Analysis: EDMC flirts with debt covenant breach as profit slides

Thu Sep 20, 2012 2:04pm EDT

(Reuters) - Education Management Corp (EDMC.O), once a $3.4 billion jewel for Goldman Sachs and Providence Equity Partners, has sunk to less than $500 million in value, as profits fall and risks grow that it may breach debt covenants and be forced to refinance on expensive terms.

The financial pressure means the company is looking to sell assets and there is speculation its private equity backers might take it private again.

EDMC, the second-largest for-profit college operator in the United States based on student numbers, has carried a heavy debt load since it was bought by its private equity owners in 2006.

It has since been caught in a slump at for-profit colleges following U.S. government investigations that revealed low graduation rates and fraud in the sector -- prompting tough new enrollment rules.

The soft U.S. economy and fears over mounting student debt have also hurt demand, helping cut EDMC's student numbers at the end of June by 11 percent from a year earlier.

EDMC's stock has fallen 88 percent this year, much more than its peers, as investors are increasingly concerned that the company may not generate enough cash to pay down debt or refinance on favorable terms, analysts said.

EDMC maintains it will meet the conditions on its debt but analysts say even nearing a breach would mean an expensive refinancing round with lenders.

The company last month forecast a 22 percent drop in annual earnings before interest, tax, deprecation and amortization (EBITDA), a measure of profitability, due to falling student sign-ups over four straight quarters.

If EBITDA were to fall a little further, say by 25 percent, EDMC would risk violating operating leverage and interest coverage ratios used to measure compliance with debt covenants, Wells Fargo analyst Trace Urdan said, a view shared by other analysts.

"Based on my projections, it does look like they could potentially be in violation of the operating leverage measure by March 2013," Piper Jaffray analyst Peter Appert said.

Lenders would be prepared to renegotiate terms but on more expensive terms for the company, in part because of the falling equity value, Urdan said.

TIGHTENED MEASURES

In its annual filing with the U.S. Securities and Exchange Commission last week, EDMC said both ratios will be made tougher to meet from September 30.

The limit for EDMC's leverage ratio, net debt divided by EBITDA, will be set to a maximum of 3.5 times, down from 4 earlier. For the year to June 30, 2012 net debt was 2.6 times EBITDA, according to the annual report.

For fiscal year 2013, falling profits mean the ratio may rise to 3.46, Reuters calculations show, based on EDMC's net debt and its own forecast for $400 million in annual EBITDA. The EBITDA figure could change based on whether one-time items are included.

EDMC has net debt of about $1.39 billion because its private equity owners took control of the company in a leveraged buyout.

"They would have to redeploy free cash flow to bring down their debt level more aggressively," Wells Fargo's Urdan said.

From the end of the month, EDMC's maximum interest coverage ratio has been tightened to 2.75, which the company will meet comfortably in the current financial year to June 30, 2013, based on its earnings forecast. An interest coverage ratio is calculated by dividing EBITDA by the company's interest costs.

EDMC spokeswoman Jacquelyn Muller said the company believes it has sufficient coverage to meet both the operating leverage and interest coverage tests under its debt covenants.

She declined to say whether the company was currently in talks to refinance its debt.

"We always look at and evaluate refinancing opportunities related to our debt. We will prudently balance the needs of all of our constituents when making capital structure decisions," Muller told Reuters in an emailed statement.

EDMC CEO Ed West told an industry conference last week that he is confident the company can survive in its current form. He said it is looking at ways to free up cash flow, reduce capital expenditure and sell assets to pay down debt.

OPTIONS

Providence Equity Partners and Goldman Sachs Capital Partners, along with Leeds Equity Partners, bought EDMC in 2006 for $3.4 billion, or $43 per share, and took the company public in 2009.

The shares were sold for $18 and hit a peak of $29.29 at the beginning of this year before a long slide to below $4 this month. The stock was down 8 percent at $3.33 on Nasdaq on Thursday.

One answer may be for one or both of the private equity shareholders, which between them still hold about 84 percent of the shares, to take EDMC private again.

"It is an obvious question because the float is very small. Will Goldman just buy up the remaining stake and take them private," said Wells Fargo analyst Trace Urdan.

In its annual filing, EDMC has included new risk factors regarding a "going private transaction."

Goldman Sachs and Providence declined to comment for this story.

Another option to raise cash would be for EDMC to sell one of its many colleges, Urdan said. EDMC owns the Art Institutes, Argosy University, Brown Mackie Colleges and South University.

(Editing by Rodney Joyce)

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