One couldn’t help but notice the sharp drop in Apollo (APOL – $61) a few days ago in response to a downgrade from Credit Suisse.   What’s more intriguing to us is the extreme change of view over a short 3 week period.

On April 1st analyst Kelly Flynn felt that concerns post the Q2 report were “overblown” and that concerns and less margin expansion were “already reflected” in valuation.  As for concerns coming on the regulatory front the were said to be “less credible than [they have been] for several years given management’s obvious constructive approach to educational quality and all regulatory issues.”  In the note the analyst went on to increase estimates and reiterate their Outperform rating and $95 price target.

Since the report we have been seeing matters of real concern about Apollo and written about them right here. Because we are short the name we were pleased to see Credit Suisse come out just 20 days later on April 21st with a downgrade of the shares.  But it’s still puzzling that now the analyst feels exactly the opposite regarding regulatory scrutiny and a slowing of the business going forward.

Our best guess is that the deeper you look the more problems you see.  Again it’s not that the company is bad but that the risk from more regulatory scrutiny and estimates that look simply too high argue for there being much more risk than most are factoring in.

Thankfully for Apollo shareholders Deutche Bank joined the cheerleading section by coming out with a Buy rating on the shares the same day as the Credit Suisse downgrade.  The analyst at DB must have felt odd watching the stock tank that day but able to use the well worn phrase “we loved it at $65 so we really love it down here at $60.”

Recently the current administration has been making clear noises about reform in the credit card industry.  This is just more evidence to us that the government will want to know that the debt that is being piled on students by for-profit educational companies is actually in their best interests.  Apollo has mounted a major advertising campaign to keep visibility and enrollments up but it will also ensure that they are in the sights of whomever might be interested in reforming questionable industry practices.

Lastly there’s something about feel that we can’t ignore with this company.  From the management commentary to the website the company comes off as a enrollment and degree granting *machine* which can be seen as a good thing if you stand to profit from the volume. It’s not very consistent with an institution of higher learning or even a trade school.  Everything shouts “enroll in a program” and it can be financed with student loans.   We realize that Apollo Group is a real company and many students and alumni get good value from their involvement with the company.  But it seems that a many, possibly a majority, do not and Apollo has business practices that don’t seem above reproach.

[Disclosure: As mentioned above Research 2.0 is unabashedly short some shares of Apollo Group based on what we see as a mis-pricing of risk in the market price of the stock.]

Shares of Apollo Group (NASDAQ: APOL – $66.88) are down over 14% today after their quarterly report last night.  We don’t follow the stock from a research standpoint but have taken an interest in the share price in the last few months as it has defied market gravity.

Most of the analyst reports we have seen so far are defending the shares here and see the concerns fueling the sell-off as overblown.  However the stock decline merely reflects a moderation of what have been near-perfect conditions for Apollo during the last few quarters.  Analysts tend to straight-line these trends into unrealistic expectations. Management outlined very sensible business plans going forward but they may produce less than historic upside and margin expansion.

Apollo has been blessed with rising prices and decreasing costs to put the wind at their back and create a string of solid execution and strong quarters.  Now there are some very minor blemishes in the future vision as 1) government programs are shifted to direct-to-student lending, 2) Apollo will be getting a bit more scrutiny from regulators, 3) the company says they will be making some investments to improve their technology and programs and while not yet evident in results per-se, 4) there are some signs that the economy is having a minor impact on Apollo.

So what does one do with Apollo here?  The simple view is that the price of the shares now looks fair at 16-17x current estimates.  The complicating factor is that most analysts that follow the stock continue to somewhat stubbornly defend it and some are (perversely) still raising forward estimates on the stock.  (Note to sell-side analysts: If you like a stock you want to keep estimates low and if you hate a stock you keep your estimates high.  It goes against peer pressure and conventional wisdom but that’s how it works.  You do your work with unpublished numbers and commentary.)

Before the report we saw some models that were suggesting a fairly strong accelerating in top-line growth.  It’s too soon to tell how things will settle out with consensus as we’ve only seen a few reports so far.  But the ones we saw are raising earnings estimates for the current year and the out year.

Based on what we know now it’s hard to imagine the company will make new 52-week highs this year.  So that suggests to us a stock that’s range-bound in the $75-55 band.  It’s a wide one but well within the 52-week high/low on the shares. The reason we think another 10 points of downside exists from here is that the company may transition into a “meets expectations” from a “beat and raise” sort of momentum stock.  That will attract a different type of investor at more GARP (growth at a reasonable price) style valuations.  The company also has $500M authorized for stock repurchasing so that could be a factor in the market at some point.

From a short perspective the home run possibility is that there is a major “hiccup” in the transition to direct-to-student loans which is a major shift.  Apollo certainly can navigate it without a hitch but as everyone knows any change brings some risks along with rewards.

Despite all the efforts of management we still feel that Phoenix retains the cloud of a “mail order degree” during a time when degrees of any sort (even Harvard) seem to matter less.

We think that future recruiting is more “show me what you can do” and less  “show me what you know.”  Not something we would make a stock call from but a trend that argues against taking on loans to get a piece of paper versus alternatives.

[Disclosure: Research 2.0 has a small short position in APOL.]

Apollo Group (APOL) has remained one of the few high-flying stocks in the market these days.  There are a few obvious reasons including:

The firm has continued to execute very well.  In their most recent quarterly report in January they posted solid results.  Revenue grew 24% and operating margins rose to an a very rich 31.6%. 

There is a belief that in a down economy characterized by job losses that online education companies like Apollo are in a very strong position and will be able to thrive while other parts of the economy swoon.  More people in transition means more opportunity for incremental education to help them get into a new job.

Most analysts and investors love the management team at Apollo and feel that they are one of the best in the business for sure and perhaps near the top for public companies in general.

About a month ago the notorious short seller Citron Research began to pick on Apollo Group with some comments suggesting that their business practices were questionable and might not be sustained.

We’d say that the concerns raised by Citron were largely dismissed by analysts and investors.  Although the shares have retreated a little bit, forward estimates and valuation all suppose that the company will be one of the few (the only?) to be able to grow right through the current economic environment.

Perhaps more concerning is a rasher of new documents and information released by Citron yesterday that point to more than a few eye brow raising practices at the company.  Since Apollo is dependent on government education loans their practices are likely to fall under greater scrutiny than other companies.

One can’t help but think in reading through these documents that the "enrollment counselors" at Apollo are a lot like the "mortgage officers" of the current banking crisis.  Paying people to "get people into the program" when that program is funded with government money is one of those things that gets a company or even a whole industry into trouble. 

The showdown seems to be on the way as analysts have recently raised forward estimates for APOL and have price targets in the vicinity of $95/share.  In fact most models we have seen are calling for an acceleration of top-line growth in 2009 and 2010.

According to S&P/CapitalIQ there are only 11M shares sold short out of about 159M.  The stock has come in a bit with the market and trades at a TEV/REV of 3.2x and about 23x earnings.  Insiders have been consistent sellers but continue to own large positions in the company.

We haven’t done any of the research here but we have reviewed what is out there on both sides of the argument.  Given the valuation and forward estimates for this company we think there is some cause for alarm.

[Disclosure: Research 2.0 has a small short position in the shares of APOL at the time of this writing.]