We saw professor David Gelernter at the December 2009 Gilder Telecosm and he made some profound points about the structural dysfunction of the higher educational system. We summarize them here and I’m sure this topic will be a recurring theme over the next decade (or two.)

Education is a famously slow-to-evolve institution and most have resisted the onslaught of technology advancement thusfar. However the RealVR Cloud is putting more pressure than ever on the system and some believe we will soon see the end of the education “mainframe” was we call it where essentially all the elements of an education are combined into one institution. Here we focus on higher learning like college and university but ultimately the effects will filter down into K-12 education. A typical university takes in the students admitted and provides a set of teachers and classes along with some guidance and curriculum to reach a point where the school grants a degree. Thanks to a process called accreditation the degree the school grants is certified and accepted as bona fide. That being said a college degree still leaves lots of open questions since the school, choice of classes and student aptitude creates a rather broad quality range in graduating class even if all of them have the same degree.

Even students see the shortcomings of such a system. Schools have great teachers, good teachers and some so-so teachers. In addition different students absorb information differently. Being able to select the best curriculums and teachers to fulfill requirements would mean that many students would get a better education.

So how would it work? The essence of the plan would be to provide for a clear separation of teachers/course content, guides/deans and certification authorities. This would allow an open process by which students could select an advisor who would work with them on developing an educational plan that is comprised of different teachers and courses that will meet the needs put forth by the certification authority.

Why do we need this? Some of the reasons that jump to mind are:

1. The limited supply of university “seats” compared to the demand.
2. The incredibly high cost of full-time degree granting institutions.
3. Incredibly slow change and innovation at some institutions which have become so paralyzed by tenured curmudgeons that their curriculum and learning process dates back to the 19th century.
4. Students also need more options in fields that are growing and changing quickly. Some evolve so fast that over a typical four year period the needs have changed the bulk of the needed curriculum.

Education is a very large and slowly changing industry. But technology is having a greater impact every day. From an investment standpoint we note that new classroom technology companies are planning to come public next year. So our coverage universe in “Education 2.0” might yet expand.

Apollo Group (APOL – $60), parent company of the University of Phoenix (UoP), has never been one to welcome scrutiny and this time the intensity and impact may be greater than ever.  The new administration is smarter and the US Department of Education (DOE) is more aggressive about allocating the billions of taxpayer dollars to ensure efficient and effective results.

While there are plenty of inefficiencies in the education industry, the Apollo situation appears acute.  It’s already known that Apollo has illegally compensated “enrollment counselors” in violation of regulations for those receiving so-called Title IV dollars from the US DOE.  There have also been a number of smaller settled lawsuits for violations of labor laws, unequal-opportunity employment, non-payment of student refunds, failure to meet teaching schedule requirements and even investment fraud (overturned later by a higher court.)  We mention these not to suggest that any of it is new but to indicate that the company is no stranger to operating outside the limits of fair and legal practice.

The is some new bad news for Apollo will have to be digested and factored into the share price from here.  Court documents that have just recently been unsealed allege that Apollo actually went so far as to maintain two distinct sets of books and records to pacify investigators at the US DOE and hide their illegal practices of rewarding enrollment staff with commissions, bonuses and other incentives based on numbers.  Staff was given direct incentives to get students regardless of their qualifications or the suitability of the programs offered to their objectives.  At the same time Apollo created and maintained a set of files that showed enrollment counselor evaluation criteria in line with what the DOE wants to see.

Here’s how it works: A would-be student sees an inspiring commercial from the University of Phoenix and calls an 800 number.  They are told that yes, they can change their life and get a valuable college degree from UOP.  And the best news of all is that they are eligible to receive student loans from the government to pay for it!  All good news but for one thing, Apollo gets to keep the money, the student gets a dubious education (most don’t complete a degree program) and even those that do more often than not won’t get a job with the UOP degree.  The student then ends up saddled with debt that they owe to the government while Apollo staff, executives and shareholders keep the profits. The money machine works very well which is why so many investors and sell-side analysts have loved the stock.  (Sound familiar?)

More than 1/2 of all Apollo revenue comes directly from government financial aid programs.    There remains an unresolved set of allegations about Apollo that includes written testimony about their intentional deception of DOE officials that is scheduled for trial in March of 2010.  At an even more fundamental level the Apollo engine of using sometimes marginal students to take on debt and transfer the money to them in exchange for a degree program of questionable value (in terms of both probability of completion and opportunity for a better job and/or higher pay) feels like it’s not going to run as well in this economy and administration as it has in the past.  Most published estimates indicate otherwise; analysts are looking for continued 20%+ revenue growth and estimates have continued to trend up although even management has been cautioning that business conditions may not be as favorable for them in the back half of this fiscal year.

So according to just about everyone the future is only bright for the company and now the company looks fairly valued if not cheap on current estimates.  However we think that the risk factors touched on here merit some real attention and argue for lower growth (if not much worse) going forward.  Even though nothing reviewed here is an absolute, the company has a history of violations and settlements across different practice areas and the durability of the charges and strength of evidence presented suggests that there is a probability much greater than zero that the piece of the Apollo business financed with taxpayer dollars may be at risk.   A realization of this outcome would have the effect of cutting the Apollo business about in half and eliminating most if not all historical and prospective profits.   Apollo would be able to stay in business but would have to compete more on equal footing to other universities, colleges and trade schools, not to mention good old fashioned on the job training.

[Disclosure:  Based on what appear to be real risks for APOL, Research 2.0 has established a short position in the shares of Apollo Group.  Please see our website for additional important disclaimers.]