		42,222		13.6	%	37,159		9.9	%
December 31		Not applicable		Not applicable		37,076		13.6	%

 

The following table sets forth our total new student enrollment:

 

New Student Enrollment		2004				2003
For the Three Months Ended:		New Student Enrollment		Increase Over Prior Year		New Student Enrollment		Increase Over Prior Year
March 31		9,255		28.0	%	7,233		6.1	%
June 30		10,261		18.3	%	8,677		14.6	%
September 30		14,534		14.5	%	12,693		19.1	%
December 31		Not applicable		Not applicable		7,277		27.4	%
Total for the year		Not applicable		Not applicable		35,880		16.6	%

 

For the Nine Months Ended:
September 30		34,050		19.0	%	28,603		14.2	%

 

We generally organize the academic schedule for programs of study offered at our institutes on the basis of four 12-week academic quarters in a calendar year that typically begin in March, June, September and December.  To measure the persistence of our students, the number of continuing students in any academic quarter is divided by the total student enrollment as of the end of the immediate preceding academic quarter.  A continuing student is any student who, in any academic quarter, is enrolled in a program of study at an ITT Technical Institute and was enrolled in the same program at any ITT Technical Institute at the end of the immediate preceding academic quarter.  Total student enrollment includes all new and continuing students enrolled at our ITT Technical Institutes at the end of an academic quarter.

 

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