Attached files

file filename
EX-32.1 - EXHIBIT 32.1 - EDUCATION MANAGEMENT CORPORATIONc00729exv32w1.htm
EX-32.2 - EXHIBIT 32.2 - EDUCATION MANAGEMENT CORPORATIONc00729exv32w2.htm
EX-31.1 - EXHIBIT 31.1 - EDUCATION MANAGEMENT CORPORATIONc00729exv31w1.htm
EX-31.2 - EXHIBIT 31.2 - EDUCATION MANAGEMENT CORPORATIONc00729exv31w2.htm
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: March 31, 2010
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: 001-34466
 
EDUCATION MANAGEMENT CORPORATION
(Exact name of registrant as specified in its charter)
 
     
Pennsylvania   25-1119571
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
     
210 Sixth Avenue, Pittsburgh, PA, 33rd Floor   15222
(Address of principal executive offices)   (Zip Code)
Registrant’s telephone number, including area code: (412) 562-0900
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 þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
             
Large accelerated filer o   Accelerated filer o   Non-accelerated filer þ (Do not check if a smaller reporting company)   Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes o No þ
As of May 11, 2010, 142,849,833 shares of the registrant’s common stock were outstanding.
 
 

 

 


 

Table of Contents
INDEX
         
    PAGE  
 
       
PART I — FINANCIAL INFORMATION
       
 
       
ITEM 1 FINANCIAL STATEMENTS
    2  
 
       
    25  
 
       
    37  
 
       
    38  
 
       
       
 
       
    39  
 
       
    39  
 
       
    41  
 
       
    41  
 
       
    41  
 
       
    41  
 
       
    41  
 
       
    42  
 
       
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2

 

1


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
                         
    March 31,
2010
    June 30,
2009
    March 31,
2009
 
    (Unaudited)             (Unaudited)  
Assets
                       
Current assets:
                       
Cash and cash equivalents
  $ 472,637     $ 363,318     $ 525,710  
Restricted cash
    26,482       10,372       36,177  
 
                 
Total cash, cash equivalents and restricted cash
    499,119       373,690       561,887  
Receivables, net of allowances of $118,246, $83,691 and $79,069
    94,776       122,272       57,131  
Notes, advances and other
    17,457       13,678       21,632  
Inventories
    13,242       9,355       10,635  
Deferred income taxes
    46,320       45,164       27,047  
Other current assets
    44,442       30,163       28,360  
 
                 
Total current assets
    715,356       594,322       706,692  
Property and equipment, net
    634,587       580,965       532,835  
Other long-term assets
    82,168       58,945       57,636  
Intangible assets, net
    468,224       471,882       473,913  
Goodwill
    2,579,131       2,579,131       2,579,131  
 
                 
Total assets
  $ 4,479,466     $ 4,285,245     $ 4,350,207  
 
                 
 
                       
Liabilities and shareholders’ equity
                       
Current liabilities:
                       
Current portion of long-term debt
  $ 12,172     $ 12,622     $ 12,705  
Revolving credit facility
          100,000       180,000  
Accounts payable
    48,150       53,516       35,192  
Accrued liabilities
    187,812       163,485       158,638  
Accrued income taxes
    31,704       5,015       16,061  
Unearned tuition
    89,540       118,741       59,192  
Advance payments
    158,788       67,020       176,335  
 
                 
Total current liabilities
    528,166       520,399       638,123  
Long-term debt, less current portion
    1,529,661       1,876,021       1,879,025  
Deferred income taxes
    178,388       187,583       165,128  
Deferred rent
    154,240       123,656       105,871  
Other long-term liabilities
    66,624       91,933       109,555  
Shareholders’ equity:
                       
Common Stock, par value $0.01 per share; 600,000,000 shares authorized; 142,848,312 issued and outstanding at March 31, 2010 and 119,770,277 issued and outstanding at June 30, 2009 and March 31, 2009
    1,428       1,198       1,198  
Additional paid-in capital
    1,745,512       1,338,316       1,338,316  
Retained earnings
    302,373       181,767       160,488  
Accumulated other comprehensive loss
    (26,926 )     (35,628 )     (47,497 )
 
                 
Total shareholders’ equity
    2,022,387       1,485,653       1,452,505  
 
                 
Total liabilities and shareholders’ equity
  $ 4,479,466     $ 4,285,245     $ 4,350,207  
 
                 
The accompanying notes are an integral part of these consolidated financial statements.

 

2


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
(In thousands except per share amounts)
                                 
    For the Three Months     For the Nine Months  
    Ended March 31,     Ended March 31,  
    2010     2009     2010     2009  
Net revenues
  $ 667,896     $ 535,438     $ 1,857,764     $ 1,491,884  
Costs and expenses:
                               
Educational services
    323,146       268,499       934,125       787,629  
General and administrative
    174,446       129,272       491,608       369,995  
Management fees paid to affiliates
          1,250       32,055       3,750  
Depreciation and amortization
    30,674       28,828       88,902       83,007  
 
                       
Total costs and expenses
    528,266       427,849       1,546,690       1,244,381  
 
                       
Income before interest, loss on early retirement of debt and income taxes
    139,630       107,589       311,074       247,503  
Interest expense, net
    27,933       37,400       94,652       116,014  
Loss on early retirement of debt
    2,445             47,207        
 
                       
Income before income taxes
    109,252       70,189       169,215       131,489  
Provision for income taxes
    24,682       26,062       48,609       48,363  
 
                       
Net income
  $ 84,570     $ 44,127     $ 120,606     $ 83,126  
 
                       
 
 
Earnings per share:
                               
Basic
  $ 0.59     $ 0.37     $ 0.89     $ 0.69  
Diluted
  $ 0.59     $ 0.37     $ 0.89     $ 0.69  
Weighted average number of shares outstanding:
                               
Basic
    142,831       119,770       134,939       119,769  
Diluted
    143,936       119,770       135,675       119,769  
The accompanying notes are an integral part of these consolidated financial statements.

 

3


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(Dollars in thousands)
                 
    For the Nine Months  
    Ended March 31,  
    2010     2009  
Cash flows from operating activities:
               
Net income
  $ 120,606     $ 83,126  
Adjustments to reconcile net income to net cash flows provided by operating activities:
               
Depreciation and amortization of property and equipment
    82,231       69,875  
Bad debt expense
    78,574       52,845  
Amortization of intangible assets
    6,671       13,132  
Amortization of debt issuance costs
    6,127       5,768  
Loss on early retirement of debt
    47,207        
Share-based compensation
    19,428        
Non cash adjustments related to deferred rent
    1,898       (2,045 )
Purchase of private loans
    (51,501 )     (3,235 )
Reimbursements for tenant improvements
    8,229       19,191  
Changes in assets and liabilities:
               
Restricted cash
    (16,110 )     (22,355 )
Receivables
    (39,520 )     (19,057 )
Inventories
    (3,868 )     (2,202 )
Other assets
    (18,325 )     (21,246 )
Accounts payable
    696       (13,369 )
Accrued liabilities
    35,675       48,795  
Unearned tuition
    (29,202 )     (9,962 )
Advance payments
    91,341       115,656  
 
           
Total adjustments
    219,551       231,791  
 
           
Net cash flows provided by operating activities
    340,157       314,917  
 
           
 
               
Cash flows from investing activities:
               
Expenditures for long-lived assets
    (119,825 )     (97,985 )
Reimbursements for tenant improvements
    (8,229 )     (19,191 )
 
           
Net cash flows used in investing activities
    (128,054 )     (117,176 )
 
           
 
               
Cash flows from financing activities:
               
Borrowings under revolving credit facility
          180,000  
Payments under revolving credit facility
    (100,000 )     (120,000 )
Retirement of senior subordinated notes
    (378,952 )      
Net proceeds from issuance of common stock, including stock option exercises
    387,998        
Principal payments on long-term debt
    (9,489 )     (9,715 )
Debt issuance costs
    (2,400 )     (887 )
 
           
Net cash flows (used in) provided by financing activities
    (102,843 )     49,398  
 
           
 
               
Effect of exchange rate changes on cash and cash equivalents
    59       1,163  
 
           
Net change in cash and cash equivalents
    109,319       248,302  
Cash and cash equivalents, beginning of period
    363,318       277,408  
 
           
Cash and cash equivalents, end of period
  $ 472,637     $ 525,710  
 
           
 
               
Cash paid during the period for:
               
Interest (including swap settlement)
  $ 81,734     $ 92,914  
Income taxes
    53,868       47,421  
The accompanying notes are an integral part of these consolidated financial statements.

 

4


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Dollars in thousands)
                                         
                            Accumulated        
    Common     Additional             Other        
    Stock at     Paid-in     Retained     Comprehensive        
    Par Value     Capital     Earnings     Loss     Total  
Balance, June 30, 2008
  $ 1,198     $ 1,338,302     $ 77,362     $ (24,685 )   $ 1,392,177  
 
                             
Comprehensive income:
                                       
Net income
                104,405             104,405  
Foreign currency translation
                      (1,147 )     (1,147 )
Unrealized loss on interest rate swaps, net of tax benefit of $5,709
                      (9,796 )     (9,796 )
 
                                     
Comprehensive income
                                    93,462 (a)
 
                                     
Other
          14                   14  
 
                             
Balance, June 30, 2009
    1,198       1,338,316       181,767       (35,628 )(b)     1,485,653  
 
                             
 
(Unaudited)
                                       
Issuance of common stock including stock option exercises
    230       387,768                   387,998  
Share-based compensation
          19,428                   19,428  
Comprehensive income:
                                       
Net income
                120,606             120,606  
Foreign currency translation
                      1,046       1,046  
Unrealized gain on interest rate swaps, net of tax expense of $4,447
                      7,656       7,656  
 
                                     
Comprehensive income
                                    129,308  
 
                             
Balance, March 31, 2010
  $ 1,428     $ 1,745,512     $ 302,373     $ (26,926 )(b)   $ 2,022,387  
 
                             
     
(a)   During the nine months ended March 31, 2009, other comprehensive loss consisted of a $22.2 million unrealized loss on interest rate swaps, net of tax benefit, and a $0.6 million foreign currency translation loss.
 
(b)   The balance in accumulated other comprehensive loss at March 31, 2010, June 30, 2009 and March 31, 2009 is comprised of $26.5 million, $34.2 million and $46.6 million of unrealized losses on interest rate swaps, net of tax benefit, respectively and $0.4 million, $1.4 million and $0.9 million of cumulative foreign currency translation losses, respectively.
The accompanying notes are an integral part of these consolidated financial statements.

 

5


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
Nature of operations
Education Management Corporation and its subsidiaries (the “Company”) is among the largest providers of post-secondary education in North America, with approximately 136,000 active students as of October 2009. The Company offers education through four different education systems (The Art Institutes, Argosy University, Brown Mackie Colleges and South University) and through online platforms at three of the four education systems. The schools provide students a wide variety of programmatic and degree choices in a flexible learning environment. The curriculum is designed with a distinct emphasis on applied career-oriented content and is primarily taught by faculty members that possess practical and relevant professional experience in their respective fields.
Basis of presentation
The accompanying unaudited consolidated financial statements of the Company have been prepared by management in accordance with generally accepted accounting principles for interim financial information and applicable rules and regulations of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States for annual financial statements. The unaudited consolidated financial statements included herein contain all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary to present fairly the Company’s financial position as of March 31, 2010 and 2009, the statements of operations for the three and nine months ended March 31, 2010 and 2009 and the statements of cash flows for the nine months ended March 31, 2010 and 2009. The statements of operations for the three and nine months ended March 31, 2010 and 2009 are not necessarily indicative of the results to be expected for future periods. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s prospectus dated October 1, 2009 for the fiscal year ended June 30, 2009 as filed with the Securities and Exchange Commission (“SEC”). The accompanying consolidated balance sheet at June 30, 2009 has been derived from the consolidated audited balance sheet included in the prospectus dated October 1, 2009 as filed with the SEC.
On September 30, 2009, the Company’s Board of Directors declared a 4.4737 for one split of the Company’s common stock, which was paid in the form of a stock dividend on September 30, 2009. In connection with this stock split, the Company amended and restated its articles of incorporation to, among other things, increase the Company’s number of authorized shares of common stock. The stock split also resulted in the issuance of approximately 93.0 million additional shares of common stock, increased the number of stock options outstanding and exercisable in all periods presented, changed earnings per share information and resulted in a reclassification of $0.9 million from additional paid-in capital to common stock on the accompanying consolidated balance sheets. All information presented in the accompanying consolidated financial statements and related notes has been adjusted to reflect the Company’s amended and restated articles of incorporation and stock split.
In November 2009, the Company guaranteed the indebtedness of wholly owned subsidiary Education Management LLC (“EM LLC”) and Education Management Finance Corp. (a wholly owned subsidiary of EM LLC) under the 8.75% senior notes due 2014 (the “Senior Notes”) and 10.25% senior subordinated notes due 2016 (the “Senior Subordinated Notes” and, together with the Senior Notes, the “Notes”).
Ownership
On June 1, 2006, the Company was acquired by a consortium of private equity investment funds led by Providence Equity Partners, Goldman Sachs Capital Partners and Leeds Equity Partners (collectively, the “Sponsors”). The acquisition was accomplished through the merger of EM Acquisition Corporation into the Company, with the Company surviving the merger (the “Transaction”). Pursuant to the terms of the merger agreement, all outstanding shares of the Company’s common stock were cancelled in exchange for cash. The Sponsors, together with certain other investors, became the owners of the Company.

 

6


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
The acquisition of the Company was financed by equity invested in EM Acquisition Corporation by the Sponsors and other investors, cash on hand, borrowings under a new senior secured credit facility by EM LLC and the issuance by EM LLC and Education Management Finance Corp. of the Notes.
Initial public offering
In October 2009, the Company completed an initial public offering of 23.0 million shares of common stock, $0.01 par value, at a per share price of $18.00 (the “initial public offering”). Net proceeds to the Company, after transaction costs, totaled approximately $387.3 million. No Sponsor-owned shares were sold in connection with the initial public offering. After the consummation of the initial public offering, the equity funds controlled by the Sponsors owned approximately 69.2% of the Company’s outstanding common stock. Of the net proceeds from the initial public offering, $355.5 million was used to purchase $316.0 million of the Senior Subordinated Notes in a tender offer and $29.6 million was used to terminate a management agreement entered into with the Sponsors in connection with the Transaction.
The Company recognized several non-recurring expenses in the consolidated statement of operations as a direct result of the initial public offering, including a $44.8 million loss related to the early retirement of indebtedness, $15.2 million of previously unrecognized stock-based compensation costs due to the removal of certain conditions that existed related to the option holders’ inability to obtain fair value for stock options, and $29.6 million in advisory fees for the early termination of the management agreement with the Sponsors. In addition, the availability for borrowing under EM LLC’s revolving credit facility increased from $388.5 million to $442.5 million effective upon the closing of the initial public offering.
Seasonality
The Company’s quarterly net revenues and net income fluctuate primarily as a result of the pattern of student enrollments at its schools. The seasonality of the Company’s business has decreased over the last several years due to an increase in the percentage of students enrolling in online programs, which generally experience less seasonal fluctuations than campus-based programs. The Company’s first fiscal quarter is typically its lowest revenue recognition quarter due to student vacations.
Reclassifications
Certain reclassifications of March 31, 2009 data have been made to conform to the March 31, 2010 presentation.
2. RECENT ACCOUNTING PRONOUNCEMENTS
In June 2009, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 168, “The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles (“GAAP”), a replacement of FASB Statement No. 162”. All existing accounting standard documents are superseded by the Codification, which does not change or alter existing GAAP. Since the Company adopted SFAS No. 168 in the first fiscal quarter of 2010, any references to GAAP included in the Company’s historical public filings with the SEC are no longer included in the Company’s filings. The adoption of SFAS No. 168 had no impact on the Company’s consolidated financial statements.

 

7


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
3. EARNINGS PER SHARE
Basic earnings per share (“EPS”) is computed using the weighted average number of shares outstanding during the period. The Company uses the treasury stock method to compute diluted EPS, which assumes that vested restricted stock was converted into common stock and outstanding stock options were exercised and the resultant proceeds were used to acquire shares of common stock at its average market price during the reporting period.
Basic and diluted EPS were calculated as follows (in thousands, except per share amounts):
                                 
    For the Three Months     For the Nine Months  
    Ended March 31,     Ended March 31,  
    2010     2009     2010     2009  
Net income
  $ 84,570     $ 44,127     $ 120,606     $ 83,126  
 
                               
Weighted average number of shares outstanding:
                               
Basic
    142,831       119,770       134,939       119,769  
Effect of stock-based awards
    1,105             736        
 
                       
Diluted
    143,936       119,770       135,675       119,769  
 
                               
Earnings per share:
                               
Basic
  $ 0.59     $ 0.37     $ 0.89     $ 0.69  
Diluted
  $ 0.59     $ 0.37     $ 0.89     $ 0.69  
Time-based options to purchase 1.6 million shares of common stock were outstanding for the three and nine months ended March 31, 2010 but were not included in the computation of diluted EPS because the effect of applying the treasury stock method would have been antidilutive. Because certain performance and market conditions have not been met with respect to the Company’s performance-based options, as further described in Note 4 below, they were determined to be contingently issuable at March 31, 2010. As a result, time-based options that have a dilutive effect were the only options included in the diluted EPS calculation. In addition, all stock options for the fiscal 2009 periods were contingently issuable, and therefore were not included in the computation of diluted EPS in those periods.
4. SHARE-BASED PAYMENT
Upon completion of the initial public offering in October 2009, the Company recognized $15.2 million of previously deferred stock-based compensation costs due to the removal of certain conditions that existed related to the inability of option holders to obtain fair market value for stock options. During the nine months ended March 31, 2010, the Company recognized a total of approximately $19.4 million of stock-based compensation expense, $2.7 million of which was recorded in educational services expense and $16.7 million of which was recorded in general and administrative expense. During the three months ended March 31, 2010, the Company recognized a total of approximately $2.2 million of stock-based compensation expense, $0.3 million of which was recorded in educational services expense and $1.9 million of which was recorded in general and administrative expense. All of the expense recognized in the nine-month period related to time-based options and restricted stock.
Net of estimated forfeitures, the Company had $17.3 million of unrecognized compensation cost relating to time-based stock option and restricted stock awards and $11.6 million of unrecognized compensation cost related to performance-based stock option and other awards at March 31, 2010.
Approximately 60,000 time-based options were exercised during the nine-month period ended March 31, 2010.
2006 Stock Option Plan
In fiscal 2007, the Company’s Board of Directors approved the 2006 Stock Option Plan (the “Option Plan”), which authorized equity awards to be granted for up to approximately 8.3 million shares of the Company’s common stock. Under the Option Plan, certain employees of the Company were granted a combination of time-based and performance-based options to purchase the Company’s common stock.

 

8


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Time-based options vest ratably over the applicable service period, which is generally five years, on each anniversary of the date of grant. Performance-based options vest upon the attainment of specified returns on capital invested in the Company by Providence Equity Partners and Goldman Sachs Capital Partners (together, the “Principal Shareholders”). Time-based and performance-based options also generally vest upon a change in control or realization event, subject to certain conditions, and generally expire ten years from the date of grant.
At March 31, 2010, the Company considered the conditions entitling performance-based option holders to receive fair value for their options to be less than probable. Compensation expense on all performance-based option grants is not recognized until one of the conditions entitling option holders to fair value for exercised options becomes probable. Accordingly, the Company has not recognized compensation expense related to performance-based options granted since the Transaction.
Omnibus Long-Term Incentive Plan
In April 2009, the Company’s Board of Directors adopted the Omnibus Long-Term Incentive Plan (the “Omnibus Plan”), which became effective upon the completion of the initial public offering. Approximately 6.4 million shares of common stock have been reserved for issuance under the Omnibus Plan, which may be used to issue stock options, stock-option appreciation rights, restricted stock, restricted stock units and other forms of long-term incentive compensation. Forfeitures of options under the Option Plan are added to the shares available for issuance under the Omnibus Plan.
During the nine months ended March 31, 2010, the Company granted 1.3 million of time-vested stock options under the Omnibus Plan. The options vest over a four year period and have an exercise price of $18.00 per share, the price at which shares were sold to the public in the initial public offering. These options were valued using the Black-Scholes method, and the Company used an estimated stock price volatility assumption of 44% and an expected term assumption of 6.25 years. In addition, approximately 20,000 shares of restricted stock, which vest one year from the date of grant, were issued under the Omnibus Plan. These shares of restricted stock were valued at the closing price of a share of the Company’s common stock on the date of grant, which averaged $21.89 per share.
Long Term Incentive Compensation Plan
In fiscal 2007, the Company adopted the Long-Term Incentive Compensation Plan (the “LTIC Plan”), which is accounted for as an equity-based plan. The LTIC Plan consists of a bonus pool that will be valued and paid in the Company’s common stock based on returns to the Principal Shareholders in connection with a change in control of the Company. Out of a total of 1,000,000 units authorized, approximately 733,000 units were outstanding under the LTIC Plan at March 31, 2010. Each unit represents the right to receive a payment based on the value of the bonus pool. As the contingent future events that would result in value to the unit-holders are not probable, no compensation expense has been recognized by the Company during any of the periods following the Transaction.

 

9


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
5. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following amounts (in thousands):
                         
Asset Class   March 31,
2010
    June 30,
2009
    March 31,
2009
 
Land
  $ 17,861     $ 17,805     $ 17,805  
Buildings and improvements
    73,917       74,171       73,901  
Leasehold improvements and capitalized lease costs
    404,383       329,449       315,893  
Furniture and equipment
    117,117       97,783       95,593  
Technology and other equipment
    205,144       170,818       160,803  
Software
    53,083       45,651       40,702  
Library books
    33,551       29,778       28,566  
Construction in progress
    44,553       43,470       23,029  
 
                 
Total
    949,609       808,925       756,292  
Less accumulated depreciation
    (315,022 )     (227,960 )     (223,457 )
 
                 
Property and equipment, net
  $ 634,587     $ 580,965     $ 532,835  
 
                 
Depreciation and amortization of property and equipment was $28.6 million and $24.4 million, respectively, for the three months ended March 31, 2010 and 2009. Depreciation and amortization of property and equipment was $82.2 million and $69.9 million, respectively, for the nine months ended March 31, 2010 and 2009.
6. GOODWILL AND INTANGIBLE ASSETS
Goodwill
As a result of the Transaction, the Company recorded approximately $2.6 billion of goodwill. Goodwill is recognized as an asset in the financial statements and is initially measured as the excess of the purchase price of the acquired company over the amounts assigned to net assets acquired. In connection with the Transaction, property, equipment, intangible assets other than goodwill and other assets and liabilities were recorded at fair value. The remaining value was assigned to goodwill and represents the intrinsic value of the Company beyond its tangible and identifiable intangible assets. This is evidenced by the excess of the amount paid to acquire the Company over the values of these respective assets.
The Company formally evaluates the carrying amount of goodwill for impairment on April 1 of each fiscal year. During interim periods, the Company reviews forecasts, business plans, regulatory and legal matters and other activities necessary to identify events that may trigger more frequent impairment tests. During the nine months ended March 31, 2010, the Company identified no such triggering events, and as a result, no impairments were recorded.

 

10


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Intangible Assets
Intangible assets consisted of the following amounts (in thousands):
                                                 
    March 31, 2010     June 30, 2009     March 31, 2009  
    Gross             Gross             Gross        
    Carrying     Accumulated     Carrying     Accumulated     Carrying     Accumulated  
    Amount     Amortization     Amount     Amortization     Amount     Amortization  
Tradename-Art Institute
  $ 330,000     $     $ 330,000     $     $ 330,000     $  
Tradename-Argosy University
    3,000       (1,278 )     3,000       (1,028 )     3,000       (944 )
Licensing, accreditation and Title IV program participation
    112,179             112,179             112,179        
Curriculum and programs
    30,935       (17,191 )     27,974       (13,520 )     26,446       (12,457 )
Student contracts, applications and relationships
    39,511       (33,687 )     39,511       (32,479 )     39,511       (30,723 )
Favorable leases and other
    16,425       (11,670 )     16,351       (10,106 )     16,318       (9,417 )
 
                                   
Total intangible assets
  $ 532,050     $ (63,826 )   $ 529,015     $ (57,133 )   $ 527,454     $ (53,541 )
 
                                   
State licenses and accreditations of the Company’s schools as well as their eligibility for Title IV program participation are periodically renewed in cycles ranging from every year to up to every ten years depending upon government and accreditation regulations. The Company considers these renewal processes to be a routine aspect of the overall business and assigned these assets indefinite lives.
Tradenames are often considered to have useful lives similar to that of the overall business, which generally means such assets are assigned an indefinite life for accounting purposes. However, the Argosy tradename was assigned a finite life at the date of the Transaction due to the potential for that tradename to be eliminated.
Amortization of intangible assets for the three months ended March 31, 2010 and 2009 was $2.1 million and $4.3 million, respectively. Amortization of intangible assets for the nine months ended March 31, 2010 and 2009 was $6.7 million and $13.1 million, respectively.
Total estimated amortization on the Company’s existing intangible assets at March 31, 2010 for each of the years ending June 30, 2010 through 2014 and thereafter is as follows (in thousands):
         
    Amortization  
Fiscal years   Expense  
2010 (remainder)
  $ 1,937  
2011
    8,044  
2012
    6,978  
2013
    4,631  
2014
    2,862  
Thereafter
    1,593  

 

11


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
7. ACCRUED LIABILITIES
Accrued liabilities consisted of the following amounts (in thousands):
                         
    March 31,
2010
    June 30,
2009
    March 31,
2009
 
Payroll and related taxes
  $ 67,775     $ 77,894     $ 51,791  
Capital expenditures
    11,187       8,032       7,403  
Advertising
    30,009       25,192       32,452  
Interest
    21,790       13,878       31,448  
Benefits
    9,569       8,597       10,023  
Other
    47,482       29,892       25,521  
 
                 
Total accrued liabilities
  $ 187,812     $ 163,485     $ 158,638  
 
                 
In March 2010, the Company implemented a corporate services restructuring plan to improve operational efficiencies by realigning functions between corporate services and the Company’s education systems. As a result of the restructuring plan, the Company recorded a charge of $5.7 million in general and administrative expense on the consolidated statement of operations for the three months ended March 31, 2010. This expense was recorded in accrued liabilities on the accompanying consolidated balance sheet and primarily relates to severance and benefit payments that will be made to terminated employees through the end of fiscal 2011.
8. SHORT-TERM AND LONG-TERM DEBT
EM LLC increased the capacity on its revolving credit facility from $388.5 million to $442.5 million in connection with the completion of the initial public offering. In addition, EM LLC added two letter of credit issuing banks in August 2009, which increased the amounts available for letters of credit issued under the revolving credit facility from $175.0 million to $375.0 million. Outstanding letters of credit reduce availability of borrowings under the revolving credit facility.
Short-Term Debt:
No borrowings were outstanding at March 31, 2010 under the $442.5 million revolving credit facility as compared to outstanding balances of $100.0 million and $180.0 million, respectively, at June 30, 2009 and March 31, 2009. The interest rates on outstanding borrowings on the revolving credit facility at June 30, 2009 and March 31, 2009 were 3.75% and 2.31%, respectively. The applicable margin for borrowings under the revolving credit facility changes based on certain leverage ratios. EM LLC is obligated to pay a per annum commitment fee on undrawn amounts under the revolving credit facility, which is currently 0.375% and varies based on certain leverage ratios. The revolving credit facility is secured by certain of EM LLC’s assets and is subject to certain covenants and financial ratios described in Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Covenant Compliance”.
EM LLC had outstanding letters of credit of $210.7 million at March 31, 2010. The U.S. Department of Education requires the Company to maintain a letter of credit due to the Company’s failure to satisfy certain regulatory financial ratios after giving effect to the Transaction. The amount of the letter of credit, which was $173.2 million at March 31, 2010, is currently set at 10% of the Title IV aid received by students attending the Company’s schools. The majority of the remainder of the outstanding letters of credit relate to obligations to purchase loans under the Education Finance Loan program, which is further described in Note 12. The Company has $231.8 million of additional borrowings available under the revolving credit facility at March 31, 2010. Subsequent to March 31, 2010, the U.S. Department of Education requested the Company increase its letter of credit as described in Note 15.

 

12


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
Long-Term Debt:
The Company’s long-term debt consisted of the following amounts (in thousands):
                         
    March 31,
2010
    June 30,
2009
    March 31,
2009
 
Senior secured term loan facility, due 2013
  $ 1,117,940     $ 1,126,827     $ 1,129,790  
Senior notes due 2014 at 8.75%
    375,000       375,000       375,000  
Senior subordinated notes due 2016 at 10.25%
    47,680       385,000       385,000  
Other
    1,213       1,816       1,940  
 
                 
Total long-term debt
    1,541,833       1,888,643       1,891,730  
Less current portion
    12,172       12,622       12,705  
 
                 
Total long term debt, less current portion
  $ 1,529,661     $ 1,876,021     $ 1,879,025  
 
                 
During the nine months ended March 31, 2010, the Company purchased Senior Subordinated Notes with a total face value of approximately $337.4 million at a premium through two tender offer transactions. The Company recorded losses of $2.4 million and $47.2 million in the three and nine months ended March 31, 2010, respectively, on the early retirement of the Senior Subordinated Notes, which includes the acceleration of amortization on previously deferred debt fees of $0.3 million and $5.6 million, respectively.
The interest rate on the senior secured term loan facility, which equals LIBOR plus a margin spread of 1.75%, was 2.1% at March 31, 2010, 2.4% at June 30, 2009 and 3.0% at March 31, 2009.
9. DERIVATIVE INSTRUMENTS
EM LLC utilizes interest rate swap agreements, which are contractual agreements to exchange payments based on underlying interest rates, to manage the floating rate portion of its term debt. Currently, EM LLC has two five-year interest rate swaps outstanding through July 1, 2011, each for a notional amount of $375.0 million. The interest rate swaps effectively convert a portion of the variable interest rate on the senior secured term loan to a fixed rate. EM LLC receives payments based on the three-month LIBOR and makes payments based on a fixed rate of 5.4%.
The fair value of the interest rate swaps was $42.3 million, $54.4 million and $74.1 million at March 31, 2010, June 30, 2009 and March 31, 2009, respectively, which was recorded in other long-term liabilities on the accompanying consolidated balance sheets. The Company recorded an unrealized after-tax gain(loss) of $2.6 million and $(0.2) million for the three months ended March 31, 2010 and 2009, respectively, and $7.7 million and $(22.2) million for the nine months ended March 31, 2010 and 2009, respectively, in other comprehensive loss related to the change in market value of the swap agreements. Additionally, at March 31, 2010, there was a cumulative unrealized loss of $26.5 million, net of tax, related to these interest rate swaps included in accumulated other comprehensive loss on the Company’s accompanying consolidated balance sheet. This loss would be immediately recognized in the consolidated statement of operations if these instruments fail to meet certain cash flow hedge requirements.
During the three and nine months ended March 31, 2010, the Company reclassified approximately $6.1 million and $17.8 million, respectively, from accumulated other comprehensive loss to the consolidated statement of operations, all of which was paid due to regularly recurring quarterly settlements of the interest rate swaps. Over the next twelve months, the Company estimates approximately $24.1 million will be reclassified from accumulated other comprehensive loss to the consolidated statement of operations based on current interest rates and underlying debt obligations at March 31, 2010.
The Company used “level two” inputs to value its interest rate swaps. These inputs are defined as other than quoted prices in active markets that are either directly or indirectly observable. The application of level two inputs includes obtaining quotes from counterparties, which are based on LIBOR forward curves, and assessing non-performance risk based upon published market data.

 

13


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
10. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying amounts and fair values of financial instruments (in thousands):
                                                 
    March 31, 2010     June 30, 2009     March 31, 2009  
    Carrying             Carrying             Carrying        
    Value     Fair Value     Value     Fair Value     Value     Fair Value  
Interest rate swap liabilities
  $ 42,319     $ 42,319     $ 54,421     $ 54,421     $ 74,057     $ 74,057  
Variable rate debt
    1,117,940       1,089,992       1,126,827       1,031,047       1,129,790       949,024  
Fixed rate debt
    423,893       437,082       761,816       738,916       761,940       720,040  
The fair values of cash and cash equivalents, accounts receivable, borrowings under the revolving credit facility, accounts payable and accrued expenses approximate carrying values due to the short-term nature of these instruments. The derivative financial instruments are carried at fair value, which is based on the framework discussed in Note 9. The fair values of the Company’s debt instruments are generally determined based on each instrument’s trading value at each reporting date.
11. INCOME TAXES
The Company’s effective tax rate was 22.6% and 28.7% for the three and nine months ended March 31, 2010 and 37.1% and 36.8% for the three and nine months ended March 31, 2009. The effective rates differed from the combined federal and state statutory rates primarily due to valuation allowances, expenses that are non-deductible for tax purposes, and accounting for uncertain tax positions.
As a result of the expiration of certain statutes of limitation with respect to the 2006 tax year, the Company’s liability for uncertain tax positions decreased by $16.3 million during the three months ended March 31, 2010, excluding interest and the indirect benefits associated with state income taxes of $1.6 million. As of March 31, 2010, the Company’s accrual for uncertain tax positions, excluding interest and the indirect benefits associated with state income taxes, was $7.8 million. It is reasonably possible that the total amount of unrecognized tax benefits will decrease by $4.4 million within the next twelve months due to the expiration of certain statutes of limitation with respect to fiscal year 2007. If recognized, this benefit will be a discrete item in the third quarter of fiscal year 2011.
The statutes of limitation for the Company’s U.S. income tax returns are closed for years through fiscal 2006. The statutes of limitation for the Company’s state and local income tax returns for prior periods vary by jurisdiction. However, the statutes of limitation with respect to the major jurisdictions in which the Company files state and local income tax returns are generally closed for years through fiscal 2005.

 

14


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
12. CONTINGENCIES
In August 2009, a complaint was filed in the District Court for Dallas County, Texas in the case of Capalbo et al. v. Argosy University, Education Management LLC, Education Management Corporation and Marilyn Powell-Kissinger. In September 2009, the defendants removed the case to the United States District Court for the Northern District of Texas, Dallas division. The case was remanded back to State court in November 2009 by agreement after the plaintiffs amended their pleadings to specify their allegations and agreed to dismiss Ms. Powell-Kissinger as a defendant. The plaintiffs filed an amended complaint in state court in January 2010 adding three additional plaintiffs, among other things. The plaintiffs in the litigation are 18 former students who were enrolled in the Clinical Psychology doctoral program at the Argosy University Dallas campus. The complaint alleges that, prior to the plaintiffs’ enrollment and/or while the plaintiffs were enrolled in the program, the defendants violated the Texas Deceptive Trade Practices and Consumer Protection Act and made material misrepresentations regarding the importance of accreditation of the program by the Commission on Accreditation, American Psychological Association, the status of the application of the Dallas campus for such accreditation, the availability of loan repayment options for the plaintiffs, and the quantity and quality of the plaintiffs’ career options. Plaintiffs seek unspecified monetary compensatory and punitive damages. In March 2010, lawsuits filed by three of the plaintiffs who signed arbitration agreements with Argosy University were remanded for binding arbitration. The remaining lawsuits in the Capalbo case were stayed pending the resolution of the three arbitrations.
In March 2010, the same counsel representing the plaintiffs in the Capalbo case filed a complaint in the District Court for Dallas County, Texas in the case of Adibian et al. v. Argosy University, Education Management LLC and Education Management Corporation. In Adibian, three former students who were enrolled in the Clinical Psychology doctoral program at the Argosy University Dallas campus make similar allegations to those set forth in the Capalbo case and seek unspecified monetary compensatory and punitive damages.
In June 2009, a complaint was filed in the Twelfth Judicial Circuit of Tennessee by plaintiff The University of the South against defendants South University, LLC, Education Management LLC, and Education Management Corporation. In July 2009, defendants removed the case to the United States District Court for the Eastern District of Tennessee, Winchester Division. Plaintiff subsequently filed an amended complaint in which it alleges that defendants’ offering of psychology and interdisciplinary studies degrees under the South University name breaches a prior settlement and consent agreement entered into between the parties, and that the use of South University’s mark infringes on plaintiff’s federal and state trademark rights. Plaintiff also alleges that defendants’ actions constitute false designation of origin and unfair competition under federal law (Lanham Act) and unfair and deceptive trade practices under Tennessee state law. Plaintiff seeks an unspecified amount of damages, attorneys’ fees, and permanent injunction relief. In response to the amended complaint, Defendants Education Management LLC and Education Management Corporation filed a motion to dismiss the case against them for lack of personal jurisdiction. Their motion was granted and they were dismissed from the lawsuit. Defendant South University, LLC denies the allegations against it, and filed a counter-complaint alleging that plaintiff breached the settlement and consent agreement based on a failure of consideration and requesting declaratory judgment that plaintiff abandoned its mark and is engaging in trademark misuse, that the settlement and consent agreement has been terminated based on plaintiff’s abandonment of the asserted trademark, and that South University is not in breach of the contract, has not engaged unfair competition, and is not infringing on plaintiff’s mark. South University seeks damages in an unspecified amount, rescission of the Settlement and Consent Agreement, restitution, and attorneys’ fees. The plaintiff filed for a preliminary injunction against the defendant in November 2009 seeking, among other things, to enjoin the defendant from offering its psychology and interdisciplinary studies degree programs. No trial date has been set for the lawsuit.
On May 6, 2010, a qui tam action captioned Buchanan v. South University Online and Education Management Corporation filed under the False Claims Act in July 2007 was unsealed due to the U.S. Department of Justice’s decision to not intervene in the action at this time. The case, which is pending in the United States District Court for the Western District of Pennsylvania, relates to whether the defendants’ compensation plans for admission representatives violated the Higher Education Act and U.S. Department of Education regulations prohibiting an institution participating in Title IV Programs from providing any commission, bonus or other incentive payment based directly or indirectly on success in securing enrollments to any person or entity engaged in any student recruitment or admissions activity. A number of similar lawsuits have been filed in recent years against educational institutions that receive Title IV funds. The complaint, which was filed by a former admissions representative for the online programs offered by South University, outlines a theory of damages based upon Title IV funding disbursements to the Company over a number of years and asserts the plaintiff is entitled to recover treble the amount of actual damages allegedly sustained by the federal government as a result of the alleged activity, plus civil monetary penalties. The Company believes the claims to be without merit and intends to defend this action vigorously.

 

15


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
In June 2007, The New England Institute of Art (“NEIA”) received a civil investigative demand letter from the Massachusetts State Attorney General requesting information in connection with the Attorney General’s review of alleged submissions of false claims by NEIA to the Commonwealth of Massachusetts and alleged unfair and deceptive student lending and marketing practices engaged in by the school. In February 2008, the Attorney General informed NEIA that it does not plan to further pursue its investigation of the false claims and deceptive marketing practices. NEIA intends to fully cooperate with the Attorney General in connection with its investigation of NEIA’s student lending practices to the extent further cooperation is required.
In addition to the matters described above, the Company is a defendant in certain legal proceedings arising out of the conduct of its business. In the opinion of management, based upon an investigation of these claims and discussion with legal counsel, the ultimate outcome of such legal proceedings, individually and in the aggregate, is not expected to have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity.
In August 2008, the Company introduced the Education Finance Loan program with a private lender, which enables students who have exhausted all available government-sponsored or other aid and have been denied a private loan to borrow funds to finance a portion of their tuition and other educational expenses. Under the Education Finance Loan program, the Company purchases loans that are originated by a private lender. As of March 31, 2010, the Company is committed to purchase less than $40 million of loans during the remainder of fiscal 2010 and 2011.
13. RELATED PARTY TRANSACTIONS
In September 2009, South University LLC, a wholly-owned subsidiary of the Company, renewed a long term leasing arrangement of two buildings from two separate entities owned by John T. South, who is one of the Company’s executive officers. Annual rent payments under this lease, which begins June 1, 2010, will approximate $2.2 million.
In connection with the Transaction and under the terms of an agreement between the Company and the Sponsors, the Company agreed to pay annual advisory fees of $5.0 million to the Sponsors. This agreement included customary exculpation and indemnification provisions in favor of the Sponsors and their affiliates. Upon the completion of the initial public offering, the Company terminated the agreement with the Sponsors and paid a non-recurring fee of $29.6 million. This has been included in management fees paid to affiliates in the accompanying consolidated statements of operations for nine months ended March 31, 2010.
An affiliate of one of the Sponsors participated as one of the joint book-running managers of the Company’s initial public offering. This affiliate was paid $5.5 million pursuant to a customary underwriting agreement among the Company and several underwriters. This fee was recorded as a reduction to additional paid-in capital in the consolidated balance sheet as it reduced the net proceeds received from the initial public offering. In addition, the Company paid an affiliate of one of the Sponsors approximately $0.5 million in tender offer fees related to the two debt repurchases that occurred during the nine-month period ended March 31, 2010. These fees were recorded in general and administrative expense in the consolidated statement of operations.
In June 2006, the Company entered into a five-year interest rate swap agreement in the amount of $375.0 million with an affiliate of one of the Sponsors. The terms of this swap are discussed in Note 9.

 

16


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
14. GUARANTOR SUBSIDIARIES FINANCIAL INFORMATION
On June 1, 2006, in connection with the Transaction, EM LLC and Education Management Finance Corp. issued the Notes. The Notes are fully and unconditionally guaranteed by all of EM LLC’s existing direct and indirect domestic restricted subsidiaries, other than any subsidiary that directly owns or operates a school, or has been formed for such purposes, and subsidiaries that have no material assets (collectively, the “Guarantors”). All other subsidiaries of EM LLC, either direct or indirect, do not guarantee the Notes (“Non-Guarantors”).
In November 2009, the Company became a guarantor of the Notes. The following tables present the condensed consolidated financial position of EM LLC, the Guarantor Subsidiaries, the Non-Guarantor Subsidiaries and Parent (“EDMC”) as of March 31, 2010, June 30, 2009 and March 31, 2009. The results of operations for the three and nine month periods ended March 31, 2010 and 2009 and the condensed statements of cash flows for the nine month periods ended March 31, 2010 and 2009 are presented for EM LLC, the Guarantor Subsidiaries, the Non-Guarantor Subsidiaries and Parent (“EDMC”).
CONDENSED CONSOLIDATED BALANCE SHEET
March 31, 2010 (In thousands)
                                                                 
            Guarantor     Non-Guarantor             EM LLC                     EDMC  
    EM LLC     Subsidiaries     Subsidiaries     Eliminations     Consolidated     EDMC     Eliminations     Consolidated  
Assets
                                                               
Current:
                                                               
Cash and cash equivalents
  $ 402,671     $ 4,685     $ 18,867     $     $ 426,223     $ 46,414     $     $ 472,637  
Restricted cash
    737       500       25,245             26,482                   26,482  
Notes, advances and trade receivables, net
    14,900       96       97,235             112,231       2             112,233  
Inventories
          168       13,074             13,242                   13,242  
Other current assets
    28,492       615       61,655             90,762                   90,762  
 
                                               
Total current assets
    446,800       6,064       216,076             668,940       46,416             715,356  
 
                                               
 
                                                               
Property and equipment, net
    55,787       6,610       572,190             634,587                   634,587  
Intangible assets, net
    2,829       67       465,328             468,224                   468,224  
Goodwill
    7,328             2,571,803             2,579,131                   2,579,131  
Intercompany balances
    937,892       (62,315 )     (1,277,814 )           (402,237 )     402,237              
Other long-term assets
    41,276       35,295       5,598             82,169       (1 )           82,168  
Investment in subsidiaries
    1,835,815                   (1,835,815 )           1,573,920       (1,573,920 )      
 
                                               
Total assets
  $ 3,327,727     $ (14,279 )   $ 2,553,181     $ (1,835,815 )   $ 4,030,814     $ 2,022,572     $ (1,573,920 )   $ 4,479,466  
 
                                               
 
                                                               
Liabilities and shareholders’ equity (deficit)
                                                               
Current:
                                                               
Current portion of long-term debt
  $ 11,850     $     $ 322     $     $ 12,172     $     $     $ 12,172  
Accounts payable, accrued and other current liabilities
    162,718       3,934       349,157             515,809       185             515,994  
 
                                               
Total current liabilities
    174,568       3,934       349,479             527,981       185             528,166  
 
                                               
 
                                                               
Long-term debt, less current portion
    1,528,770             891             1,529,661                   1,529,661  
Other long-term liabilities
    66,066       7,395       147,403             220,864                   220,864  
Deferred income taxes
    (15,597 )     (12,206 )     206,191             178,388                   178,388  
 
                                               
Total liabilities
    1,753,807       (877 )     703,964             2,456,894       185             2,457,079  
 
                                               
 
                                                               
Total shareholders’ equity (deficit)
    1,573,920       (13,402 )     1,849,217       (1,835,815 )     1,573,920       2,022,387       (1,573,920 )     2,022,387  
 
                                               
Total liabilities and shareholders’ equity (deficit)
  $ 3,327,727     $ (14,279 )   $ 2,553,181     $ (1,835,815 )   $ 4,030,814     $ 2,022,572     $ (1,573,920 )   $ 4,479,466  
 
                                               

 

17


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
CONDENSED CONSOLIDATED BALANCE SHEET
June 30, 2009 (In thousands)
                                                                 
            Guarantor     Non-Guarantor             EM LLC                     EDMC  
    EM LLC     Subsidiaries     Subsidiaries     Eliminations     Consolidated     EDMC     Eliminations     Consolidated  
Assets
                                                               
Current:
                                                               
Cash and cash equivalents
  $ 15,789     $ 481     $ 305,287     $     $ 321,557     $ 41,761     $     $ 363,318  
Restricted cash
    789             9,583             10,372                   10,372  
Notes, advances and trade receivables, net
    172       35       135,738             135,945       5             135,950  
Inventories
                9,355             9,355                   9,355  
Other current assets
    19,056       1,213       55,058             75,327                   75,327  
 
                                               
Total current assets
    35,806       1,729       515,021             552,556       41,766             594,322  
 
                                               
 
                                                               
Property and equipment, net
    52,190       6,137       522,638             580,965                   580,965  
Intangible assets, net
    3,119       61       468,702             471,882                   471,882  
Goodwill
    7,328             2,571,803             2,579,131                   2,579,131  
Intercompany balances
    1,880,889       (20,819 )     (1,859,626 )           444       (444 )            
Other long-term assets
    48,447       9,764       734             58,945                     58,945  
Investment in subsidiaries
    1,590,364                   (1,590,364 )           1,444,515       (1,444,515 )      
 
                                               
Total assets
  $ 3,618,143     $ (3,128 )   $ 2,219,272     $ (1,590,364 )   $ 4,243,923     $ 1,485,837     $ (1,444,515 )   $ 4,285,245  
 
                                               
 
                                                               
Liabilities and shareholders’ equity (deficit)
                                                               
Current:
                                                               
Current portion of long-term debt
  $ 111,911     $     $ 711     $     $ 112,622     $     $     $ 112,622  
Accounts payable, accrued and other current liabilities
    111,694       4,739       291,159             407,592       185             407,777  
 
                                               
Total current liabilities
    223,605       4,739       291,870             520,214       185             520,399  
 
                                               
 
                                                               
Long-term debt, less current portion
    1,874,921             1,100             1,876,021                   1,876,021  
Other long-term liabilities
    91,124       4,649       119,817             215,590       (1 )           215,589  
Deferred income taxes
    (16,022 )     72       203,533             187,583                   187,583  
 
                                               
Total liabilities
    2,173,628       9,460       616,320             2,799,408       184             2,799,592  
 
                                               
 
                                                               
Total shareholders’ equity (deficit)
    1,444,515       (12,588 )     1,602,952       (1,590,364 )     1,444,515       1,485,653       (1,444,515 )     1,485,653  
 
                                               
Total liabilities and shareholders’ equity (deficit)
  $ 3,618,143     $ (3,128 )   $ 2,219,272     $ (1,590,364 )   $ 4,243,923     $ 1,485,837     $ (1,444,515 )   $ 4,285,245  
 
                                               

 

18


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
CONDENSED CONSOLIDATED BALANCE SHEET
March 31, 2009 (In thousands)
                                                                 
            Guarantor     Non-Guarantor             EM LLC                     EDMC  
    EM LLC     Subsidiaries     Subsidiaries     Eliminations     Consolidated     EDMC     Eliminations     Consolidated  
Assets
                                                               
Current:
                                                               
Cash and cash equivalents
  $ 475,979     $ 614     $ 7,394     $     $ 483,987     $ 41,723     $     $ 525,710  
Restricted cash
    311             35,866             36,177                   36,177  
Notes, advances and trade receivables, net
    (402 )     47       79,103             78,748       15             78,763  
Inventories
                10,635             10,635                   10,635  
Other current assets
    16,533       686       38,188             55,407                   55,407  
 
                                               
Total current assets
    492,421       1,347       171,186             664,954       41,738             706,692  
 
                                               
 
                                                               
Property and equipment, net
    48,472       6,137       478,226             532,835                   532,835  
Intangible assets, net
    399       61       473,453             473,913                   473,913  
Goodwill
    7,328             2,571,803             2,579,131                   2,579,131  
Intercompany balances
    1,551,643       (13,211 )     (1,537,932 )           500       (500 )            
Other long-term assets
    50,645       1,764       5,227             57,636                   57,636  
Investment in subsidiaries
    1,547,113                   (1,547,113 )           1,411,452       (1,411,452 )      
 
                                               
Total assets
  $ 3,698,021     $ (3,902 )   $ 2,161,963     $ (1,547,113 )   $ 4,308,969     $ 1,452,690     $ (1,411,452 )   $ 4,350,207  
 
                                               
 
                                                               
Liabilities and shareholders’ equity (deficit)
                                                               
Current:
                                                               
Short-term and current portion of long-term debt
  $ 191,913     $     $ 792     $     $ 192,705     $     $     $ 192,705  
Accounts payable, accrued and other current liabilities
    126,473       4,739       314,021             445,233       185             445,418  
 
                                               
Total current liabilities
    318,386       4,739       314,813             637,938       185             638,123  
 
                                               
 
                                                               
Long-term debt, less current portion
    1,877,888             1,137             1,879,025                   1,879,025  
Other long-term liabilities
    110,334       3,305       101,787             215,426                   215,426  
Deferred income taxes
    (20,039 )     72       185,095             165,128                   165,128  
 
                                               
Total liabilities
    2,286,569       8,116       602,832             2,897,517       185             2,897,702  
 
                                               
 
                                                               
Total shareholders’ equity (deficit)
    1,411,452       (12,018 )     1,559,131       (1,547,113 )     1,411,452       1,452,505       (1,411,452 )     1,452,505  
 
                                               
Total liabilities and shareholders’ equity (deficit)
  $ 3,698,021     $ (3,902 )   $ 2,161,963     $ (1,547,113 )   $ 4,308,969     $ 1,452,690     $ (1,411,452 )   $ 4,350,207  
 
                                               

 

19


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
CONSOLIDATED STATEMENT OF OPERATIONS
For the Three Months Ended March 31, 2010 (In thousands)
                                                                 
            Guarantor     Non-Guarantor             EM LLC                     EDMC  
    EM LLC     Subsidiaries     Subsidiaries     Eliminations     Consolidated     EDMC     Eliminations     Consolidated  
Net revenues
  $     $ (1,232 )   $ 669,128     $     $ 667,896     $     $     $ 667,896  
Costs and expenses:
                                                               
Educational services
    17,068       (738 )     306,816             323,146                   323,146  
General and administrative
    (19,587 )     (94 )     194,070             174,389       57             174,446  
Management fees paid to affiliates
                                               
Depreciation and amortization
    4,570       59       26,045             30,674                   30,674  
 
                                               
Total costs and expenses
    2,051       (773 )     526,931             528,209       57             528,266  
 
                                               
 
                                                               
Income (loss) before interest, loss on early retirement of debt and income taxes
    (2,051 )     (459 )     142,197             139,687       (57 )           139,630  
Interest (income) expense, net
    27,811       (560 )     688             27,939       (6 )           27,933  
Loss on early retirement of debt
    2,445                         2,445                   2,445  
Equity in earnings of subsidiaries
    (123,604 )                 123,604             (84,621 )     84,621        
 
                                               
Income (loss) before income taxes
    91,297       101       141,509       (123,604 )     109,303       84,570       (84,621 )     109,252  
Provision for income taxes
    6,676       168       17,838             24,682                   24,682  
 
                                               
Net income (loss)
  $ 84,621     $ (67 )   $ 123,671     $ (123,604 )   $ 84,621     $ 84,570     $ (84,621 )   $ 84,570  
 
                                               
                                                                 
CONSOLIDATED STATEMENT OF OPERATIONS
For the Three Months Ended March 31, 2009 (In thousands)
                                                                 
            Guarantor     Non-Guarantor             EM LLC                     EDMC  
    EM LLC     Subsidiaries     Subsidiaries     Eliminations     Consolidated     EDMC     Eliminations     Consolidated  
Net revenues
  $     $ (613 )   $ 536,051     $     $ 535,438     $     $     $ 535,438  
Costs and expenses:
                                                               
Educational services
    11,165       (867 )     258,201             268,499                   268,499  
General and administrative
    (18,281 )     903       146,592             129,214       58             129,272  
Management fees paid to affiliates
    1,250                         1,250                   1,250  
Depreciation and amortization
    3,805       43       24,980             28,828                   28,828  
 
                                               
Total costs and expenses
    (2,061 )     79       429,773             427,791       58             427,849  
 
                                               
 
                                                               
Income (loss) before interest and income taxes
    2,061       (692 )     106,278             107,647       (58 )           107,589  
Interest (income) expense, net
    36,728             726             37,454       (54 )           37,400  
Equity in earnings of subsidiaries
    (66,599 )                 66,599             (44,129 )     44,129        
 
                                               
Income (loss) before income taxes
    31,932       (692 )     105,552       (66,599 )     70,193       44,125       (44,129 )     70,189  
Provision for (benefit from) income taxes
    (12,197 )     (255 )     38,516             26,064       (2 )           26,062  
 
                                               
Net income (loss)
  $ 44,129     $ (437 )   $ 67,036     $ (66,599 )   $ 44,129     $ 44,127     $ (44,129 )   $ 44,127  
 
                                               

 

20


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
CONSOLIDATED STATEMENT OF OPERATIONS
For the Nine Months Ended March 31, 2010 (In thousands)
                                                                 
            Guarantor     Non-Guarantor             EM LLC                     EDMC  
    EM LLC     Subsidiaries     Subsidiaries     Eliminations     Consolidated     EDMC     Eliminations     Consolidated  
Net revenues
  $     $ (4,691 )   $ 1,862,455     $     $ 1,857,764     $     $     $ 1,857,764  
Costs and expenses:
                                                               
Educational services
    43,242       (3,264 )     894,147             934,125                   934,125  
General and administrative
    (54,293 )     297       545,433             491,437       171             491,608  
Management fees paid to affiliates
    32,055                         32,055                   32,055  
Depreciation and amortization
    13,472       186       75,244             88,902                   88,902  
 
                                               
Total costs and expenses
    34,476       (2,781 )     1,514,824             1,546,519       171             1,546,690  
 
                                               
 
                                                               
Income (loss) before interest, loss on early retirement of debt and income taxes
    (34,476 )     (1,910 )     347,631             311,245       (171 )           311,074  
Interest (income) expense, net
    93,334       (768 )     2,130             94,696       (44 )           94,652  
Loss on early retirement of debt
    47,207                         47,207                   47,207  
Equity in earnings of subsidiaries
    (245,451 )                 245,451             (120,703 )     120,703        
 
                                               
Income (loss) before income taxes
    70,434       (1,142 )     345,501       (245,451 )     169,342       120,576       (120,703 )     169,215  
Provision for (benefit from) income taxes
    (50,269 )     (328 )     99,236             48,639       (30 )           48,609  
 
                                               
Net income (loss)
  $ 120,703     $ (814 )   $ 246,265     $ (245,451 )   $ 120,703     $ 120,606     $ (120,703 )   $ 120,606  
 
                                               
                                                                 
CONSOLIDATED STATEMENT OF OPERATIONS
For the Nine Months Ended March 31, 2009 (In thousands)
                                                                 
            Guarantor     Non-Guarantor             EM LLC                     EDMC  
    EM LLC     Subsidiaries     Subsidiaries     Eliminations     Consolidated     EDMC     Eliminations     Consolidated  
Net revenues
  $     $ 4,617     $ 1,487,267     $     $ 1,491,884     $     $     $ 1,491,884  
Costs and expenses:
                                                               
Educational services
    33,320       2,992       751,317             787,629                   787,629  
General and administrative
    (48,723 )     2,400       416,146             369,823       172             369,995  
Management fees paid to affiliates
    3,750                         3,750                   3,750  
Depreciation and amortization
    11,323       134       71,550             83,007                   83,007  
 
                                               
Total costs and expenses
    (330 )     5,526       1,239,013             1,244,209       172             1,244,381  
 
                                               
 
                                                               
Income (loss) before interest and income taxes
    330       (909 )     248,254             247,675       (172 )           247,503  
Interest (income) expense, net
    114,117             2,193             116,310       (296 )           116,014  
Equity in earnings of subsidiaries
    (155,858 )                 155,858             (83,049 )     83,049        
 
                                               
Income (loss) before income taxes
    42,071       (909 )     246,061       (155,858 )     131,365       83,173       (83,049 )     131,489  
Provision for (benefit from) income taxes
    (40,978 )     (334 )     89,628             48,316       47             48,363  
 
                                               
Net income (loss)
  $ 83,049     $ (575 )   $ 156,433     $ (155,858 )   $ 83,049     $ 83,126     $ (83,049 )   $ 83,126  
 
                                               

 

21


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
For the Nine Months Ended March 31, 2010 (In thousands)
                                                 
            Guarantor     Non-Guarantor     EM LLC             EDMC  
    EM LLC     Subsidiaries     Subsidiaries     Consolidated     EDMC     Consolidated  
 
                                               
Net cash flows provided by (used in) operations
  $ (55,044 )   $ (24,367 )   $ 419,098     $ 339,687     $ 470     $ 340,157  
 
                                   
 
                                               
Cash flows from investing activities
                                               
Expenditures for long-lived assets
    (10,534 )     (1,248 )     (108,043 )     (119,825 )           (119,825 )
Other investing activities
                (8,229 )     (8,229 )           (8,229 )
 
                                   
Net cash flows used in investing activities
    (10,534 )     (1,248 )     (116,272 )     (128,054 )           (128,054 )
 
                                   
 
                                               
Cash flows from financing activities
                                               
Net repayments of debt and other
    (490,243 )           (598 )     (490,841 )           (490,841 )
Net proceeds from issuance of common stock, including stock option exercises
                            387,998       387,998  
Intercompany transactions
    942,703       29,819       (588,707 )     383,815       (383,815 )      
 
                                   
Net cash flows provided by (used in) financing activities
    452,460       29,819       (589,305 )     (107,026 )     4,183       (102,843 )
 
                                   
 
                                               
Effect of exchange rate changes on cash and cash equivalents
                59       59             59  
 
                                   
 
                                               
Increase (decrease) in cash and cash equivalents
    386,882       4,204       (286,420 )     104,666       4,653       109,319  
Beginning cash and cash equivalents
    15,789       481       305,287       321,557       41,761       363,318  
 
                                   
Ending cash and cash equivalents
  $ 402,671     $ 4,685     $ 18,867     $ 426,223     $ 46,414     $ 472,637  
 
                                   

 

22


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
For the Nine Months Ended March 31, 2009 (In thousands)
                                                 
            Guarantor     Non-Guarantor     EM LLC             EDMC  
    EM LLC     Subsidiaries     Subsidiaries     Consolidated     EDMC     Consolidated  
 
                                               
Net cash flows provided by (used in) operations
  $ (30,758 )   $ 1,674     $ 343,659     $ 314,575     $ 342     $ 314,917  
 
                                   
 
                                               
Cash flows from investing activities
                                               
Expenditures for long-lived assets
    (8,914 )     (1,128 )     (87,943 )     (97,985 )           (97,985 )
Other investing activities
                (19,191 )     (19,191 )           (19,191 )
 
                                   
Net cash flows used in investing activities
    (8,914 )     (1,128 )     (107,134 )     (117,176 )           (117,176 )
 
                                   
 
                                               
Cash flows from financing activities
                                               
Net proceeds from (payments of) debt and other
    50,208       (1 )     (809 )     49,398             49,398  
Intercompany transactions
    463,132       (66 )     (463,066 )                  
 
                                   
Net cash flows provided by (used in) financing activities
    513,340       (67 )     (463,875 )     49,398             49,398  
 
                                   
 
                                               
Effect of exchange rate changes on cash and cash equivalents
                1,163       1,163             1,163  
 
                                   
 
                                               
Increase (decrease) in cash and cash equivalents
    473,668       479       (226,187 )     247,960       342       248,302  
Beginning cash and cash equivalents
    2,311       135       233,581       236,027       41,381       277,408  
 
                                   
Ending cash and cash equivalents
  $ 475,979     $ 614     $ 7,394     $ 483,987     $ 41,723     $ 525,710  
 
                                   

 

23


Table of Contents

EDUCATION MANAGEMENT CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Continued)
15. SUBSEQUENT EVENTS
On May 7, 2010, the U.S. Department of Education requested the Company increase its letter of credit to $259.8 million based on 10% of projected Title IV aid to be received by students attending the Company’s institutions during fiscal 2011. In response, the size of the letter of credit issued to the U.S. Department of Education will be increased by $86.6 million by June 4, 2010. As described in Note 8, letters of credit reduce availability under the Company’s revolving credit facility. Immediately following this increase, the Company will have $145.2 million of additional borrowings available under the revolving credit facility.

 

24


Table of Contents

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Results of Operations
The following table presents the relationship of each item in the consolidated statements of operations for the three and nine month periods ended March 31, 2010 and 2009 as a percentage of net revenues.
Amounts expressed as a percentage of net revenues
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
                                 
    For the Three Months     For the Nine Months  
    Ended March 31,     Ended March 31,  
    2010     2009     2010     2009  
Net revenues
    100.0 %     100.0 %     100.0 %     100.0 %
 
                               
Costs and expenses:
                               
Educational services
    48.4 %     50.1 %     50.3 %     52.8 %
General and administrative
    26.1 %     24.1 %     26.5 %     24.7 %
Management fees paid to affiliates
    0.0 %     0.2 %     1.7 %     0.3 %
Depreciation and amortization
    4.6 %     5.4 %     4.8 %     5.6 %
 
                       
Total costs and expenses
    79.1 %     79.8 %     83.3 %     83.4 %
 
                       
 
                               
Income before interest, loss on early retirement of debt and income taxes
    20.9 %     20.2 %     16.7 %     16.6 %
Interest expense, net
    4.2 %     7.0 %     5.1 %     7.8 %
Loss on early retirement of debt
    0.4 %     0.0 %     2.5 %     0.0 %
 
                       
 
                               
Income before income taxes
    16.3 %     13.2 %     9.1 %     8.8 %
Provision for income taxes
    3.7 %     4.9 %     2.6 %     3.2 %
 
                       
Net income
    12.6 %     8.3 %     6.5 %     5.6 %
 
                       
Three months ended March 31, 2010 compared to the three months ended March 31, 2009
All basis point changes are presented as a percentage of net revenues in each period of comparison.
Net revenues
Net revenues for the three months ended March 31, 2010 increased 24.7% to $667.9 million, compared to $535.4 million in the same period a year ago. The January starting student enrollment increased 22.4% in the current year quarter compared to the prior year quarter due primarily to growth at existing schools aided by the introduction of new academic programs, the growth in our fully online programs and the opening of new school locations. In addition, tuition rates increased approximately 6% in the current quarter compared to the fiscal 2009 quarter. These factors were partially offset by a lower average credit load taken by students. The decrease in credit load was primarily the result of growth in the number of students enrolled in fully online programs, in which students typically take a lesser credit load than onground students. None of the increase in student enrollment was due to acquisitions of schools. Tuition revenue generally varies based on the average tuition charge per credit hour, average credits per student and the average student population.

 

25


Table of Contents

Our quarterly net revenues and net income fluctuate primarily as a result of the pattern of student enrollments at our schools. The seasonality of our business has decreased over the last several years due to an increased percentage of students enrolling in online programs, which generally experience less seasonal fluctuations than campus-based programs. Our first fiscal quarter is typically our lowest revenue recognition quarter due to student vacations.
Educational services expense
Educational services expense consists primarily of costs related to the development, delivery and administration of our education programs. The major cost components include faculty compensation, salaries of administrative and student services staff, costs of educational materials, facility occupancy costs, information systems costs, loan fees and bad debt expense.
Educational services expense increased by $54.6 million, or 20.4%, to $323.1 million in the current quarter due primarily to the incremental costs incurred to support higher student enrollment. As a percentage of net revenues, educational services expense decreased by 176 basis points from the quarter ended March 31, 2009 to the current quarter.
Salaries and benefits expense decreased by 154 basis points from the prior year quarter. This decrease was primarily due to operating leverage at existing onground campuses, partially offset by an increase in these costs for our fully online programs. We also experienced operating leverage on rent associated with our schools, which decreased 62 basis points as a percentage of net revenues to $42.0 million in the current quarter compared to $37.0 million in the prior year quarter. We also experienced a decrease of 59 basis points from the prior year quarter in fees paid to private lenders to originate loans obtained by our students. This trend is discussed more fully in Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity - Federal Family Education Loan Program and Private Student Loans”.
Bad debt expense was $28.0 million, or 4.2% of net revenues, in the current quarter compared to $17.8 million, or 3.3% of net revenues, in the prior period, which represented an increase of 88 basis points. The increase in bad debt expense as a percentage of net revenues was primarily due to larger receivable balances as a result of our assistance with students’ cost of education, higher delinquency rates, prevailing economic conditions and an increase in the proportion of our receivables from out-of-school students, which are reserved for at a higher rate than receivables from in-school students. In addition, allowances recorded in connection with our Education Finance Loan program negatively impacted bad debt expense. The remaining net increase of 11 basis points in educational services expense in the current quarter was the result of a decrease in other costs, none of which were individually significant.
General and administrative expense
General and administrative expense consists of marketing and student admissions expenses and certain central staff departmental costs such as executive management, finance and accounting, legal, corporate development and other departments that do not provide direct services to our students.
General and administrative expense was $174.5 million for the current quarter, an increase of 34.9% from $129.3 million in the prior year quarter. As a percentage of net revenues, general and administrative expense increased 198 basis points compared to the quarter ended March 31, 2009. During the current quarter, we implemented a corporate services restructuring plan designed to improve operational efficiencies by realigning functions between corporate services and our education systems. As a result of the restructuring plan, we recorded a non-recurring charge of $5.7 million.

 

26


Table of Contents

After adjusting for the costs described above, general and administrative expense increased by 112 basis points in the current period compared to the prior year period. The increase was primarily the result of recording non-cash equity-based compensation expense of $1.7 million, or a 26 basis point increase from the prior year quarter. Equity-based compensation expense was not required to be recorded in the prior fiscal year due to the existence of certain conditions associated with the options that were removed upon the completion of the initial public offering. There was also a 22 basis point increase in total marketing and admissions costs, which were 21.6% of net revenues in the current quarter compared to 21.4% of net revenues in the prior year quarter. The remaining net increase of 64 basis points compared to the prior year quarter was primarily the result of net increases in other items including benefits, insurance and legal costs.
Management fees paid to affiliates
For the quarter ended March 31, 2009, management fees paid to affiliates consisted of the pro-rata portion of the $5.0 million annual fee paid to the Sponsors under an agreement executed in connection with the Transaction. In connection with the initial public offering, the management agreement was terminated in October 2009 and no expense was incurred for the quarter ended March 31, 2010.
Depreciation and amortization expense
Depreciation and amortization expense on long-lived assets was $30.7 million in the current quarter, an increase of 6.4% from the prior year quarter. As a percentage of net revenues, depreciation and amortization expense decreased by 79 basis points compared to the prior year quarter, due to leverage in relation to revenue growth and a reduction in amortization of intangible assets due primarily to the expiration in June 2009 of an intangible asset recorded in connection with the Transaction.
Interest expense, net
Net interest expense was $27.9 million in the current quarter, a decrease of $9.5 million from the prior year quarter. The decrease in net interest expense is primarily related to the early retirement of $316.0 million of the Senior Subordinated Notes in connection with the initial public offering in October 2009 and a lower interest rate on our term loan during the current quarter compared to the prior year quarter.
Loss on early retirement of debt
During the quarter ended March 31, 2010, we purchased Senior Subordinated Notes with a face value of approximately $21.4 million, on which we recorded a loss of $2.4 million.
Provision for income taxes
Our effective tax rate was 22.6% for the three months ended March 31, 2010 as compared to 37.1% for the same period in the prior year. The effective tax rates differed from the combined federal and state statutory rates primarily due to valuation allowances, expenses that are non-deductible for tax purposes, and accounting for uncertain tax positions.
The decrease in the effective tax rate for the three months ended March 31, 2010 as compared to the prior year quarter was primarily due to a $16.3 million decrease in the liability for uncertain tax positions and $1.6 million of interest and the indirect benefits associated with state income taxes as the result of the expiration of certain statutes of limitation with respect to fiscal year 2006.

 

27


Table of Contents

Nine months ended March 31, 2010 compared to the nine months ended March 31, 2009
All basis point changes are presented as a percentage of net revenues in each period of comparison.
Net revenues
Net revenues for the nine months ended March 31, 2010 increased 24.5% to $1,857.8 million, compared to $1,491.9 million in the same period a year ago. Average student enrollment increased 22.7% in the current year period compared to the prior year period primarily due to growth at existing schools aided by the introduction of new academic programs, the growth in our fully online programs and the opening of new school locations. In addition, tuition rates increased approximately 6% in the current period compared to the prior year period. These factors were partially offset by a lower average credit load taken by students. The decrease in credit load was primarily the result of growth in the number of students enrolled in fully online programs, in which students typically take a lesser credit load than onground students. None of the increase in student enrollment was due to acquisitions of schools.
Educational services expense
Educational services expense increased by $146.5 million, or 18.6%, to $934.1 million in the current year period due primarily to the incremental costs incurred to support higher student enrollment. As a percentage of net revenues, educational services expense decreased by 251 basis points in the current nine month period compared to the nine months ended March 31, 2009.
Salaries and benefits expense decreased by 164 basis points from the prior year period due primarily to operating leverage at existing onground campuses, partially offset by an increase in these costs for our fully online programs. We also experienced operating leverage on rent associated with our schools, which decreased 64 basis points as a percentage of net revenues to $124.4 million in the current year period compared to $109.5 million in the prior year period. Additionally, costs related to outside services and insurance, utilities and information technology maintenance decreased 50 basis points in the current period compared to the prior year period. We also experienced a decrease of 30 basis points from the prior year period in fees paid to private lenders to originate loans obtained by our students. This trend is discussed more fully in Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity - Federal Family Education Loan Program and Private Student Loans”.
Bad debt expense was $78.6 million, or 4.2% of net revenues, in the current period compared to $52.8 million, or 3.5% of net revenues, in the prior year period, which represented an increase of 69 basis points. The increase in bad debt expense as a percentage of net revenues was primarily due to larger receivable balances as a result of our assistance with students’ cost of education, higher delinquency rates, prevailing economic conditions and an increase in the proportion of our receivables from out-of-school students, which are reserved for at a higher rate than in-school students. In addition, allowances recorded in connection with our Education Finance Loan program negatively impacted bad debt expense. The remaining net decrease of 12 basis points in educational services expense in the current period was the result of a decrease in other costs, none of which were individually significant.
General and administrative expense
General and administrative expense was $491.6 million for the current period, an increase of 32.9% from $370.0 million in the prior year period. As a percentage of net revenues, general and administrative expense increased 166 basis points compared to the prior year period. During the current period, we incurred non-cash equity-based compensation expense of $13.1 million in connection with the initial public offering. This expense was previously deferred due to the existence of certain conditions associated with the options which were removed upon the completion of the initial public offering. We also incurred $1.0 million of legal costs and other fees associated with the repurchases of $337.4 million of Senior Subordinated Notes. Further, in March 2010 we implemented a corporate services restructuring plan that was designed to improve operational efficiencies and to support the growth of our education systems. As a result of the restructuring plan, we recorded a non-recurring charge of $5.7 million.
After adjusting for the costs described above, general and administrative expense increased by 59 basis points in the current period compared to the prior year period. We incurred non-cash equity-based compensation expense of $3.3 million, or an 18 basis point increase since this was not required to be recorded in the prior year period.

 

28


Table of Contents

Marketing and admissions costs were 21.9% of net revenues in the current nine month period compared to 22.0% of net revenues in the prior year period, or a decrease of two basis points. The remaining net increase of 43 basis points in the current nine-month period was primarily the result of increases in other items including benefits and legal costs.
Management fees paid to affiliates
For the nine-month period ended March 31, 2010, management fees paid to affiliates consisted of the pro-rata portion of the $5.0 million annual fee paid to the Sponsors through December 31, 2009 under an agreement executed in connection with the Transaction and a non-recurring fee of $29.6 million to terminate the agreement which was paid at the time of the initial public offering.
Depreciation and amortization expense
Depreciation and amortization expense on long-lived assets was $88.9 million in the current period, an increase of 7.1% from the prior year period. As a percentage of net revenues, depreciation and amortization expense decreased by 78 basis points compared to the prior year period, due to leverage in relation to revenue growth and a reduction in amortization of intangible assets due primarily to the expiration in June 2009 of an intangible asset recorded in connection with the Transaction.
Interest expense, net
Net interest expense was $94.7 million in the current period, a decrease of $21.4 million from the prior year period. The decrease in net interest expense is primarily related to the early retirement of $316.0 million of the Senior Subordinated Notes in connection with the initial public offering in October 2009 and a lower interest rate on our term loan during the current year period compared to the prior year period.
Loss on early retirement of debt
During the nine months ended March 31, 2010, we purchased Senior Subordinated Notes with a face value of approximately $337.4 million through two tender offer transactions. We recorded a loss of $47.2 million during this period on the early retirement of these notes, which was comprised of a premium of $41.6 million over face value to repurchase debt and accelerated amortization on the prorated portion of deferred financing costs related to these notes of $5.6 million.
Provision for income taxes
Our effective tax rate was 28.7% for the nine months ended March 31, 2010 as compared to 36.8% for the same period in the prior year. The effective tax rates differed from the combined federal and state statutory rates primarily due to valuation allowances, expenses that are non-deductible for tax purposes, and accounting for uncertain tax positions.
The decrease in the effective tax rate for the nine months ended March 31, 2010 as compared to the prior year period was primarily due to a $16.3 million decrease in the liability for uncertain tax positions and $1.6 million of interest and the indirect benefits associated with state income taxes as the result of the expiration of certain statutes of limitation with respect to fiscal year 2006.
Liquidity and Funds of Capital Resources
We finance our operating activities primarily from cash generated from operations, and our primary source of cash is tuition collected from our students. We believe that cash flow from operations, supplemented from time to time with borrowings under our $442.5 million revolving credit facility, will provide adequate funds for ongoing operations, planned expansion to new locations, planned capital expenditures, debt service and acquisitions during the next twelve months.

 

29


Table of Contents

Operating cash flows
Cash flow from operations for the nine month period ended March 31, 2010 was $340.2 million, including the effect of a non-recurring $29.6 million cash payment to terminate the Sponsor management agreement in connection with the initial public offering, compared to $314.9 million in the prior year period. The increase in operating cash flows as compared to the prior year period was primarily related to improved operating performance compared to the prior year period and a reduction of $11.2 million in the amount of interest paid on our debt compared to the prior year period as a result of debt repurchases and lower interest rates.
Days sales outstanding (“DSO”) in receivables increased to 15.1 days at March 31, 2010 compared to 12.8 days at March 31, 2009. We calculate DSO by dividing net student and other receivables at period end by average daily net revenues for the most recently completed quarter. Net accounts receivable can be affected significantly by the changes in the start dates of academic terms from reporting period to reporting period. There were no significant changes to the start dates of academic terms in session as compared to the prior year.
The level of accounts receivable reaches a peak immediately after the billing of tuition and fees at the beginning of each academic term. Collection of these receivables is heaviest at the start of each academic term. Additionally, federal financial aid proceeds for continuing students can be received up to ten days prior to the start of an academic term, which can result in fluctuations in quarterly cash receipts due to the timing of the start of academic terms.
In an effort to provide our students with financing for the cost of tuition, we have established relationships with alternative or private loan providers. Private loans help bridge the funding gap created by tuition rates that have risen more quickly than federally-guaranteed student loans. In addition, we introduced the Education Finance Loan program in August 2008, which enables students who have exhausted all available government-sponsored or other aid and have been denied a private loan to borrow a portion of their tuition and other educational expenses at our schools if they or a co-borrower meet certain eligibility and underwriting criteria. We purchased loans totaling $51.5 million and $3.2 million during the nine-month periods ended March 31, 2010 and 2009, respectively related to the Education Finance Loan program.
We have accrued a total of $7.8 million as of March 31, 2010 for uncertain tax positions, excluding interest and the indirect benefits associated with state income taxes. We may have cash payments in future periods relating to the amount accrued if we are ultimately unsuccessful in defending these uncertain tax positions. However, we cannot reasonably predict at this time the future period in which these payments may occur.
Investing cash flows
Capital expenditures were $119.8 million, or 6.4% of net revenues, for the nine month period ended March 31, 2010, compared to $98.0 million, or 6.6% of net revenues, for the prior year period. During fiscal 2010, we have continued to invest both in new facilities and in the expansion of existing facilities. We expect capital expenditures in fiscal 2010 to approximate 7.0% of net revenues compared to 7.5% of net revenues in fiscal 2009.
Reimbursements for tenant improvements represent cash received from lessors based on the terms of lease agreements to be used for leasehold improvements. We lease most of our facilities under operating lease agreements. We anticipate that future commitments on existing leases will be satisfied from cash provided from operating activities. We also expect to extend the terms of leases that will expire in the near future or enter into similar long-term commitments for comparable space.

 

30


Table of Contents

Financing cash flows
In October 2009, we consummated an initial public offering of 23.0 million shares of our common stock for net proceeds of approximately $387.3 million. The proceeds were primarily used to purchase a face value of $316.0 million of the Senior Subordinated Notes in a tender offer for $355.5 million and to pay $29.6 million to terminate a management agreement entered into with the Sponsors in connection with the Transaction. In addition, we purchased Senior Subordinated Notes with a face value of approximately $21.4 million through a tender offer during the quarter ended March 31, 2010.
As a result of the Transaction, we are highly leveraged and our debt service requirements are significant. At March 31, 2010, we had $1,541.8 million in aggregate indebtedness outstanding. After giving effect to outstanding letters of credit, we had $231.8 million of additional borrowing capacity on this facility at March 31, 2010. We expect our cash flows from operations, combined with availability under our revolving credit facility, to provide sufficient liquidity to fund our current obligations, projected working capital requirements and capital spending over the next twelve months.
Our revolving credit facility is available to draw upon in order to satisfy certain year-end regulatory financial ratios, fund working capital needs that may result from the seasonal pattern of cash receipts that occur throughout the year and finance acquisitions. On July 1, 2009, we repaid the revolving credit facility’s balance outstanding of $100.0 million, which existed in order to satisfy year-end regulatory financial ratios, from cash on hand at June 30, 2009.
We may issue up to $375.0 million of letters of credit under the revolving credit facility. We have outstanding letters of credit of $210.7 million at March 31, 2010. We are required to maintain a letter of credit with the U.S. Department of Education due to our failure to satisfy certain regulatory financial ratios after giving effect to the Transaction. The amount of the letter of credit, which was $173.2 million at March 31, 2010, is set at 10% of the Title IV aid received by students attending our schools. The majority of the remainder of the outstanding letters of credit at March 31, 2010 relate to obligations to purchase loans under the Education Finance Loan program. On May 7, 2010, the U.S. Department of Education requested us to increase our letter of credit to $259.8 million by June 4, 2010 based on projected Title IV aid to be received by students attending our institutions during fiscal 2011. Immediately following this increase, we will have $145.2 million of additional borrowings available under the revolving credit facility.
In November 2009, Education Management Corporation guaranteed the Notes. At March 31, 2010, total indebtedness outstanding under the Notes was $422.7 million. We do not expect the guarantee will adversely affect our liquidity within the next twelve months or restrict our ability to declare dividends or incur additional indebtedness in the future.
We may from time to time use cash on hand to retire or purchase our outstanding debt through open market transactions, privately negotiated transactions or otherwise. Such repurchases, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material.
Federal Family Education Loan Program and Private Student Loans
Approximately 81.5% and 13.1% of our net revenues were indirectly derived from Title IV programs under the Higher Education Act of 1965 and private loan programs, respectively, in fiscal 2009 compared to 70.2% and 22.3% from Title IV programs and private loan programs, respectively, in fiscal 2008. There have been significant recent developments that have impacted these programs.

 

31


Table of Contents

With the enactment of the Ensuring Continued Access to Student Loans Act of 2008, the U.S. government has made additional financial aid available to students in order to meet rising post-secondary education costs and decreased availability of private loans. Effective July 1, 2008, the annual unsubsidized Stafford loans made available to all undergraduate students under the FFEL and Direct Loan program increased by $2,000. On July 1, 2009, the maximum amount of availability of a Pell grant increased to $5,350 per year from a maximum of $4,731 per year in fiscal 2009. In addition, with the enactment of the Higher Education Opportunity Act of 2008, effective July 1, 2009 students are eligible for up to two annual scheduled Pell Grant awards, which should encourage students to accelerate their programs. The maximum Pell grant available to eligible students is scheduled to increase to $5,550 per award year effective July 1, 2010.
The credit and equity markets of both mature and developing economies have experienced extraordinary volatility, asset erosion and uncertainty in recent periods. In particular, adverse market conditions for consumer student loans have resulted in providers of private loans reducing the attractiveness and/or decreasing the availability of private loans to post-secondary students, including students with low credit scores who would not otherwise be eligible for credit-based private loans. In order to provide student loans to certain of our students who do not satisfy the new standard underwriting, we pay credit enhancement fees to certain lenders (including SLM Corporation, or “Sallie Mae”) based on the principal balance of each loan disbursed by the lender. An agreement we entered into with Sallie Mae to provide loans to certain students who received a private loan from Sallie Mae prior to April 17, 2008 and are continuing their education but who do not satisfy Sallie Mae’s current standard underwriting criteria expires in June 2010. As the number of students receiving loans through this program has decreased substantially throughout fiscal 2009 and 2010, we do not expect to extend this program beyond June 2010.
The reliance by students attending our schools on private loans decreased substantially during fiscal 2009 due to the increased availability of federal aid and certain operating initiatives. Excluding activity under our Education Finance Loan program, private loans accounted for approximately 13% of our net revenues in fiscal 2009 as compared to approximately 22% in fiscal 2008. This trend of decreasing reliance on private loans continued during the first nine months of fiscal 2010, as private loans accounted for approximately 5% of net revenues as compared to approximately 15% of net revenues in the first nine months of fiscal 2009.
We introduced the Education Finance Loan program through a private lender in August 2008 due to tightened credit markets facing our students. This program enables students who have exhausted all available government-sponsored or other aid and have been denied a private loan to borrow a portion of their tuition and other educational expenses at our schools if they or a co-borrower meet certain eligibility and underwriting criteria. Under the program, we purchase loans made by a private lender to students who attend our schools. Aid awarded under the Education Finance Loan program represented approximately 1.0% and 3.0% as a percentage of net revenues during fiscal 2009 and the first nine months of 2010, respectively. We estimate that total aid awarded under this program during fiscal 2010 will be approximately $70 million.
The Education Finance Loan program adversely impacts our liquidity and exposes us to new and greater credit risk because we own loans to our students. This financing provides for payments to us by our students over an extended term, which could have a material adverse effect on our cash flows from operations. In addition, we have the risk of collection with respect to these loans, which has resulted in an increase in our bad debt expense as a percentage of net revenues compared to prior fiscal years. While we are taking steps to address the private loan needs of our students, the consumer lending market could worsen. The inability of our students to finance their education could cause our student population to decrease, which could have a material adverse effect on our financial condition, results of operations and cash flows.

 

32


Table of Contents

Contingencies
Refer to Item 1 — “Financial Statements — Note 12, Contingencies”.
New Accounting Standards Not Yet Adopted
Refer to Item 1 — “Financial Statements — Note 2, Recent Accounting Pronouncements”.
Non-GAAP Financial Measures
We use EBITDA, defined as net income plus interest expense, net, loss on early retirement of debt, income taxes, depreciation and amortization, to measure operating performance. EBITDA is not a recognized term under GAAP and does not purport to be an alternative to net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity. Additionally, EBITDA is not intended to be a measure of free cash flow available for our discretionary use, as it does not consider certain cash requirements such as interest payments, tax payments and debt service requirements.
We believe EBITDA is helpful in highlighting trends because EBITDA excludes the results of decisions that are outside the control of operating management and can differ significantly from company to company depending on long-term strategic decisions regarding capital structure, the tax jurisdictions in which companies operate and capital investments. We compensate for the limitations of using non-GAAP financial measures by using them to supplement GAAP results to provide a more complete understanding of the factors and trends affecting the business than GAAP results alone. Because not all companies use identical calculations, these presentations of EBITDA may not be comparable to similarly titled measures of other companies. EBITDA is calculated as follows (in millions):
                                 
    For the Three Months     For the Nine Months  
    Ended March 31,     Ended March 31,  
    2010     2009     2010     2009  
Net income
  $ 84.6     $ 44.1     $ 120.6     $ 83.1  
Interest expense, net
    27.9       37.4       94.7       116.0  
Loss on early retirement of debt (1)
    2.4       0.0       47.2       0.0  
Provision for income taxes
    24.7       26.1       48.6       48.4  
Depreciation and amortization
    30.7       28.8       88.9       83.0  
 
                       
EBITDA
  $ 170.3     $ 136.4     $ 400.0     $ 330.5  
 
                       
     
(1)   In connection with the initial public offering in October 2009, we retired $316.0 million of the Senior Subordinated Notes in a tender offer. We also purchased Senior Subordinated Notes with a face value of $21.4 million in the third quarter of fiscal 2010 through another tender offer.
Covenant Compliance
Under its senior secured credit facilities, our subsidiary, Education Management LLC, is required to satisfy a maximum total leverage ratio, a minimum interest coverage ratio and other tests of financial condition. At March 31, 2010, Education Management LLC was in compliance with the financial and non-financial covenants. Its continued ability to meet those financial ratios and tests can be affected by events beyond our control, and we cannot assure you that it will meet those ratios and tests in the future.

 

33


Table of Contents

Adjusted EBITDA is a non-GAAP measure used to determine Education Management LLC’s compliance with certain covenants contained in the indentures governing the Senior Notes and Senior Subordinated Notes and in its senior secured credit facilities. Adjusted EBITDA is defined as EBITDA further adjusted to exclude unusual items and other adjustments permitted in calculating covenant compliance under the indentures governing the Senior Notes and Senior Subordinated Notes and its senior secured credit facilities. We believe that the inclusion of supplementary adjustments to EBITDA applied in presenting Adjusted EBITDA is appropriate to provide additional information to investors to demonstrate compliance with our financing covenants.
The breach of covenants in the senior secured credit facilities that are tied to ratios based on Adjusted EBITDA could result in a default under that agreement, in which case the lenders could elect to declare all amounts borrowed due and payable. Any such acceleration would also result in a default under the indentures governing the Senior Notes and Senior Subordinated Notes. Additionally, under the senior secured credit facilities and the indentures governing the Senior Notes and Senior Subordinated Notes, our ability to engage in activities such as incurring additional indebtedness, making investments and paying dividends is also tied to ratios based on Adjusted EBITDA.
Adjusted EBITDA does not represent net income or cash flows from operations as those terms are defined by GAAP and does not necessarily indicate whether cash flows will be sufficient to fund cash needs. In addition, unlike GAAP measures such as net income and earnings per share, Adjusted EBITDA does not reflect the impact of our obligations to make interest payments on outstanding debt, which have increased substantially as a result of our indebtedness incurred in June 2006 to finance the Transaction and related expenses. While Adjusted EBITDA and similar measures are frequently used as measures of operations and the ability to meet debt service requirements, these terms are not necessarily comparable to other similarly titled captions of other companies due to the potential inconsistencies in the method of calculation.
Adjusted EBITDA does not reflect the impact of earnings or charges resulting from matters that we may consider not to be indicative of our ongoing operations. In particular, the definition of Adjusted EBITDA in the senior credit facilities and the indentures allows us to add back certain non-cash, extraordinary, unusual or non-recurring charges that are deducted in calculating net income. However, these are expenses that may recur, vary greatly and are difficult to predict. Further, our debt instruments require that Adjusted EBITDA be calculated for the most recent four fiscal quarters. As a result, the measure can be disproportionately affected by a particularly strong or weak quarter. Further, it may not be comparable to the measure for any subsequent four-quarter period or any complete fiscal year.
The following is a reconciliation of net income, which is a GAAP measure of operating results, to Adjusted EBITDA for Education Management LLC as defined in its debt agreements. The terms and related calculations are defined in the senior secured credit agreement (in millions).

 

34


Table of Contents

         
    For the twelve  
    months ended  
    March 31,  
    2010  
 
       
Net income
  $ 141.9  
Interest expense, net
    132.0  
Loss on early retirement of debt (1)
    47.2  
Provision for income taxes
    61.5  
Depreciation and amortization
    118.2  
 
     
EBITDA
    500.8  
 
     
 
       
Reversal of impact of unfavorable leases (2)
    (0.9 )
Management fees paid to affiliates (3)
    33.3  
Severance and relocation
    7.0  
Non-cash compensation
    19.4  
Capital taxes
    5.0  
Other
    6.9  
 
     
Adjusted EBITDA — Covenant Compliance
  $ 571.5  
 
     
     
(1)   In connection with the initial public offering in October 2009, we retired $316.0 million of the Senior Subordinated Notes in a tender offer. We also purchased Senior Surbordinated Notes with a face value of $21.4 million in the third quarter of fiscal 2010 through another tender offer.
 
(2)   Represents non-cash reduction to rent expense due to the amortization on $7.3 million of unfavorable lease liabilities resulting from fair value adjustments required as part of the Transaction.
 
(3)   Represents fees incurred under a management advisory agreement with the Sponsors. Upon the completion of our initial public offering, we terminated the agreement with the Sponsors for a fee of $29.6 million.
Our covenant requirements and actual ratios for the twelve months ended March 31, 2010 are as follows:
                 
    Covenant     Actual  
Senior secured credit facility   Requirements     Ratios  
Adjusted EBITDA to Consolidated Interest Expense ratio
  Minimum of 2.00x     4.31x  
Consolidated Total Debt to Adjusted EBITDA ratio
  Maximum of 5.75x     1.95x  

 

35


Table of Contents

Certain Risks and Uncertainties
Certain of the matters we discuss in this report may constitute forward-looking statements. Forward-looking statements contain words such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,” “estimates,” or “anticipates” or similar expressions which concern our strategy, plans or intentions. All statements we make relating to estimated and projected earnings, margins, costs, expenditures, cash flows, growth rates and financial results are forward-looking statements. In addition, from time to time we make forward-looking public statements concerning our expected future operations and performance and other developments. All of these forward-looking statements are subject to risks and uncertainties that may change at any time, and, therefore, our actual results may differ materially from those that we expected. We derive most of our forward-looking statements from our operating budgets and forecasts, which are based upon many detailed assumptions. While we believe that our assumptions are reasonable, we caution that it is very difficult to predict the impact of known factors, and, of course, it is impossible for us to anticipate all factors that could affect our actual results. Some of the factors that we believe could affect our results include: our high degree of leverage; our ability to generate sufficient cash to service all of our debt obligations; general economic and market conditions; the condition of the post-secondary education industry; changes to rules and regulations that affect our business by the U.S. Department of Education, accrediting agencies and state licensing bodies; the integration of acquired businesses, the performance of acquired businesses, and the prospects for future acquisitions; the effect of war, terrorism, natural disasters or other catastrophic events; the effect of disruptions to our systems and infrastructure; the timing and magnitude of student enrollment; the timing and scope of technological advances; the trend in information availability toward solutions utilizing more dedicated resources; the market and credit risks associated with the post-secondary education industry; the ability to retain and attract students and key personnel; and risks relating to the foreign countries where we transact business. The factors described in this paragraph and other factors that may affect our business or future financial results are discussed in our filings with the Securities and Exchange Commission, including this report.

 

36


Table of Contents

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to market risks in the ordinary course of business that include fluctuations in the value of the Canadian dollar relative to the U.S. dollar. Due to the size of our Canadian operations relative to our total business, we do not believe we are subject to material risks from reasonably possible near-term changes in exchange rates and do not utilize forward or option contracts on foreign currencies.
The fair values of cash and cash equivalents, accounts receivable, borrowings under our revolving credit facility, accounts payable and accrued expenses approximate carrying values because of the short-term nature of these instruments.
At March 31, 2010, we had total debt obligations of $1,541.8 million, including $1,117.9 million of variable rate debt under the senior secured credit facility at a weighted average interest rate of 6.4%. A hypothetical change of 1.25% in interest rates from March 31, 2010 levels would have increased or decreased interest expense by approximately $3.4 million for the variable rate debt in the nine month period ended March 31, 2010.
Two five-year interest rate swap agreements fix the interest rate on $750.0 million of our variable rate debt through July 1, 2011. At March 31, 2010, we had variable rate debt of $367.9 million that was subject to market rate risk, as our interest payments fluctuated as a result of market changes. Under the terms of the interest rate swaps, we receive variable payments based on the three month LIBOR and make payments based on a fixed rate of 5.4%. The net receipt or payment from the interest rate swap agreements is recorded in interest expense. The interest rate swaps are designated as and qualify as cash flow hedges. The derivative financial instruments are carried at fair value, which is based on the framework discussed in Note 9 to the accompanying consolidated financial statements. We do not use derivative instruments for trading or speculative purposes.
For the nine-month period ended March 31, 2010, we recorded an unrealized after-tax gain of $7.7 million in other comprehensive loss related to the change in market value of the interest rate swaps. The cumulative unrealized loss of $26.5 million, net of tax, at March 31, 2010 related to the swaps may be recognized in the consolidated statement of operations if these instruments fail to meet certain cash flow hedge requirements, which include a change in certain terms of the senior secured credit facilities or the extinguishment or termination of the senior secured credit facilities or swap agreements prior to maturity.

 

37


Table of Contents

ITEM 4. CONTROLS AND PROCEDURES
The Company, under the supervision and participation of its management, which include the Company’s chief executive officer and chief financial officer, evaluated the effectiveness of its “disclosure controls and procedures,” as defined in Rule 13a-15(e) under the Securities Act of 1934, as amended (the “Exchange Act”). This evaluation was conducted as of the end of the period covered by this Form 10-Q. Based on that evaluation, our chief executive officer and chief financial officer have concluded that the Company’s disclosure controls and procedures are effective. Effective controls ensure that information required to be disclosed by the Company in reports that it files under the Exchange Act is recorded, processed and summarized within the time periods specified in Securities and Exchange Commission’s rules and forms. These controls and procedures are designed to ensure that information required to be disclosed by the Company in such reports are accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.
There were no changes that occurred during the fiscal quarter covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

38


Table of Contents

PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Information relating to legal proceedings is included in Note 12, Contingencies, to the Consolidated Financial Statements set forth in Part I, Item 1 of this Quarterly Report on Form 10-Q, which is incorporated herein by reference.
ITEM 1A. RISK FACTORS
Except for the following Risk Factors, there have been no material changes to our Risk Factors as previously disclosed in our Prospectus filed on October 2, 2009 with the Securities and Exchange Commission (file no. 333-148259):
The U.S. Department of Education is in the process of preparing proposed regulatory changes that, if enacted, could materially and adversely impact our business.
The U.S. Department of Education published a notice in the Federal Register in September 2009 announcing its intention to establish two negotiated rulemaking committees to prepare proposed regulations under Title IV of the Higher Education Act of 1965, as amended (“HEA”). The HEA requires that the U.S. Department of Education obtain public involvement in the development of proposed regulations before publishing any proposed regulations to implement programs authorized under Title IV of the HEA. The U.S. Department of Education uses a negotiated rulemaking process to develop the proposed regulations with representatives of organizations and groups affected by the proposed regulations.
The U.S. Department of Education convened two negotiated rulemaking committees in November 2009 to consider proposed regulations related to program integrity and foreign schools. The program integrity committee considered proposed regulations for 14 issues including incentive compensation, gainful employment in a recognized occupation, state authorization as a component of institutional eligibility, misrepresentation of information, definition of a credit hour, definition of high school diploma, ability to benefit, agreements between institutions of higher education, verification of information included on student aid applications, satisfactory academic progress, retaking coursework, disbursement of Title IV funds, return of Title IV funds and taking attendance, and return of Title IV funds for term-based programs with modules or compressed courses. The committee did not reach consensus on the proposed regulations for five of the 14 issues, including incentive compensation, gainful employment, state authorization, and the two return of-Title-IV funds issues. As a result, the U.S. Department of Education is not bound by the proposed regulations presented to the committee on any of the 14 issues. The U.S. Department of Education is expected to publish proposed regulations on these issues later this year for public comment, and the published versions may or may not differ from those presented to the committee. The U.S. Department of Education has stated that its intent is to publish final versions of the regulations by November 1, 2010. Any such regulations would become effective on July 1, 2011.

 

39


Table of Contents

We cannot predict what regulations the U.S. Department of Education will publish in proposed form later this year or the impact that enactment of the proposed regulations might have on our business. The implementation of regulations removing previously enacted “safe harbors” under the incentive compensation rule or otherwise limiting types of compensation to employees or third party entities involved in admissions, student enrollment and financial aid may have a material adverse affect on our recruiting processes and cause a decrease in student enrollment at our schools or a decrease in the productivity of our admissions representatives. The implementation of a definition of “gainful employment” tied to anticipated student debt and income for the purpose of determining whether certain educational programs, including those provided by a for-profit institution, prepare students for gainful employment in a recognized occupation and, in turn, whether that program qualifies as a Title IV eligible program, may affect our ability to provide Title IV funds to students enrolled in some of our educational programs or require us to decrease the tuition charged at our schools. Any actions that result in a decrease in student enrollment or tuition charged at our schools or affect our ability to participate in Title IV programs could materially and adversely affect our cash flows, results of operations and financial condition. The implementation of regulations which limit the ability of an institution to rely on the authorization of a state licensing agency to establish its eligibility to participate in the Title IV programs if the state agency does not meet or bring itself into compliance with prescribed standards and requirements could prevent our schools in that state from remaining eligible for Title IV funds and could materially and adversely affect our enrollments, revenues, and results of operations.
If our institutions do not comply with the 90/10 Rule, they will lose eligibility to participate in federal student financial aid programs.
Regulations promulgated under the HEA require all for-profit education institutions to comply with the 90/10 Rule, which imposes sanctions on participating institutions that derive more than 90% of their total revenue on a cash accounting basis from Title IV programs as calculated under the regulations. An institution that derives more than 90% of its total revenue on a cash accounting basis from the Title IV programs for each of two consecutive fiscal years loses its eligibility to participate in Title IV programs and is not permitted to reapply for eligibility until the end of the following two fiscal years. Institutions which fail to satisfy the 90/10 Rule for one fiscal year are placed on provisional certification and may be subject to other sanctions. Compliance with the 90/10 Rule is measured at the end of each of our fiscal years. For those of our institutions that disbursed federal financial aid during fiscal 2009, the percentage of revenues derived from Title IV programs ranged from approximately 55% to 86%, with a weighted average of approximately 70% as compared to a weighted average of approximately 65% in fiscal 2008. We anticipate that our 90/10 rates will continue to increase in fiscal 2010 due to recent increases in grants from the Federal Pell Grant (“Pell”) program and other Title IV loan limits, coupled with decreases in the availability of state grants and private loans and the inability of households to pay cash due to the current economic climate. While our consolidated 90/10 rate for fiscal 2010 is projected to remain under the 90% threshold, we project that some of our institutions will exceed the 90% threshold if we do not continue to successfully implement certain changes to these institutions during fiscal 2010 which would decrease their 90/10 rate, such as increases in international and military students and certain internal restructuring designed to achieve additional operational efficiencies. In prior years, similar changes to operations resulted in lower 90/10 rates at our institutions where we implemented such changes. Completion of our proposed internal restructuring requires the prior approval of the U.S. Department of Education, as well as approvals from certain accrediting bodies and state licensing agencies, some of which must be obtained prior to the restructuring. Failure to obtain U.S. Department of Education or other required approvals prior to the end of our fiscal year may result in failure of some of our institutions to comply with the 90/10 Rule. Additionally, the HEA reauthorization includes relief through June 30, 2011 from a $2,000 increase in the annual Stafford loan availability for undergraduate students which became effective July 1, 2008. We anticipate that our 90/10 rate will increase substantially in fiscal 2012 in the event that relief from this additional $2,000 is not extended beyond June 30, 2011, which would adversely affect our ability to comply with the 90/10 Rule. Continued decreases in the availability of state grants would also adversely impact our ability to comply with the 90/10 Rule because state grants generally are considered cash payments for purposes of the 90/10 Rule. We continue to monitor the compliance with the 90/10 Rule by each of our institutions and assess the impact of increased financial aid received by our students under the current rule. If any of our institutions violates the 90/10 Rule for at least two years, its ineligibility to participate in Title IV programs could have a material adverse effect on our enrollments, revenues and results of operations.

 

40


Table of Contents

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS
Not applicable.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS INDEX
         
Number   Document
       
 
  31.1    
Certification of Todd S. Nelson required by Rule 13a-14(a) or Rule 15d-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002.
       
 
  31.2    
Certification of Edward H. West required by Rule 13a-14(a) or Rule 15d-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002.
       
 
  32.1    
Certification of Todd S. Nelson required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002.
       
 
  32.2    
Certification of Edward H. West required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002.

 

41


Table of Contents

SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
       
   
/s/ Edward H. West
 
   
 
Edward H. West
 
   
President and Chief Financial Officer
 
Date: May 11, 2010

 

42