UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

x                              QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2007

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: 0-23245

GRAPHIC

CAREER EDUCATION CORPORATION

(Exact name of registrant as specified in its charter)

Delaware

 

36-3932190

(State or other jurisdiction

 

(I.R.S. Employer

of incorporation or organization)

 

Identification No.)

 

2895 Greenspoint Parkway, Suite 600,

 

 

Hoffman Estates, Illinois

 

60169

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code: (847) 781-3600

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 x  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.

Large accelerated filer x

Accelerated filer o

Non-accelerated filer 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 x

Number of shares of registrant’s common stock, par value $0.01, outstanding as of May 1, 2007: 95,014,040

 




CAREER EDUCATION CORPORATION
INDEX

 

Page

PART I—FINANCIAL INFORMATION

 

 

Item 1.

 

Financial Statements

 

3

 

 

Unaudited Condensed Consolidated Balance Sheets

 

3

 

 

Unaudited Condensed Consolidated Statements of Income

 

4

 

 

Unaudited Condensed Consolidated Statement of Stockholders’ Equity

 

5

 

 

Unaudited Condensed Consolidated Statements of Cash Flows

 

6

 

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

7

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

43

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

64

Item 4.

 

Controls and Procedures

 

65

PART II—OTHER INFORMATION

 

 

Item 1.

 

Legal Proceedings

 

67

Item 1A.

 

Risk Factors

 

67

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

67

Item 5.

 

Other Information

 

67

Item 6.

 

Exhibits

 

68

SIGNATURES

 

69

 

2




PART I—FINANCIAL INFORMATION

Item 1.                        Financial Statements

CAREER EDUCATION CORPORATION AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts)

 

 

March 31,
2007

 

December 31,
2006

 

ASSETS

 

 

 

 

 

CURRENT ASSETS:

 

 

 

 

 

Cash and cash equivalents

 

$

165,593

 

$

188,058

 

Investments

 

284,234

 

259,766

 

Total cash and cash equivalents and investments

 

449,827

 

447,824

 

Receivables:

 

 

 

 

 

Students, net of allowance for doubtful accounts of $26,791 and $28,532 as of March 31, 2007, and December 31, 2006, respectively

 

45,063

 

48,160

 

Other, net

 

7,768

 

8,084

 

Prepaid expenses

 

42,188

 

29,457

 

Inventories

 

18,318

 

16,713

 

Deferred income tax assets

 

6,705

 

10,970

 

Assets held for sale

 

64,455

 

69,171

 

Other current assets

 

16,822

 

32,064

 

Total current assets

 

651,146

 

662,443

 

PROPERTY AND EQUIPMENT, net

 

341,606

 

349,414

 

GOODWILL

 

379,454

 

349,703

 

INTANGIBLE ASSETS, net

 

45,708

 

33,984

 

OTHER ASSETS

 

28,432

 

30,119

 

TOTAL ASSETS

 

$

1,446,346

 

$

1,425,663

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

CURRENT LIABILITIES:

 

 

 

 

 

Current maturities of long-term debt

 

$

12,840

 

$

12,098

 

Accounts payable

 

27,468

 

29,861

 

Accrued expenses:

 

 

 

 

 

Payroll and related benefits

 

23,804

 

26,678

 

Income taxes

 

19,588

 

 

Other

 

79,728

 

78,513

 

Deferred tuition revenue

 

143,507

 

131,651

 

Liabilities held for sale

 

32,008

 

33,702

 

Total current liabilities

 

338,943

 

312,503

 

LONG-TERM LIABILITIES:

 

 

 

 

 

Long-term debt, net of current maturities

 

3,293

 

2,763

 

Deferred rent obligations

 

89,710

 

90,013

 

Deferred income tax liabilities

 

16,244

 

16,527

 

Other

 

8,946

 

7,979

 

Total long-term liabilities

 

118,193

 

117,282

 

SHARE-BASED AWARDS SUBJECT TO REDEMPTION

 

12,084

 

13,477

 

STOCKHOLDERS’ EQUITY:

 

 

 

 

 

Preferred stock, $0.01 par value; 1,000,000 shares authorized; no shares issued or outstanding

 

 

 

Common stock, $0.01 par value; 300,000,000 shares authorized; 107,391,662 and 106,923,310 shares issued, 94,974,490 and 96,148,825 shares outstanding as of March 31, 2007, and December 31, 2006, respectively

 

1,074

 

1,069

 

Additional paid-in capital

 

678,945

 

666,780

 

Accumulated other comprehensive income

 

6,774

 

5,683

 

Retained earnings

 

706,619

 

675,188

 

Cost of 12,417,172 and 10,774,485 shares in treasury as of March 31, 2007, and December 31,
2006, respectively

 

(416,286

)

(366,319

)

Total stockholders’ equity

 

977,126

 

982,401

 

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

 

$

1,446,346

 

$

1,425,663

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated statements.

3




CAREER EDUCATION CORPORATION AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share amounts)

 

 

For the Three Months Ended
March 31,

 

 

 

2007

 

2006

 

REVENUE:

 

 

 

 

 

Tuition and registration fees

 

$

405,054

 

$

465,281

 

Other

 

18,954

 

19,360

 

Total revenue

 

424,008

 

484,641

 

OPERATING EXPENSES:

 

 

 

 

 

Educational services and facilities

 

141,647

 

138,992

 

General and administrative

 

215,375

 

228,193

 

Depreciation and amortization

 

18,781

 

17,776

 

Total operating expenses

 

375,803

 

384,961

 

Income from operations

 

48,205

 

99,680

 

OTHER INCOME (EXPENSE):

 

 

 

 

 

Interest income

 

4,705

 

4,294

 

Interest expense

 

(354

)

(338

)

Share of affiliate earnings

 

1,712

 

903

 

Miscellaneous income

 

238

 

156

 

Total other income

 

6,301

 

5,015

 

Income before provision for income taxes

 

54,506

 

104,695

 

PROVISION FOR INCOME TAXES

 

19,895

 

39,157

 

Income from continuing operations

 

34,611

 

65,538

 

LOSS FROM DISCONTINUED OPERATIONS, net of tax

 

(4,573

)

(12,839

)

NET INCOME

 

$

30,038

 

$

52,699

 

NET INCOME PER SHARE—BASIC:

 

 

 

 

 

Income from continuing operations

 

$

0.36

 

$

0.67

 

Loss from discontinued operations

 

(0.05

)

(0.13

)

Net income

 

$

0.31

 

$

0.54

 

NET INCOME PER SHARE—DILUTED:

 

 

 

 

 

Income from continuing operations

 

$

0.36

 

$

0.65

 

Loss from discontinued operations

 

(0.05

)

(0.12

)

Net income

 

$

0.31

 

$

0.53

 

WEIGHTED AVERAGE SHARES OUTSTANDING:

 

 

 

 

 

Basic

 

96,282

 

98,143

 

Diluted

 

96,798

 

100,220

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated statements.

4




CAREER EDUCATION CORPORATION AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(In thousands)

 

 

Common Stock

 

Treasury Stock

 

Additional

 

Accumulated
Other

 

 

 

 

 

 

 

Issued 
Shares

 

$0.01 Par
Value

 

Purchased
Shares

 

Cost

 

Paid-in
Capital

 

Comprehensive
Income

 

Retained
Earnings

 

Total

 

BALANCE, December 31, 2006

 

106,924

 

$

1,069

 

(10,774

)

$

(366,319

)

$

666,780

 

$

5,683

 

$

675,188

 

$

982,401

 

Net income

 

 

 

 

 

 

 

30,038

 

30,038

 

Foreign currency translation

 

 

 

 

 

 

1,085

 

 

1,085

 

Unrealized gain on
investments

 

 

 

 

 

 

6

 

 

6

 

Total comprehensive
income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

31,129

 

Treasury stock purchased

 

 

 

(1,643

)

(49,967

)

 

 

 

(49,967

)

Share-based compensation

 

 

 

 

 

3,101

 

 

 

3,101

 

Common stock issued under:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock option plans

 

425

 

4

 

 

 

6,234

 

 

 

6,238

 

Employee stock purchase
plan

 

43

 

1

 

 

 

905

 

 

 

906

 

Tax benefit of options
exercised

 

 

 

 

 

1,925

 

 

 

1,925

 

Adjustment to share-based awards subject to redemption

 

 —

 

 —

 

 —

 

 —

 

 —

 

 —

 

 1,393

 

 1,393

 

BALANCE, March 31, 2007

 

107,392

 

$

1,074

 

(12,417

)

$

(416,286

)

$

678,945

 

$

6,774

 

$

706,619

 

$

977,126

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated statements.

5




CAREER EDUCATION CORPORATION AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

 

 

For the Three Months
Ended March 31,

 

 

 

2007

 

2006

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

30,038

 

$

52,699

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Goodwill impairment charge

 

 

10,389

 

Depreciation and amortization expense

 

18,781

 

21,009

 

Compensation expense related to share-based awards

 

3,101

 

4,015

 

Loss on disposition of property and equipment

 

1

 

23

 

Share of affiliate earnings, net of dividends received

 

230

 

(903

)

Changes in operating assets and liabilities, net of acquisition

 

36,996

 

35,405

 

Net cash provided by operating activities

 

89,147

 

122,637

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Business acquisition, net of acquired cash

 

(30,324

)

 

Acquisition transaction costs

 

(1,106

)

 

Purchases of property and equipment

 

(16,812

)

(17,543

)

Purchases of available-for-sale investments

 

(209,454

)

(361,619

)

Sales of available-for-sale investments

 

186,955

 

243,772

 

Other

 

6

 

(5

)

Net cash used in investing activities

 

(70,735

)

(135,395

)

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Purchase of treasury stock

 

(49,967

)

(24,925

)

Issuance of common stock

 

7,144

 

2,932

 

Tax benefit associated with stock option exercises

 

1,925

 

720

 

Payments of capital lease obligations and other long-term debt

 

(29

)

(89

)

Net cash used in financing activities

 

(40,927

)

(21,362

)

EFFECT OF FOREIGN CURRENCY EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS

 

706

 

834

 

NET DECREASE IN CASH AND CASH EQUIVALENTS

 

(21,809

)

(33,286

)

DISCONTINUED OPERATIONS CASH ACTIVITY INCLUDED ABOVE:

 

 

 

 

 

Add: Cash balance of discontinued operations at beginning of the period

 

1,758

 

3,033

 

Less: Cash balance of discontinued operations at end of the period

 

2,414

 

1,995

 

CASH AND CASH EQUIVALENTS, beginning of the period

 

188,058

 

129,275

 

CASH AND CASH EQUIVALENTS, end of the period

 

$

165,593

 

$

97,027

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated statements.

6




CAREER EDUCATION CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.                 DESCRIPTION OF THE COMPANY

We are a dynamic educational services company committed to quality, career-focused learning and led by passionate professionals who inspire individual worth and lifelong achievement. Since our founding in 1994, we have progressed rapidly toward our goal of becoming the world’s leading provider of quality educational services. We are one of the world’s leading on-ground providers of private, for-profit, postsecondary education and have a substantial presence in online education. Our schools and universities prepare students for professionally and personally rewarding careers through the continuing operation of 75 on-ground campuses located throughout the United States and in France, Canada, Italy, and the United Kingdom and two fully-online academic programs.

Our schools and universities offer doctoral degree, master’s degree, bachelor’s degree, associate degree, and non-degree certificate and diploma programs in the following core career-oriented disciplines:

·       Culinary Arts: Programs within this discipline include culinary arts, hotel and restaurant management, and baking and pastry arts.

·       Visual Communication and Design Technologies: Programs within this discipline include desktop publishing, graphic design, fashion design and merchandising, interior design, graphic imaging, web page design, animation, photography, game design, digital film and media, and visual journalism.

·       Health Education: Programs within this discipline include medical assistance, medical billing and coding, massage therapy, pharmacy technician, diagnostic medical ultrasound, cardiovascular technician, surgical technician, dental assistance, and medical office administration.

·       Business Studies: Programs within this discipline include business administration, business operations, merchandising management, business administration and marketing, paralegal studies, hospitality management, criminal justice, and education.

·       Information Technology: Programs within this discipline include PC/LAN, PC/Net, computer technical support, computer network operation, computer information management, computer science, computer engineering, and computer programming.

2.                 BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the financial statements do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments, including normal recurring accruals, considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2007, are not necessarily indicative of the results that may be expected for the year ending December 31, 2007. The condensed consolidated balance sheet as of December 31, 2006, has been derived from the audited consolidated financial statements as of that date but does not include all of the information and notes required by GAAP for complete financial statements. For additional information, refer to the consolidated financial statements and notes to consolidated financial statements as of and for the year ended December 31, 2006, included in Part IV, Item 15 of our Annual Report on Form 10-K for

7




the year ended December 31, 2006, filed with the Securities and Exchange Commission (“SEC”) on March 1, 2007.

As used in this Quarterly Report on Form 10-Q, the terms “we,” “us,” “our,” and “CEC” refer to Career Education Corporation and our wholly-owned subsidiaries. The terms “school” and “university” refer to an individual, branded, proprietary educational institution, owned by us and including its campus locations. The term “campus” refers to an individual main or branch campus operated by one of our schools or universities.

The unaudited condensed consolidated financial statements presented herein include the accounts of CEC and our wholly-owned subsidiaries. All inter-company transactions and balances have been eliminated. The results of operations of all acquired businesses have been consolidated for all periods subsequent to the date of acquisition.

3.                 BUSINESS ACQUISITION

On January 25, 2007, we acquired 100% of the issued and outstanding stock of Istituto Marangoni for approximately $37.2 million. The purchase price was funded with cash generated from operating activities. Istituto Marangoni is a world-renowned private, for-profit, post-secondary fashion and design school with locations in Milan, Italy; London, England; and Paris, France. We acquired Istituto Marangoni primarily because of its potential for market leadership, the economic attractiveness of the educational markets that it serves, and its potential for strong returns on invested capital. The acquisition of Istituto Marangoni also provides us with a platform for additional expansion in Europe and represents our entry into the Italian educational market.

The purchase price of approximately $39.6 million, including acquisition costs of approximately $2.4 million, was allocated to the estimated fair values of acquired tangible and identifiable intangible assets of approximately $27.0 million and assumed liabilities of approximately $16.2 million as of January 25, 2007. Intangible assets acquired include, among others, trade names with a total estimated fair value of approximately $9.8 million and student contracts with an estimated fair value of approximately $1.5 million. Based on our preliminary purchase price allocation, we have recorded goodwill of approximately $28.8 million. We do not expect any portion of this goodwill balance to be deductible for income tax reporting purposes.

Subsequent adjustments may be made to the purchase price and the purchase price allocation. However, we do not believe that any such adjustments will be significant.

8




The following table summarizes the estimated fair values of assets acquired and liabilities assumed as of January 25, 2007 (in thousands):

Current assets

 

$

12,648

 

Property and equipment

 

2,099

 

Intangible assets not subject to amortization

 

 

 

Trade names

 

9,782

 

Intangible assets subject to amortization

 

 

 

Student contracts (1.5-year useful life)

 

1,456

 

Covenant not to compete (3-year usefull life)

 

479

 

Goodwill

 

28,793

 

Other assets

 

541

 

Total assets acquired

 

55,798

 

Current liabilities

 

11,134

 

Long-term liabilities

 

5,070

 

Total liabilities assumed

 

16,204

 

Net assets acquired

 

$

39,594

 

 

Supplemental pro forma financial statement disclosures have not been included as this acquisition was not material to our consolidated financial position or results of operations.

4.                 FINANCIAL INSTRUMENTS

Cash and Cash Equivalents and Investments

Cash equivalents include short-term investments with a term to maturity of less than 90 days.

The postsecondary education industry includes approximately 6,500 institutions that participate in federally-sponsored financial aid programs authorized by Title IV of the Higher Education Act of 1965, as amended (“HEA,”), which we refer to as “Title IV Programs.”  The U.S. Department of Education (“ED”) requires that Title IV Program funds collected in advance of student billings be kept in a separate cash account until the students are billed for the portion of their program related to those Title IV Program funds collected. The ED further requires that Title IV Program funds be disbursed to students within three business days of receipt. We do not recognize restricted cash balances on our consolidated balance sheet until all restrictions have lapsed. As of March 31, 2007, and December 31, 2006, the amount of restricted cash balances held in separate cash accounts was not significant. Restrictions on cash balances have not affected our ability to fund daily operations.

9




Investments, which primarily consist of municipal auction rate securities, are classified as “available-for-sale” in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities and are recorded at fair value. Any unrealized gains or temporary unrealized losses, net of income tax effects, are reported as a component of accumulated other comprehensive income on our consolidated balance sheet. Realized gains and losses are computed on the basis of specific identification and are included in miscellaneous other income (expense) in our consolidated income statement. As of March 31, 2007, our investments in municipal auction rate securities generally have stated terms to maturity of greater than one year. However, we classify such investments as current on our consolidated balance sheet because we are generally able to divest our holdings in municipal auction rate securities at auction 30 days from our purchase date. Cash and cash equivalents and investments consist of the following as of March 31, 2007, and December 31, 2006 (in thousands):

 

 

March 31, 2007

 

 

 

 

 

Gross Unrealized

 

 

 

 

 

Cost

 

Gain

 

(Loss)

 

Fair Value

 

Cash and cash equivalents:

 

 

 

 

 

 

 

 

 

Cash

 

$

57,876

 

$

 

$

 

$

57,876

 

Money market funds

 

107,717

 

 

 

107,717

 

Commercial paper

 

 

 

 

 

Total cash and cash equivalents

 

165,593

 

 

 

165,593

 

Investments (available-for-sale):

 

 

 

 

 

 

 

 

 

Auction rate municipal bonds

 

282,632

 

 

(2

)

282,630

 

Asset-backed securities

 

 

 

 

 

Commercial paper

 

 

 

 

 

Mortgage-backed securities

 

1,610

 

1

 

(7

)

1,604

 

Total investments

 

284,242

 

1

 

(9

)

284,234

 

Total cash and cash equivalents and investments

 

$

449,835

 

$

1

 

$

(9

)

$

449,827

 

 

 

 

December 31, 2006

 

 

 

 

 

Gross Unrealized

 

 

 

 

 

Cost

 

Gain

 

(Loss)

 

Fair Value

 

Cash and cash equivalents:

 

 

 

 

 

 

 

 

 

Cash

 

$

49,164

 

$

 

$

 

$

49,164

 

Money market funds

 

120,934

 

 

 

120,934

 

Commercial paper

 

17,958

 

2

 

 

17,960

 

Total cash and cash equivalents

 

188,056

 

2

 

 

188,058

 

Investments (available-for-sale):

 

 

 

 

 

 

 

 

 

Auction rate municipal bonds

 

249,007

 

2

 

(1

)

249,008

 

Asset-backed securities

 

8,203

 

 

(2

)

8,201

 

Mortgage-backed securities

 

2,566

 

 

(9

)

2,557

 

Total investments

 

259,776

 

2

 

(12

)

259,766

 

Total cash and cash equivalents and investments

 

$

447,832

 

$

4

 

$

(12

)

$

447,824

 

 

10




Student Receivables Valuation Allowance

Changes in our student receivables allowance during the three months ended March 31, 2007 and  2006, were as follows:

 

 

Balance,

 

 

 

 

 

Purchase

 

 

 

 

 

Beginning of

 

Charges to

 

Amounts

 

Accounting

 

Balance, End

 

 

 

Period

 

Expense

 

Written-off

 

Adjustment

 

of Period

 

 

 

(In thousands)

 

For the three months ended March 31, 2007

 

$

28,532

 

$

7,725

 

$

(9,475

)

$

9

 

$

26,791

 

For the three months ended March 31, 2006

 

$

37,961

 

$

13,268

 

$

(15,549

)

$

 

$

35,680

 

 

Credit Agreements

As of March 31, 2007, we have outstanding under our $200.0 million U.S. Credit Agreement revolving loans totaling $11.6 million and letters of credit totaling $16.1 million. Credit availability under our U.S. Credit Agreement as of March 31, 2007, is $172.3 million.

As of March 31, 2007, we have no revolving loans outstanding under our $10.0 million (USD) Canadian Credit Agreement.

5.     RECOURSE LOAN AGREEMENTS

We have entered into agreements with Sallie Mae and Stillwater National Bank (“Stillwater”) to provide private recourse loans to qualifying students.

Sallie Mae.   Our original recourse loan agreement with Sallie Mae was effective from July 1, 2002, to February 28, 2006. We entered into a new risk sharing agreement with Sallie Mae effective March 1, 2006, which has an expiration date of June 30, 2009. Under both our original and subsequent recourse loan agreements with Sallie Mae, we are required to deposit 20% of all recourse loans funded into a Sallie Mae reserve account.

Under our original recourse loan agreement, loans funded were intended for students whose credit scores were less than the credit score required under Sallie Mae’s non-recourse loan program for our students. A student was generally eligible for a Sallie Mae recourse loan under the original agreement if (1) the student demonstrated a specified minimum credit score, (2) any bankruptcy proceeding involving the student had been discharged for at least 18 months, and (3) the student was not in default or delinquent with respect to any prior student loan. Under the terms of the original agreement, we are obligated to purchase, with funds that have been deposited into the reserve account as discussed above, recourse loans funded under the original agreement (a) that have been delinquent for 150 days or (b) upon the bankruptcy, death, or total and permanent disability of the borrower. The amount of our repurchase obligation under the original agreement may not exceed 20% of loans funded under the original agreement, which also represents the amount that is withheld by Sallie Mae and deposited into the reserve account. Any balance remaining in the reserve account after all recourse loans have been either repaid in full or repurchased by us will be paid to us. Our new recourse loan agreement with Sallie Mae has substantially similar terms, with the exception that students and, if applicable, their qualified co-borrowers, must demonstrate a slightly higher specified minimum credit score than the credit score required under the original agreement to be eligible for a recourse loan.

We record amounts withheld by Sallie Mae in the reserve account as a deposit in long-term assets on our consolidated balance sheet. Amounts on deposit may ultimately be utilized to purchase loans in default, in which case recoverability of such amounts would be in question. Therefore, we establish a 100%

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reserve against amounts on deposit through the use of a deposit contra-account. We believe that costs associated with our Sallie Mae recourse loan programs are directly attributable to the educational activity of our schools and the support of our students. Therefore, such costs are classified as educational services and facilities expense in our consolidated statement of income. Costs are recognized on a straight-line basis over the course of the instructional term for which the underlying loan was granted as the related revenues are earned. Upon purchasing Sallie Mae loans in default, we transfer an amount equal to the total balance of the loans purchased from the deposit account to a long-term recourse loan receivable account and transfer an offsetting amount from the deposit contra-account to a long-term recourse loan receivable contra-account, such that the net book value of the purchased loans is generally zero.

In October 2006, we negotiated an amendment to our risk sharing agreement that reduced the minimum credit score required for our students to qualify for non-recourse loans under Sallie Mae’s non-recourse loan program. The amendment also reduced loan fees and interest rates charged to our students for both non-recourse and recourse loans funded by Sallie Mae. Under the amendment, we are obligated to pay Sallie Mae a discount fee equal to 25% of all recourse loans funded under the agreement after March 1, 2007. Pursuant to the amendment, we will no longer be required to deposit a portion of loans funded under the agreement into a Sallie Mae reserve account. In addition, we are not required to repurchase any loans funded under the agreement.

Stillwater.   The private student loans subject to the Stillwater purchase agreement are made by Stillwater to students at our schools if (1) the student demonstrates a specified minimum credit score, which is less than the minimum credit score required pursuant to our risk sharing agreement with Sallie Mae, (2) any bankruptcy proceeding involving the student has been discharged for at least 18 months, and (3) the student is not in default or delinquent with respect to any prior student loan. The loans are serviced by Sallie Mae. Under the terms of the purchase agreement, Stillwater retains 50% of the loan amounts disbursed and deposits this amount into a reserve account. Under the terms of the purchase agreement, Stillwater has an option, but not an obligation, to sell to us 100% of these private student loans on a monthly basis. We are required to purchase all private student loans offered for sale by Stillwater for a price equal to the current principal balance plus accrued interest. To date, we have purchased all private student loans offered for sale by Stillwater. Upon purchase of private student loans from Stillwater, we receive all funds that were placed into the reserve account with respect to the specific loans purchased.

Amounts held in reserve with Stillwater will be used to finance 50% of the principal balance of any loans that we are required to purchase pursuant to the agreement. We record such amounts as a deposit in long-term assets on our consolidated balance sheet. Based on our collection experience, we establish a 100% reserve against Stillwater funds on deposit. Due to the high level of uncollectible amounts expected under the Stillwater agreement, the associated costs are classified as a reduction of the related tuition revenue in our consolidated statement of income. Costs are recognized on a straight-line basis over the course of the instructional term for which the underlying loan was granted as the related revenues are earned. Upon purchasing Stillwater loans in default, we record the total balance of the loans as a long-term recourse loan receivable and transfer the reserve for recourse loans withheld by the lender, totaling approximately 50% of the related principal balance, from the deposit contra-account to the long-term loan receivable contra-account, such that the net book value of the purchased loans is approximately 50% of the related principal balance. Based on our collection experience, we believe that the 50% reserve is reasonable to provide for Stillwater loans that have been purchased or that may be purchased and that may be ultimately uncollectible. We evaluate the collectibility of our Stillwater loan receivables on a periodic basis and may adjust our reserve estimates in future periods based on collections experience.

On January 29, 2007, we provided Stillwater with a 90-day notice to terminate our purchase agreement. Pursuant to such notice, our purchase agreement terminated on April 29, 2007. However, we are still obligated to purchase any loans made by Stillwater prior to this termination date when offered by Stillwater for sale.

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The following table reflects selected information with respect to each of our recourse loan agreements, including cumulative loan disbursements and purchase activity under the agreements from inception through March 31, 2007 (in millions, except for cumulative loan limits per student):

 

 

Agreement

 

Disbursed

 

Cumulative
Loan Limit 

 

Loans

 

Loans

 

Loans We May
be Required to

 

 

Lender

 

 

Effective Date

 

Loan Limit

 

Per Student (5)

 

Disbursed

 

Purchased

 

Purchase

 

Sallie Mae

 

July 2002 to
June 2009 (1)

 

180.0

(3)

 

$

12,000 to
$39,000

 

$

135.3

 

$

26.7

 

$

0.4

 

Stillwater

 

December 2003
to April 2007 (2)

 

$

20.0

(4)

 

$

7,500 to
$13,500

 

$

24.9

 

$

30.1

 

$

0.6

 


(1)          Our original recourse loan agreement with Sallie Mae was effective from July 1, 2002 to February 28, 2006. We have entered into a new recourse loan agreement effective March 1, 2006, that has an expiration date of June 30, 2009.

(2)          The Stillwater purchase agreement commenced in December 2003 and had no stated termination date. This agreement terminated effective April 29, 2007.

(3)          Prior to the new agreement effective March 1, 2006, the Sallie Mae agreement had no stated limit for the amount of loans disbursed under the agreement. Loans funded prior to March 1, 2006, were subject to this previous agreement. Under the new agreement, the total amount of loans that may be funded may not exceed $180.0 million through June 30, 2008, with annual funding limits of $20.0 million for the period March 1, 2006, to June 30, 2006, $80.0 million for the period July 1, 2006, to June 30, 2007, and $80.0 million for the period July 1, 2007, to June 30, 2008. There is currently no stated loan funding limit for the period of July 1, 2008, to June 30, 2009. Instead, any funding limit must be negotiated by both parties prior to July 1, 2008.

(4)          Under the Stillwater purchase agreement, the total amount of loans held by Stillwater under the agreement at any time cannot exceed $20.0 million.

(5)          Loan limit per student generally represents the maximum loan amount available to an individual student during his or her complete academic program at one of our schools. Loan limits vary based on the length of the student’s academic program.

Costs associated with our recourse loan agreements as of and for the three months ended March 31, 2007 and 2006, are set forth below (in thousands). As discussed above, costs incurred in connection with our Sallie Mae agreements are classified as a component of educational services and facilities expense in our consolidated statement of income, and costs incurred in connection with our Stillwater agreement are classified as a reduction of tuition and registration fee revenue in our consolidated statement of income.

 

 

For the Three Months
ended March 31,

 

 

 

2007

 

2006

 

Sallie Mae

 

$

2,248

 

$

1,591

 

Stillwater

 

$

1,591

 

$

1,203

 

 

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Outstanding recourse loan deposit, contra-deposit, loan receivable, and contra-loan receivable balances as of March 31, 2007, and December 31, 2006, are set forth below (in thousands).

 

 

Deposits

 

Contra-
Deposits

 

Net Book
Value

 

Sallie Mae

 

 

 

 

 

 

 

As of March 31, 2007

 

$

803

 

$

188

 

$

615

 

As of December 31, 2006

 

$

764

 

$

143

 

$

621

 

Stillwater

 

 

 

 

 

 

 

As of March 31, 2007

 

$

330

 

$

330

 

$

 

As of December 31, 2006

 

$

702

 

$

702

 

$

 

 

 

 

Loan
Receivable

 

Allowance For
Uncollectible
Loans

 

Net Book
Value

 

Sallie Mae

 

 

 

 

 

 

 

As of March 31, 2007

 

$

26,408

 

$

26,408

 

$

 

As of December 31, 2006

 

$

24,266

 

$

24,266

 

$

 

Stillwater

 

 

 

 

 

 

 

As of March 31, 2007

 

$

25,148

 

$

15,704

 

$

9,444

 

As of December 31, 2006

 

$

24,870

 

$

15,353

 

$

9,517

 

 

6.                 GOODWILL

Changes in the carrying amount of goodwill during the three months ended March 31, 2007, by reportable segment are as follows (in thousands):

 

 

 

 

 

 

Culinary

 

Health

 

 

 

 

 

 

 

 

 

Academy

 

Colleges

 

Arts

 

Education

 

International

 

University

 

 

 

 

 

segment

 

segment

 

segment

 

segment

 

Segment

 

segment

 

Total

 

Goodwill balance as of December 31, 2006

 

$

14,064

 

$

27,883

 

$

75,148

 

$

131,060

 

$

13,982

 

$

87,566

 

$

349,703

 

Goodwill related to 2007 acquisitions

 

 

 

 

 

28,793

 

 

28,793

 

Effect of foreign currency exchange
rate changes

 

38

 

 

 

 

920

 

 

958

 

Goodwill balance as of March 31, 2007

 

$

14,102

 

$

27,883

 

$

75,148

 

$

131,060

 

$

43,695

 

$

87,566

 

$

379,454

 

 

On the first day of January of each year, our goodwill balances are reviewed for impairment through the application of a fair-value-based test. The results of the test as of January 1, 2007, indicated no goodwill impairment, as, for all reporting units, which we define as our school operating divisions, our estimate of reporting unit fair value exceeded the carrying value of the reporting unit. Our estimate of fair value for each of our reporting units was based primarily on projected future operating results and cash flows and other assumptions. Although we believe our projections and resulting estimates of fair value are reasonable, historically, our projections have not always been achieved.

7.                 COMMITMENTS AND CONTINGENCIES

Litigation

We are, or were, a party to the following pending legal proceedings that are outside the scope of ordinary routine litigation incidental to our business.

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Employment Litigation

Vander Vennet, et al. v. American InterContinental University, Inc., et al.   As previously disclosed, on August 24, 2005, former admissions advisors of American InterContinental University (“AIU”) Online filed a lawsuit in the United States District Court for the Northern District of Illinois alleging that we, AIU Online, and the President of our University division violated the Fair Labor Standards Act (“FLSA”), the Illinois Minimum Wage Law, and the Illinois Wage Payment and Collection Act by failing to pay the plaintiffs for all of the overtime hours they allegedly worked. Plaintiffs seek unspecified lost wages, liquidated damages, attorneys’ fees, and injunctive relief. The plaintiffs are also seeking certification as a class under the FLSA. On December 22, 2005, and April 7, 2006, the court granted plaintiffs’ motions to send FLSA Notice, and plaintiffs’ counsel has distributed such notice to certain current and former admissions advisors. On April 7, 2006, the court granted the plaintiffs’ motion to expand the class to include temporary admissions advisors. The deadline for potential plaintiffs to opt-in to this lawsuit was June 23, 2006. Less than 10 percent of the persons to whom notice of the suit was sent, including current and former admissions advisors, have joined the litigation. Defendants deny all of the material allegations in the complaint and are vigorously defending the claims and opposing class certification. The parties are currently engaged in discovery.

Due to the inherent uncertainties of litigation, we cannot predict the ultimate outcome of this matter. An unfavorable outcome could have a material adverse impact on our business, results of operations, cash flows, and financial position.

Securities Litigation

In re Career Education Corporation Securities Litigation.   As previously disclosed, In re Career Education Corporation Securities Litigation represents the consolidation into one suit of six purported class action lawsuits filed between December 9, 2003, and February 5, 2004, in the United States District Court for the Northern District of Illinois by and on behalf of certain purchasers of our common stock, against us, John M. Larson, a former officer of CEC, and Patrick K. Pesch, a current officer of the Company. The lawsuit alleged that, in violation of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 promulgated thereunder, the defendants made certain material misrepresentations and failed to disclose certain material facts about the condition of our business and prospects during the putative class period, causing the respective plaintiffs to purchase shares of our common stock at artificially inflated prices. The plaintiffs further claimed that Larson and Pesch were liable as control persons under Section 20(a) of the Exchange Act. On March 29, 2007, the court granted the defendants’ motion to dismiss for failure to state a claim and dismissed with prejudice the plaintiffs’ third amended consolidated complaint. Plaintiffs filed a notice of appeal on April 24, 2007.

Derivative Actions.   As previously disclosed, on January 5, 2004, a derivative action captioned McSparran v. John M. Larson, et al. (“McSparran”) was filed in the United States District Court for the Northern District of Illinois on behalf of CEC against John M. Larson, Patrick K. Pesch, Wallace O. Laub, Keith K. Ogata, Dennis H. Chookaszian, Robert E. Dowdell, Thomas B. Lally, Nick Fluge, Jacob P. Gruver, and Todd H. Steele and CEC as a nominal defendant. Each individual defendant in this action is or was one of our officers or directors. The lawsuit alleged breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment, and breach of fiduciary duties for insider stock sales and misappropriation of information, generally based on allegations of conduct similar to that complained of in the In re Career Education Corporation Securities Litigation matter described above. On February 28, 2007, the court granted the defendants’ motion to dismiss for failure to plead demand futility and dismissed with prejudice the plaintiffs’ amended derivative complaint. Plaintiffs filed a notice of appeal on March 26, 2007.

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As previously disclosed, on July 2, 2004, a derivative action captioned Xiao-Qiong Huang v. John M. Larson, et al., was filed in the Circuit Court of Cook County, Illinois, Chancery Division, on behalf of CEC against John M. Larson, Patrick K. Pesch, Wallace O. Laub, Keith K. Ogata, Dennis H. Chookaszian, Robert E. Dowdell, Thomas B. Lally, Nick Fluge, and Jacob P. Gruver and CEC as a nominal defendant. Each of the individual defendants is or was one of our officers or directors. The lawsuit alleges breach of fiduciary duty and misappropriation of confidential information for personal profit by the individual defendants and seeks contribution and indemnification on behalf of CEC. On September 12, 2005, the court granted defendants’ motion to stay the case until further order of the court in deference to the prior filed McSparran action.

As previously disclosed, on November 10, 2004, a derivative suit captioned Nicholas v. Dowdell, et al., was filed in the Chancery Court of New Castle County, Delaware, on behalf of CEC against John M. Larson, Patrick K. Pesch, Wallace O. Laub, Keith K. Ogata, Dennis H. Chookaszian, Robert E. Dowdell, Thomas B. Lally, Nick Fluge, and Jacob P. Gruver and CEC as a nominal defendant. The lawsuit alleges breach of fiduciary duty for insider stock sales and misappropriation of confidential information, breach of fiduciary duty of good faith, and unjust enrichment and seeks a constructive trust, disgorgement of profits, damages, costs, and attorneys’ fees. On March 17, 2005, the court granted the parties’ joint motion to stay the action pending final resolution of the McSparran action.

As previously disclosed, on June 3, 2005, a derivative suit captioned Romero v. Dowdell, et al., was filed in the Chancery Court of New Castle County, Delaware, on behalf of CEC against John M. Larson, Patrick K. Pesch, Wallace O. Laub, Keith K. Ogata, Dennis H. Chookaszian, Robert E. Dowdell, Thomas B. Lally and CEC as a nominal defendant. The court subsequently consolidated the Romero action with Neel v. Dowdell, et al., a case filed in the same court against the same defendants on May 15, 2006. Each of the individual defendants in the Romero and Neel actions is or was one of our officers or directors. On July 18, 2006, plaintiffs filed a consolidated derivative complaint under the caption In re Career Education Corporation Securities Litigation Derivative Litigation. The consolidated derivative complaint alleges conduct similar to that complained of in the lawsuits captioned In re Career Education Corporation Securities Litigation, McSparran, Huang, and Nicholas, described above, and seeks imposition of a constructive trust and disgorgement of profits, unspecified damages, and equitable relief and reimbursement of the plaintiffs’ costs and disbursement of the action. On March 8, 2007, the court held a hearing on the defendants’ motion to dismiss the consolidated derivative complaint or, in the alternative, to stay the case. Following the hearing, the court requested supplemental briefing from each party.

Due to the inherent uncertainties of litigation, we cannot predict the ultimate outcome of these matters. An unfavorable outcome of any one or more of these matters could have a material adverse impact on our business, results of operations, cash flows, and financial position.

Special Committee Investigation

As previously disclosed, in June 2004, our Board of Directors formed a Special Committee to conduct an independent investigation of allegations of securities laws violations against us. These allegations were asserted in the In re Career Education Corporation Securities Litigation matter described above (the “Class Action”). In July 2004, the Special Committee retained the law firm of McDermott, Will & Emery LLP, which in turn retained the forensic accounting firm Navigant Consulting, Inc., to assist in the investigation. Among other things, the investigation reviewed the allegations related to our accounting practices and reported statistics relating to starts, student population, and placement.

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As previously disclosed, the Special Committee did not find support for the claims that CEC or its senior management engaged in the securities laws violations alleged in the Class Action. The Special Committee did find wrongful conduct by individual employees of CEC but specifically found that the wrongful activity was not directed or orchestrated by our senior management.

The Special Committee conducted a further investigation of assertions related to the claims of securities laws violations made for the first time, and not previously examined, in the second and third amended complaints filed in the Class Action on April 1, 2005, and May 1, 2006, respectively. The Special Committee completed its investigation of these new assertions and concluded that it did not find support for them. In so doing, the Special Committee reaffirmed its prior conclusion that it did not find support for the claims that CEC or its senior management engaged in the securities laws violations alleged in the Class Action.

We have undertaken a number of steps to improve our internal controls in the areas of finance and compliance, including the further development and expansion of our compliance, legal, and internal audit infrastructure processes. The Special Committee recommended additional improvements relating to our financial, compliance, and other controls. Our Board of Directors and senior management are continuing to evaluate the results and recommendations of the Special Committee. Our Board of Directors has requested that the Special Committee and its counsel remain in place and available, as needed.

Action against Former Owners of Western School of Health and Business Careers

As previously disclosed, on March 12, 2004, we filed a lawsuit in the U.S. District Court for the Western District of Pennsylvania against the former owners of Western School of Health and Business Careers (“Western.”). In the lawsuit, we allege that the former owners of Western made material misrepresentations of fact and breached certain representations and warranties regarding the accreditation and approval of several programs of study offered by Western and seek full indemnification for all resulting losses, costs, and damages, including attorneys’ fees. On July 12, 2004, we filed a similar complaint in the Court of Common Pleas of Allegheny County, Pennsylvania, and subsequently voluntarily dismissed the federal lawsuit. Subsequently, we amended our complaint to assert a claim for breach of contract against Western’s former accounting firm. Discovery is in progress.

The misrepresentations we allege in this matter came to light during a routine change of ownership review undertaken by the Accrediting Commission of Career Schools and Colleges of Technology (“ACCSCT”) subsequent to our acquisition of Western. On March 4, 2004, ACCSCT notified us of discrepancies in accreditation and approval documents related to several academic programs. Western suspended marketing, new enrollments, and disbursement of funds issued under Title IV Programs for all affected academic programs, and promptly applied for approval of all such programs. The diploma programs were approved in June 2004, and Western then resumed marketing, enrolling new students, and disbursement of Title IV Program aid to students in those programs. In July 2004, ACCSCT approved the degree programs effective upon Western’s satisfaction of certain stipulations. Western subsequently satisfied all stipulations and resumed marketing, enrollment of new students, and disbursing of Title IV Program funds to students in those programs. We are working in close cooperation with the ED and the U.S. Department of Justice to resolve any remaining issues in a manner that will best serve the interest of Western’s students. As a result of this matter, we expect that we will be required to reimburse the ED for a portion of Title IV Program funds improperly disbursed in relation to the effected programs, and we have recorded in our consolidated financial statements a reserve for the amount of the refund that we expect to pay to the ED. The pending lawsuit seeks to recover any such funds from the former owners of Western and its former accounting firm. Due to the inherent uncertainties of litigation, we cannot predict the ultimate outcome of this matter, but we do not expect such outcome to have a significant impact on our consolidated financial position or results of operations.

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Student Litigation

Laronda Sanders, et al. v. Ultrasound Technical Services, Inc,. et al.   This action, filed on March 15, 2006, and currently pending in the United States District Court for the District of Maryland, Greenbelt Division, is brought by 21 current and former students of the Landover, Maryland, campus of Sanford-Brown Institute (“SBI”), one of our schools, on behalf of themselves and a putative class, against us and Ultrasound Technical Services, Inc. (“UTS”), one of our subsidiaries. Plaintiffs’ second amended complaint, filed on March 12, 2007, alleges that the defendants made fraudulent misrepresentations and violated the Maryland consumer fraud act by misrepresenting or failing to disclose, among other things, details regarding instructors’ experience or preparedness, availability of clinical externship assignments, and estimates for the dates upon which the plaintiffs would receive their certificates and be able to enter the work force. The complaint also alleges that defendants breached plaintiffs’ enrollment contracts by failing to provide the promised instruction, training, externships, and placement services. Plaintiffs seek actual damages, punitive damages, and costs. Discovery is ongoing.

McCarten, et al. v. Allentown Business School, Ltd. t/a Lehigh Valley College.   As previously disclosed, on September 28, 2005, a complaint was filed against Allentown Business School, Ltd. (“Allentown”), one of our subsidiaries, in the Court of Common Pleas of Lehigh County, Pennsylvania. The complaint purports to be brought on behalf of all former students of Allentown, now known as Lehigh Valley College, who received allegedly “high interest private loans,” and alleges that Allentown violated Pennsylvania’s Unfair Trade Practices and Consumer Protection Law and engaged in intentional misrepresentation, negligent misrepresentation, and negligence in connection with the enrollment and student loan information and application processes. The complaint seeks compensatory and punitive damages in an unspecified amount. On December 12, 2005, the plaintiffs filed an amended complaint asserting the same claims as set forth in the initial complaint. On December 14, 2005, Allentown moved to compel arbitration. The motion was granted by Order dated November 13, 2006. In December 2006, the plaintiffs made a Motion for Reconsideration of the Order compelling arbitration. The court denied the motion for reconsideration by Order dated December 27, 2006.

Bradley, et al. v. Sanford Brown-College, Inc., et al.   As previously disclosed, this action, filed on August 25, 2005, and currently pending in the United States District Court for the Western District of Missouri, is brought against us, two of our subsidiaries, Sanford-Brown College (“SBC”) and Colorado Technical University, Inc., and Whitman Education Group, Inc. by eight former students of the radiography program at our Sanford-Brown College (“SBC”) school in Kansas City, Missouri. The complaint alleges that the defendants made fraudulent misrepresentations and violated the Missouri Merchandising Practices Act by misrepresenting or failing to disclose, among other things, details regarding instructors’ experience or preparedness, estimates for starting salaries of program graduates, that the curriculum would prepare the students for the state board exams for radiography, that credit hours earned at SBC were transferable, that SBC reported false expense estimates and false class credits in applications for federal and state grant and loan programs, and that admissions representatives had sales quotas for enrolling new students. The complaint also alleges that the defendants breached enrollment contracts with the plaintiffs by failing to provide the promised instruction, training, and placement services. Plaintiffs seek actual damages, punitive damages, attorneys’ fees and costs, and other relief. On July 13, 2006, plaintiffs filed a second amended complaint, adding Marlin Acquisition Corp. and CTU Corporation, Inc., both subsidiaries of CEC, as additional defendants. Our motions for summary judgment with respect to Colorado Technical University, Inc. and CTU Corporation, Inc. were granted. The parties have reached an agreement in principle to settle this matter and are in the process of finalizing settlement and general release agreements.

Thurston, et al. v. Brooks College, Ltd., et al.   As previously disclosed, on March 21, 2005, a purported class action complaint was filed in the Superior Court for the State of California, County of Los Angeles, against Brooks College, one of our schools. The complaint was purportedly filed on behalf of all current

18




and former attendees of Brooks College. The complaint alleges that Brooks College violated the California Business and Professions Code and Consumer Legal Remedies Act by allegedly misleading potential students regarding Brooks College’s admission criteria, transferability of credits, and retention and placement statistics and by engaging in false and misleading advertising. Plaintiffs seek injunctive relief, restitution, unspecified punitive and exemplary damages, attorneys’ fees, interest, costs, and other relief. On June 24, 2005, the Court ruled that this action was related to the case captioned Outten, et al. vs. Career Education Corporation, et al., which is described below. Brooks College filed an answer to the complaint on May 31, 2006.  Plaintiffs filed a motion for class certification on December 18, 2006, and we filed our opposition motion on March 5, 2007. The court has not yet set a hearing date on the motion for class certification

Nilsen v. Career Education Corporation, et al.   As previously disclosed, on February 4, 2005, three former students of Brooks Institute of Photography (“BIP”), one of our schools, filed a purported class action complaint in the Superior Court of the State of California, County of Santa Barbara, against us and BIP. The action was purportedly brought on behalf of all students who attended BIP from February 4, 2001, to the present.

Plaintiffs’ operative Third Amended Complaint states causes of action for (1) violations of the California Education Code, (2) violations of the Consumer Legal Remedies Act, (3) fraud, (4) false advertising in violation of California Business and Professions Code §17500, et seq, and (5) unfair competition in violation of California Business and Professions Code §17200, et seq. The plaintiffs primarily allege that BIP violated the California Education Code, the California Consumer Legal Remedies Act, and California’s Unfair Competition Law by allegedly misleading potential students regarding BIP’s placement rates and by engaging in false and misleading advertising. The plaintiffs seek injunctive relief, disgorgement of profits, punitive damages, interest, and attorneys’ fees and costs. On October 11, 2006, the Court overruled the defendants’ demurrers and motion to strike a portion of the Third Amended Complaint.

Plaintiffs filed their motion for class certification on February 14, 2007.   We have taken discovery from the class representatives. The hearing on the motion for class certification is set for September 11, 2007.

Outten, et al. v. Career Education Corporation, et al.   As previously disclosed, a purported class action was filed in the Superior Court of the State of California, County of Los Angeles, against us and AIU, one of our schools. The operative complaint, which claims to have been brought on behalf of present and former students of AIU, alleges that AIU violated the California Unfair Competition Law (California Business and Professions Code), the California Consumer Legal Remedies Act, and the California Education Code and engaged in common law consumer fraud by purportedly misleading potential students regarding AIU’s placement rates. The plaintiffs, on behalf of the putative class, seek injunctive relief, restitution, unspecified punitive and exemplary damages, attorneys’ fees and costs, interest, and other relief. On March 10, 2005, defendants filed an answer to the second amended complaint as well as a cross-complaint against one of the named plaintiffs for unpaid tuition. On June 24, 2005, the Court ruled that this action was related to another action captioned Thurston, et al. v. Brooks College, Ltd., et al., which is described above. A hearing on plaintiffs’ motion to certify a class is scheduled for May 25, 2007. No trial date has been set for this matter.

Due to the inherent uncertainties of litigation, we cannot predict the ultimate outcome of these matters. An unfavorable outcome of any one or more of these matters could have a material adverse impact on our business, results of operations, cash flows, and financial position.

19




Other Litigation

In addition to the legal proceedings and other matters described above, we are also subject to a variety of other claims, suits, and investigations that arise from time to time in the ordinary conduct of our business, including, but not limited to, claims involving students or graduates and routine employment matters. While we currently believe that such claims, individually or in aggregate, will not have a material adverse impact on our financial position, cash flows, or results of operations, the litigation and other claims noted above are subject to inherent uncertainties, and management’s view of these matters may change in the future. Were an unfavorable final outcome to occur in any one or more of these matters, there exists the possibility of a material adverse impact on our business, reputation, financial position, cash flows, and the results of operations for the period in which the effect becomes probable and reasonably estimable.

Federal, State, and Accrediting Body Regulatory Actions

Our schools are subject to extensive regulation by federal and state governmental agencies and accrediting bodies. On an ongoing basis, we evaluate the results of our internal compliance monitoring activities and those of applicable regulatory agencies, and, when appropriate, record liabilities to provide for the estimated costs of any necessary remediation. The following is an update of selected recent regulatory and accreditation actions affecting us and certain of our schools.

Federal Regulatory Matters

As previously disclosed, the ED notified us in June 2005 that it was reviewing certain of our financial statements and annual compliance audit opinions and evaluating pending school program reviews at certain of our schools. The ED indicated that until these matters were addressed to its satisfaction, it would not approve any new applications for pre-acquisition review or change of ownership submitted by us. The ED further advised us that during this period, it will not approve applications for any additional branch campuses, which the ED refers to generally in its regulations as “additional locations.”

In a November 6, 2006, meeting, officials of the ED informed us that the ED would select 10 to 12 of our institutions for program reviews to be conducted before it would consider lifting the restrictions on new applications described above. During the months of November and December, 2006 and January and February 2007, the ED conducted site visits at 10 of our institutions as part of such program reviews.

The ED notified us in a January 19, 2007, letter that, based upon the preliminary results of these program reviews, it would remove the growth restrictions that it imposed in June 2005. The ED stated that any subsequent request by us to expand our operations would be considered in accord with the ED’s standard operating procedures. The ED emphasized that the removal of the growth restrictions should not be construed to suggest that any Title IV compliance issues identified had been resolved or that program reviews currently in process would be concluded.

The following is an update on the status of pending ED program reviews:

As previously disclosed, an ED program review is currently pending for our Gibbs College school in Livingston, New Jersey, and the school’s branch campus, Katharine Gibbs School in Piscataway, New Jersey. In January 2004, the school responded to the ED’s initial findings report. In June 2005, the ED performed a follow-up review, and, in September 2005, the ED notified the school that additional information was required in response to its initial findings report. In November 2005, the school provided the ED with the requested additional information, and the school is awaiting a response from the ED.

As previously disclosed, in July 2006, our Briarcliffe College school was notified by the ED of the ED’s intent to conduct a program review. The school provided the ED with all information requested pursuant to the program review and is awaiting the ED’s program review report.

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In November 2006, The Cooking and Hospitality Institute of Chicago, Gibbs College in Boston, MA, Katharine Gibbs School in New York, NY, Gibbs College in Vienna, VA, Lehigh Valley College, Brooks Institute of Photography, California Culinary Academy, Sanford-Brown Institute in Atlanta, and American InterContinental University were each notified by the ED of the ED’s intent to conduct program reviews at the schools. In January 2007, our Western School of Health and Business Careers was notified by the ED of the ED’s intent to conduct a program review at the school. The ED has begun but has not yet completed each of these program reviews.

We are committed to resolving all issues identified in connection with these program reviews to the ED’s satisfaction and ensuring that our schools operate in compliance with all ED regulations.

We were advised that the Office of Inspector General of the ED (OIG) is conducting an investigation of our LCB-Atlanta school. In connection with this inquiry, LCB-Atlanta received a subpoena from the OIG seeking certain information. Generally, the subpoena calls for the production of information concerning the administration of Title IV Program funds at the school and related matters. We are in the process of providing documents and information in response to the subpoena, and intend to cooperate fully with the OIG in connection with this matter.

We cannot predict the outcome of these ED actions, and any unfavorable outcomes could have a material adverse effect on our business, results of operations, cash flows, and financial position.

SEC and Department of Justice Investigations.   As previously disclosed, on January 7, 2004, we received notification from the Midwest Regional Office of the SEC that it was conducting an inquiry concerning us and requested that we voluntarily provide certain information. On June 22, 2004, the SEC staff notified us that it was conducting a formal investigation. On April 5, 2006, we disclosed that we were advised by the staff of the Midwest Regional Office of the SEC that the staff intends to recommend to the SEC that it terminate its investigation of us. The staff of the SEC also advised us that it will recommend that no enforcement action be taken against us. Recommendations by the SEC staff do not constitute final action by the SEC, as the SEC thereafter makes its own determination as to whether to follow the recommendations of the SEC staff.

The U.S. Department of Justice (“Justice Department”) in Chicago notified us on April 19, 2007 that it was declining prosecution and closing its grand jury investigation of us. We first became aware of and disclosed the investigation in 2004. With the notification from the Justice Department, the investigation has now been terminated with no action taken against us.

As previously disclosed, we received a letter from the Civil Division of the Justice Department in Washington, D.C., dated May 30, 2006, advising us that the Justice Department was reviewing allegations that certain of our schools may have submitted false claims or statements to the ED. The letter requested that we provide documents relating to various subject areas. The Justice Department has indicated that this review is informational in nature. We have voluntarily responded to the Justice Department’s request for information and have cooperated fully with it. We believe this Civil Division informational review is ongoing.

State Regulatory Matters

Katharine Gibbs- New York (“Gibbs-NY”).   In April, 2006, the Office of College and University Evaluation of the New York State Education Department (the “Education Department”) conducted a site visit to Gibbs-NY. The purpose of the visit was to examine Gibbs-NY’s compliance with the regulations of the Education Department. On June 28, 2006, the Education Department issued a draft report relating to its site visit. The draft report included a number of findings and recommendations and indicated that Gibbs-NY may be out of compliance with Education Department regulations in several areas. Gibbs-NY was given until August 29, 2006, to comment on the draft report, point out factual errors, provide new information, and respond to the recommendations set forth therein. Gibbs-NY submitted a response to the draft report within the prescribed time period.

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On January 25, 2007, the Education Department issued a final report stating that though the school had addressed many of the Education Department’s recommendations, additional action was required. Gibbs-NY submitted a response to the Education Department’s remaining concerns on March 23, 2007, and anticipates a follow-up review in the next several months. The Education Department stated that, absent a finding of substantial compliance with registration standards in the follow-up review, it will terminate the registration of all degree programs at Gibbs-NY. While the review remains pending, the Education Department has limited enrollments commencing with the April 2007 academic quarter to not more than 50% of entering “first-time” students enrolled in the comparable academic quarter of the preceding year. The Education Department has also required Gibbs-NY to show that not less than 65% of April 2007 entering first-time, full-time students remain as students into the following term, exhibiting satisfactory academic performance and progress.

Texas Culinary Academy (“TCA”).   On October 21, 2005, the Texas Higher Education Coordinating Board (“THECB”) conducted an unannounced visit to TCA. Two follow-up visits were held in November 2005. On January 13, 2006, representatives from TCA and CEC met with the THECB to review the school’s compliance with the Texas Success Initiative. The Texas Success Initiative is a state-legislated program designed to improve student success in college. The program requires that an institution assess (with a standardized test) entering students’ ability to perform freshman-level academic coursework and provide developmental instruction to strengthen academic skills for students who do not test at required minimum levels. TCA was given 90 days, until May 26, 2006, to have a system in place, that ensured compliance with the Texas Success Initiative. In March 2006, TCA submitted a remediation plan to the THECB and, the school has since been in the process of implementing such plan. To date, the school has addressed the findings of the THECB and has implemented changes intended to minimize the risk of future noncompliance.   Additionally, the school has corrected a majority of the deficiencies outstanding as of the date of the submission to the THECB of its remediation plan and continues to address the remaining deficiencies. On March 13, 2007, the THECB informed the school that it had discontinued its audit of the school and agreed that TCA could submit new program applications at this time.

Lehigh Valley College (“Lehigh”).   As previously disclosed, on July 20, 2005, the Bureau of Consumer Protection of the Office of Attorney General in Pennsylvania (“Pennsylvania AG”) notified Lehigh that it had begun a review into the business practices of the school. The Pennsylvania AG requested certain documents, including information relating to Lehigh’s recruitment practices, student complaints, and financial aid policies and procedures, which we provided in August 2005.

In a May 31, 2006, subpoena, the Pennsylvania AG requested that Lehigh provide additional documents and information and appear to answer certain inquiries. Lehigh has produced documents responsive to the Pennsylvania AG’s additional requests and has made a former senior administrator available to answer the Pennsylvania AG’s inquiries. In October 2006, the Pennsylvania AG alleged that Lehigh and CEC engaged in conduct that violates the Pennsylvania Unfair Trade Practices and Consumer Protection Law. The Pennsylvania AG has offered us and Lehigh the opportunity to resolve this matter by entering into an assurance of voluntary compliance and paying a fine. We are currently engaged in discussions with the Pennsylvania AG regarding the resolution of its concerns and allegations. If a resolution cannot be reached, the Pennsylvania AG may commence a civil litigation for injunctive relief, costs, and fines.

Brooks Institute of Photography (“BIP”).   On April 19, 2007, the California Bureau for Private Postsecondary and Vocational Education issued a full five-year license renewal for Brooks Institute of Photography.

We cannot predict the outcome of pending state regulatory matters, and an unfavorable outcome of any one or more of these matters could have a material adverse effect on our business, results of

22




operations, cash flows, and financial position. We have evaluated these matters in connection with our ongoing evaluation of goodwill and indefinite-lived intangible assets for impairment, when applicable.

Accrediting Body Matters

American InterContinental University (“AIU”).   As previously disclosed, at SACS’ December 11, 2006, meeting, SACS extended AIU’s Probation status through December 2007. On January 9, 2007, AIU was notified that seven of the 15 previous recommendations from SACS remained unresolved to the commission’s satisfaction and that another special committee visit to AIU had been authorized. AIU is scheduled to submit a second monitoring report in September 2007 responding to these seven open recommendations, and the special committee visit is scheduled to occur in October 2007. AIU remains accredited during this probationary period and committed to resolving all issues identified by SACS. Under the SACS’ rules, an institution may only remain on Probation status for two consecutive years, after which Probation status must either be lifted or the institution’s accredited status must be terminated.

American InterContinental University London (“AIU—London”).  AIU—London   has been authorized by the applicable U.S. and United Kingdom agencies to grant academic credentials. AIU—London is authorized to grant academic degrees by the Nonpublic Postsecondary Education Commission of the State of Georgia. U.S. students that attend AIU—London are eligible to participate in Title IV Programs through AIU—London’s status as a branch campus of AIU—Buckhead. As previously disclosed, on December 12, 2005, AIU—London entered into an accreditation agreement with London South Bank University (“LSBU”), which has currently validated student degrees in AIU London’s interior design, visual communication, fashion design, fashion marketing, and fashion design with marketing programs and is currently reviewing AIU-London’s other programs in order to validate student degrees in those programs. AIU—London’s prior accreditation agreement with The Open University has terminated. As previously reported, on June 23, 2006, AIU—London filed a lawsuit against The Open University alleging wrongful termination of the accreditation agreement and wrongful denial by The Open University of its obligations to confer degrees on AIU—London students. AIU—London and the Open University signed a confidential settlement agreement on March 23, 2007, settling the proceedings and all claims between them, and a consent order was filed with the court.

We cannot predict the outcome of any pending accreditation matters, and an unfavorable outcome of any one or more of these matters could have a material adverse effect on our business, results of operations, cash flows, and financial position. We have evaluated these matters in connection with our ongoing evaluation of goodwill and indefinite-lived intangible assets for impairment, when applicable.

8.                 STOCK REPURCHASE PROGRAM

Since July 2005, our Board of Directors has authorized the use of a total of $500.2 million to repurchase outstanding shares of our common stock. Stock repurchases under this program may be made on the open market or in privately negotiated transactions from time to time, depending on factors, including market conditions and corporate and regulatory requirements. The stock repurchase program does not have an expiration date and may be suspended or discontinued at any time.

During the first quarter of 2007, we repurchased 1.6 million shares of our common stock for approximately $50.0 million at an average price of $30.42 per share.

Since the inception of the program, we have repurchased 12.4 million shares of our common stock for approximately $416.3 million at an average price of $33.53 per share. As of March 31, 2007, we are authorized under the program to use an additional $83.8 million to repurchase outstanding shares of our common stock.

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The repurchase of shares of our common stock reduces the amount of cash available to pay cash dividends to our stockholders. We have never paid cash dividends on our common stock.

9.                 SHARE-BASED COMPENSATION

Overview of Share-Based Compensation Plans

Under our 1998 Employee Incentive Compensation Plan, as amended, (the “Employee Plan”) and our 1998 Non-Employee Directors’ Stock Option Plan (the “Directors Plan”), non-employee members of our Board of Directors, officers, and other employees may receive grants of incentive stock options, nonqualified stock options, shares of non-vested stock, stock appreciation rights, and other awards. We are authorized to grant up to approximately 27.5 million shares of common stock under the plans. As of March 31, 2007, we have reserved approximately 5.8 million shares of common stock for the exercise of stock options outstanding as of March 31, 2007, approximately 0.8 million shares for awards of non-vested stock, and approximately 2.8 million additional shares of common stock for future share-based awards under the plans.

Stock Options.   The exercise price of stock options granted under the plans is equal to the fair market value of our common stock on the date of grant. Employee stock options become exercisable ratably over a four-year service period beginning on the date of grant and expire ten years after the date of grant, unless an earlier expiration date is set at the time of the grant. Non-employee directors’ stock options expire ten years after the date of grant and generally become exercisable as follows: one-third on the grant date, one-third on the first anniversary of the grant date, and one-third on the second anniversary of the grant date. Both employee stock options and non-employee director stock options are subject to possible earlier vesting and termination in certain circumstances. If a plan participant terminates his or her employment for any reason other than by death or disability during the vesting period, he or she forfeits the right to unvested stock option awards. Since the inception of the plans, grants of stock options have only been subject to the service conditions discussed previously. No stock option grants have included performance or market conditions that affect stock option vesting or other pertinent factors.

Non-vested Stock.   Shares of non-vested stock become vested three years after the date of grant. If a plan participant terminates his or her employment for any reason other than by death or disability during the vesting period, he or she forfeits the right to all shares of non-vested stock. The vesting of shares of non-vested stock is subject to possible acceleration in certain circumstances. Certain of the shares of non-vested stock that we have granted to plan participants are subject to performance conditions that may affect the number of shares of non-vested stock that will ultimately vest at the end of the requisite service period. These awards are referred to as “performance-vesting non-vested stock.”

Stock option activity during the three months ended March 31, 2007, under all of our share-based compensation plans was as follows:

 

 

 

 

 

 

Weighted
Average

 

 

 

 

 

 

 

Weighted

 

Remaining

 

Aggregate

 

 

 

 

 

Average Exercise

 

Contractual Term

 

Intrinsic Value

 

 

 

Options

 

Price

 

(In years)

 

(In thousands)

 

Outstanding as of December 31, 2006

 

6,232,895

 

$

33.50

 

 

 

 

 

Granted

 

450,200

 

29.70

 

 

 

 

 

Exercised

 

(425,354

)

27.07

 

 

 

$

5,275

 

Forfeited

 

(157,888

)

32.94

 

 

 

 

 

Cancelled

 

(313,993

)

47.03

 

 

 

 

 

Outstanding as of March 31, 2007

 

5,785,860

 

$

33.89

 

7.0

 

$

18,921

 

Exercisable as of March 31, 2007

 

3,840,824

 

$

34.72

 

6.2

 

$

18,230

 

 

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The following table summarizes information with respect to all stock options outstanding under all of our share-based compensation plans as of March 31, 2007:

 

 

Options Outstanding

 

Options Exercisable

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

 

 

 

 

Average

 

 

 

 

 

 

 

Number of

 

Weighted

 

Remaining

 

 

 

Weighted

 

 

 

Options

 

Average Exercise

 

Contractual Life

 

Number

 

Average Exercise

 

Exercise Price Ranges

 

 

 

Outstanding

 

Price

 

(In years)

 

Exercisable

 

Price

 

$2.00 - $15.57

 

486,610

 

$

10.91

 

3.8

 

486,610

 

$

10.91

 

$18.25 - $28.19

 

972,975

 

22.35

 

5.4

 

924,800

 

22.07

 

$29.35 - $33.04

 

1,926,025

 

29.86

 

7.8

 

891,207

 

29.58

 

$33.56 - $39.47

 

1,349,312

 

34.90

 

8.1

 

516,832

 

35.08

 

$40.25 - $68.24

 

1,050,938

 

61.31

 

7.2

 

1,021,375

 

61.83

 

 

 

5,785,860

 

$

33.89

 

7.0

 

3,840,824

 

$

34.72

 

 

Non-vested stock activity during the three months ended March 31, 2007, under the Employee Plan was as follows:

 

 

 

 

Weighted Average

 

 

 

Number of

 

Grant-Date Fair

 

 

 

Shares

 

Value Per Share

 

Outstanding as of December 31, 2006

 

383,100

 

$

29.02

 

Granted

 

443,950

 

$

29.69

 

Forfeited

 

(44,488

)

$

28.90

 

Outstanding as of March 31, 2007

 

782,562

 

$

29.38

 

 

Change in Control Provision

Each of the share-based awards granted under the plans, including stock options and shares of non-vested stock, is subject to a “change in control” provision included in our share-based compensation plans. As defined by the plans, a change in control is deemed to have occurred if, among other things, any corporation, person, or other entity (other than CEC, a majority-owned subsidiary of CEC or any of CEC’s subsidiaries, or an employee benefit plan sponsored or maintained by CEC), including a “group” as defined in Section 13(d)(3) of the Securities Exchange Act of 1934 (the” Exchange Act”), becomes the beneficial owner of our common stock representing more than 20 percent of the combined voting power of our then outstanding common stock.

Under the Employee Plan, in the event of a change in control:

·       Any stock options outstanding as of the date of the change in control and not then exercisable would become fully exercisable to the full extent of the original grant.

·       The restrictions applicable to any outstanding shares of non-vested stock awards would lapse, and the shares of non-vested stock would become fully-vested and transferable to the full extent of the original grant.

·       The performance goals and other conditions with respect to any performance-vesting non-vested stock or stock options subject to performance vesting conditions would be deemed to have been satisfied in full, and such awards would generally become fully distributable.

·       Plan participants holding stock option awards as of the date of the change in control would have the right, by giving notice to us during the 60-day period from and after the date of a change in control, to elect to surrender all or part of a stock option award to us and receive, within 30 days of such notice, cash in an amount equal to the amount by which the per share change of control price, as defined below, exceeds the per share amount that the employee must pay to exercise the stock

25




option award, multiplied by the number of stock options for which the employee has exercised this right.

Under the Director Plan, in the event of a change in control, any stock options outstanding as of the date of such change in control and not then exercisable will become fully exercisable to the full extent of the original grant. In addition, our Board of Directors will have full discretion to do, among other things, any or all of the following with respect to outstanding stock option awards:

·       Cause any stock option award to be cancelled, provided notice of at least 15 days thereof is provided before the date of cancellation;

·       Grant the director participants, by giving notice during a pre-set period, the right to surrender all or part of a stock option award to us and to receive cash in an amount equal to the amount by which the change in control price per share on the date of such election exceeds the per share amount that the plan participant must pay to exercise the stock option award, multiplied by the number of shares of our common stock for which the director has exercised this right; and

·       Take any other action our Board of Directors determines to take.

In the event of a change in control, as described above, the change in control price is defined by the plans as the highest reported sales price of a share of our common stock in any transaction reported on the principal exchange on which our shares are listed during the 60-day period prior to and including the date of the change in control event.

As of March 31, 2007, we are not aware of any person or entity, including a group, who beneficially owns, or at any point previously owned, 20% or more of the combined voting power of our outstanding common stock. As of March 23, 2007, no individual shareholder owned more than 11.6% of the combined voting power of our then outstanding common stock, and, based on existing facts and circumstances, we do not believe it is probable that the change in control provisions will be triggered.

If any person or entity, including a group, beneficially owned 20% or more of the combined voting power of our then outstanding common stock as of March 31, 2007, triggering the change in control provisions discussed above, we would have recognized additional share-based compensation expense of approximately $30.4 million during the first quarter of 2007. The estimated additional share-based compensation expense represents, for each outstanding share-based award, the greater of (a) the unrecognized grant date compensation expense for the share-based award as of March 31, 2007, or (b) the fair value of the cash redemption value of the share-based award as of March 31, 2007, less share-based compensation expense previously recorded under SFAS 123R or disclosed as pro forma compensation expense under SFAS 123, based on a change in control price of $32.23 per share, the highest reported share price of a share of our common stock in a transaction reported on the NASDAQ Global Select Market during the 60-day period prior to and including March 31, 2007.

Additionally, if the change in control provisions had been triggered as of March 31, 2007, or if we determined that the occurrence of a change in control event was probable, we would have recognized a liability of $24.6 million as of March 31, 2007, representing the estimated fair value of the obligation that would be due to participants who are eligible to surrender all or part of a stock option award to us in exchange for cash. Our estimation of this cash liability assumes that participants would elect to redeem for cash all stock options outstanding as of March 31, 2007, with an exercise price less than the change in control price.

Balance Sheet Presentation of Share-based Awards Subject to Redemption

As discussed above, a participant in the plans has the right, or may be granted the right, upon the occurrence of a change in control event, to surrender all or part of his or her stock option awards to us in exchange for cash. As required by SFAS No. 123 (revised), Share-Based Payment (“SFAS 123R”), the

26




grant-date cash redemption value of each outstanding stock option award is recorded as “Share-based awards subject to redemption” on our consolidated balance sheets on a pro rata basis over the requisite service period. Total grant-date cash redemption value for each outstanding stock option award represents the intrinsic value of the award as of the grant date, assuming that a change in control event occurred on the grant date. Share-based awards subject to redemption as of March 31, 2007, recorded as a reduction of retained earnings with no affect on net income, represents the portion of the total grant-date cash redemption value for all stock option awards outstanding as of March 31, 2007, earned by plan participants as a result of services rendered through such date. The adoption of SFAS 123R resulted in the cumulative effect recorded in this manner as of January 1, 2006, of $11.2 million. The balance increased during 2006 by $2.3 million, resulting in a balance of $13.5 million as of December 31, 2006, and decreased by $1.4 million during the first quarter of 2007, resulting in a balance of $12.1 million as of March 31, 2007.

Implementation of SFAS 123R

On January 1, 2006, we adopted the provisions of SFAS 123R, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), and replaces our previous method of accounting for share-based awards under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“Opinion 25”) for periods beginning in 2006. SFAS 123R requires that all share-based payments to employees, including grants of stock options, shares of non-vested stock and the compensatory elements of employee stock option plans, be recognized in the financial statements based on the estimated fair value of the equity or liability instrument issued.

We previously accounted for share-based compensation using the intrinsic value method as defined in Opinion 25. Prior to January 1, 2006, no share-based employee compensation cost, other than the insignificant costs associated with infrequent issuances of shares of non-vested stock, was reflected in our consolidated statement of income. SFAS 123R requires that we report the tax benefit from the tax deduction related to share-based compensation that is in excess of recognized compensation costs as a financing cash flow rather than as an operating cash flow in our consolidated statement of cash flows. Prior to January 1, 2006, Opinion 25 required that we report the entire tax benefit related to the exercise of stock options as an operating cash flow.

We adopted SFAS 123R using the modified prospective transition method. Under this method, employee compensation cost recognized during 2006 includes (1) compensation cost for all share-based payments granted prior to, but not yet vested, as of January 1, 2006, based on grant date fair value estimated in accordance with the provisions of SFAS 123 and (2) compensation cost for all share-based awards granted on or subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Under the modified prospective transition method, the provisions of SFAS 123R were not applied to periods prior to adoption, and, thus, prior period financial statements have not been restated.

In accordance with SFAS 123R, the fair value of each stock option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model. Consistent with our approach under the disclosure only provisions of SFAS 123, we will continue to recognize the value of share-based compensation as expense during the vesting periods of the underlying share-based awards using the straight-line method. SFAS 123R requires companies to estimate forfeitures of share-based awards at the time of grant and revise such estimates in subsequent periods if actual forfeitures differ from original projections. Consistent with our approach under the disclosure-only provisions of SFAS 123, we will continue to estimate forfeitures at the time of grant.

The fair value of each stock option award granted during the three months ended March 31, 2007 and 2006, was estimated on the date of grant using the Black-Scholes-Merton option pricing model. Our determination of the fair value of each stock option is affected by our stock price on the date of grant, as

27




well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the expected life of the awards and actual and projected stock option exercise behavior. The weighted average fair value per share of stock option awards granted during the three months ended March 31, 2007 and 2006, and assumptions used to value stock options are as follows:

 

 

For the Three
Months Ended
March 31,

 

 

 

2007

 

2006

 

Dividend yield

 

 

 

Risk-free interest rate

 

4.5

%

4.5

%

Volatility

 

51.5

%

53.0

%

Expected life (in years)

 

5.8

 

4.0

 

Weighted average fair value per share of options granted

 

$

15.94

 

$

15.36

 

 

Volatility is calculated based on the actual historical daily prices of our common stock over the expected term of the stock option award. During the three months ended March 31, 2007, we utilized a range of expected volatility assumptions for purposes of estimating the fair value of stock options awarded during the period. Such volatility assumptions ranged from 51.29% to 51.61%.

The expected life of each stock option award is estimated based primarily on our actual historical director and employee exercise behavior.

The fair value of each share of non-vested stock is equal to the fair market value of our common stock as of the date of grant.

All shares of performance-vesting non-vested stock granted during the three months ended March 31, 2007, are subject to performance conditions based on the results of school-level independent compliance audits and the compliance of our schools with federal, state, and accrediting body regulations. Share-based compensation expense associated with performance-vesting non-vested stock awards is recognized only to the extent that we believe performance conditions attributable to such awards will ultimately be satisfied. As of March 31, 2007, we believe performance conditions attributable to our performance-vesting non-vested stock awards will be satisfied.

As of March 31, 2007, we estimate that pre-tax compensation expense for all unvested share-based awards, including both stock options and shares of non-vested stock, in the amount of approximately $25.7 million will be recognized in future periods. We expect to satisfy the exercise of stock options and future distribution of shares of non-vested stock by issuing new shares of common stock.

10.          WEIGHTED AVERAGE COMMON SHARES

The weighted average numbers of common shares used to compute basic and diluted income per share during the three months ended March 31, 2007 and 2006, were as follows:

 

 

For the Three Months
Ended March 31,

 

 

 

2007

 

2006

 

 

 

(In thousands)

 

Basic common shares outstanding

 

96,282

 

98,143

 

Common stock equivalents

 

516

 

2,077

 

Diluted common shares outstanding

 

96,798

 

100,220

 

 

28




During the three months ended March 31, 2007 and 2006, we issued 468,356 and 148,258 shares, respectively, of our common stock upon the exercise of employee stock options and the purchase of common stock pursuant to our employee stock purchase plan.

Included in stock options outstanding are options to purchase 4.3 million shares and 3.1 million shares, respectively, of our common stock as of March 31, 2007 and 2006, that were not included in the computation of diluted net income per share because the options’ exercise prices were greater than the average market price of our common stock during the three-month period then ended and, therefore, the effect would have been anti-dilutive.

11.          SEGMENT REPORTING

Based on our interpretation of SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS 131”), we have identified six school reportable segments, including the Academy segment, the Colleges segment, the Culinary Arts segment, the Health Education segment, the International segment, and the University segment.

The Academy segment includes our International Academy of Design and Technology (“IADT”) campuses that collectively offer academic programs primarily in the career-oriented discipline of visual communications and design technologies in a classroom setting.

The Colleges segment includes schools that collectively offer academic programs in each of our core career-oriented disciplines of business studies, culinary arts, health education, information technology, and visual communications and design technologies in a classroom or laboratory setting.

The Culinary Arts segment includes our Le Cordon Bleu and Kitchen Academy schools that collectively offer culinary arts academic programs in the career-oriented disciplines of culinary arts, pastry arts, and hotel and restaurant management primarily in a classroom or kitchen setting.

The Health Education segment primarily includes our Sanford-Brown schools that collectively offer academic programs in the career-oriented disciplines of health education, business studies, visual communication and design technologies, and information technology in a classroom or laboratory setting.

The International segment includes our INSEEC Group schools and Istituto Marangoni schools located in France, Italy, and the United Kingdom, which collectively offer academic programs in the career-oriented disciplines of business studies, health education, and visual communication and technologies in a classroom or laboratory setting.

The University segment includes our AIU and CTU universities that collectively offer academic programs in the career-oriented disciplines of business studies, visual communication and design technologies, health education, information technology, criminal justice, and education in an online, classroom, or laboratory setting.

Our chief operating decision maker evaluates segment performance based on pretax segment profit or loss. This measure of profit or loss includes the University segment’s share of affiliate earnings and excludes interest income, interest expense, miscellaneous income and expense, and any unallocated corporate expenses. Adjustments to reconcile segment results to consolidated results are included under the caption “Corporate and other,” which primarily includes unallocated corporate activity and eliminations.

The accounting policies of each segment are consistent with those described in the summary of significant accounting policies in Note 2 “Significant Accounting Policies” of the notes to our consolidated financial statements in Part IV, Item 15 of our Annual Report on Form 10-K for the year ended December 31, 2006. Transactions between segments, which are not significant, are consummated on a basis

29




intended to reflect the market value of the underlying products or services. A majority of corporate expenses have been charged to the segments as part of a general allocation.

The results of operations of our schools’ on-ground campuses fluctuate on a quarterly basis, primarily as a result of changes in the level of student enrollment. Our schools’ on-ground campuses typically experience a seasonal increase in student population in the fall, traditionally when the largest number of new high school graduates begin postsecondary education. Furthermore, although our schools encourage year-round attendance at all campuses, certain programs at certain schools include summer breaks. As a result of these factors, total student population and revenue at our schools’ on-ground campuses are typically highest in the fourth quarter (October through December) and lowest in the second quarter (April through June). The operating costs of our schools’ on-ground campuses do not fluctuate as significantly on a quarterly basis, except for admissions and advertising expenses, which are typically higher during the second quarter and third quarter (April through September) in support of seasonally high enrollment. We anticipate that these seasonal trends will continue.

The results of operations of AIU Online, which is included in our University segment, fluctuate on a quarterly basis, primarily as a result of AIU Online’s academic calendar and, more specifically, the number of instructional days in each quarter. Historically, the number of revenue-generating instructional days has been highest during the first and second quarters (January through June), lower in the third quarter (July through September), and lowest in the fourth quarter (October through December). Operating costs for AIU Online do not fluctuate as significantly on a quarterly basis. We anticipate that these seasonal trends will continue.

The results of operations of CTU Online, which is included in our University segment, are not significantly impacted by seasonal trends, as, historically, the number of revenue-generating instructional days during each quarter has not fluctuated significantly.

Summary financial information by reportable segment is as follows (in thousands):

 

 

Revenues

 

Segment Profit (Loss)

 

 

 

For the Three Months Ended March 31,

 

 

 

2007

 

2006

 

2007

 

2006

 

Segments:

 

 

 

 

 

 

 

 

 

University segment (1)

 

$

180,575

 

$

243,582

 

$

33,723

 

$

82,390

 

Culinary Arts segment

 

88,697

 

90,628

 

11,424

 

14,009

 

Colleges segment

 

45,474

 

51,836

 

7,304

 

11,252

 

Health Education segment

 

44,871

 

40,578

 

3,444

 

1,213

 

Academy segment

 

42,366

 

43,027

 

4,005

 

4,681

 

International segment

 

21,900

 

14,883

 

6,207

 

3,862

 

Corporate and other

 

125

 

107

 

(16,190

)

(16,824

)

 

 

$

424,008

 

$

484,641

 

49,917

 

100,583

 

Reconciling items:

 

 

 

 

 

 

 

 

 

Interest income

 

 

 

 

 

4,705

 

4,294

 

Interest expense

 

 

 

 

 

(354

)

(338

)

Miscellaneous income

 

 

 

 

 

238

 

156

 

Earnings before income taxes

 

 

 

 

 

$

54,506

 

$

104,695

 


(1)          University segment profit includes share of affiliate earnings of $1.7 million and $0.9 million for the three months ended March 31, 2007 and 2006, respectively.

30




 

 

 

Depreciation and
Amortization

 

Share of Affiliate Earnings

 

 

 

For the Three Months Ended March 31,

 

 

 

2007

 

2006

 

2007

 

2006

 

University segment

 

$

4,381

 

$

4,126

 

$

1,712

 

$

903

 

Culinary Arts segment

 

4,491

 

4,411

 

 

 

Colleges segment

 

2,182

 

2,040

 

 

 

Health Education segment

 

1,727

 

1,755

 

 

 

Academy segment

 

2,144

 

2,179

 

 

 

International segment

 

598

 

396

 

 

 

Corporate and other

 

3,258

 

2,869

 

 

 

 

 

$

18,781

 

$

17,776

 

$

1,712

 

$

903

 

 

 

 

Total Assets as of

 

 

 

March 31,

 

December 31,

 

 

 

2007

 

2006

 

University segment

 

$

783,762

 

$

752,996

 

Culinary Arts segment

 

499,162

 

494,869

 

Colleges segment

 

212,256

 

204,496

 

Health Education segment

 

388,756

 

383,817

 

Academy segment

 

141,204

 

135,970

 

International segment

 

216,589

 

114,014

 

Corporate and other

 

(859,838

)

(729,670

)

Assets held for sale

 

64,455

 

69,171

 

 

 

$

1,446,346

 

$

1,425,663

 

 

The negative corporate and other segment asset balance as of March 31, 2007, and December 31, 2006, is primarily attributable to the elimination of intercompany receivable activity between corporate and our schools and campuses, which is reflected within Corporate and other.

Start-up campuses include our branch campuses that have been instructing students for less than 12 months, including those campuses that have not yet opened for instruction. The following supplemental financial information illustrates the impact of our start-up campuses on segment revenues, operating results, and capital expenditures during the three months ended March 31, 2007 and 2006 (in thousands):

 

 

Revenues

 

Operating Loss

 

 

 

March 31,

 

March 31,

 

March 31,

 

March 31,

 

 

 

2007

 

2006

 

2007

 

2006

 

Culinary Arts segment start-up campuses (1)

 

$

179

 

$

1,310

 

$

(2,092

)

$

(2,454

)

Health Education segment start-up campuses (2)

 

 

1,273

 

 

(113

)

Academy segment start-up campuses (3)

 

 

 

(1,587

)

(878

)

 

 

$

179

 

$

2,583

 

$

(3,679

)

$

(3,445

)

 

 

 

Capital Expenditures

 

 

 

March 31,

 

March 31,

 

 

 

2007

 

2006

 

Culinary Arts segment start-up campuses (1)

 

$

5,072

 

$

1,856

 

Health Education segment start-up campuses (2)

 

 

114

 

Academy segment start-up campuses (3)

 

213

 

 

 

 

$

5,285

 

$

1,970

 


(1)          For the three months ended March 31, 2007, Culinary Arts segment start-up campuses include LCB Dallas, TX; LCB Boston, MA; and Kitchen Academy campuses in St. Peters, MO; Seattle, WA; and

31




Sacramento, CA. For the three months ended March 31, 2006, Culinary Arts segment start-up campuses include LCB Dallas, TX; LCB Boston, MA; and Kitchen Academy campuses in St. Peters, MO; Seattle, WA; Holly wood, CA; and Sacramento, CA.

(2)          For the three months ended March 31, 2006, Health Education segment start-up campuses include SBC Milwaukee, WI.

(3)          For the three months ended March 31, 2007 and March 31, 2006, Academy segment start-up campuses include IADT Sacramento, CA and San Antonio, TX.

Our principal operations are located in the United States, and our results of operations and long-lived assets in geographic regions outside of the United States are not significant to our consolidated results of operations and long-lived assets. During the three months ended March 31, 2007 and 2006, no individual customer accounted for more than 10% of our consolidated revenues.

12.          DISCONTINUED OPERATIONS

Schools and Campuses Held For Sale as of March 31, 2007

In November 2006, our Board of Directors approved a plan (the “Sale Plan”) to sell 13 of our schools and campuses, including the nine campuses that comprise the Gibbs division, McIntosh College, the two campuses of Brooks College, and Lehigh Valley College (the “Sale Group”). We will continue to operate and invest in the schools and campuses within the Sale Group until the schools and campuses are sold. Continuing investment activities will include the strengthening of educational programming and services offered to the students at each school and campus and the support of local faculty and staff. Each of the schools and campuses within the Sale Group is available for immediate sale in its present condition, and we expect to complete the sale of the campuses and schools in 2007. We expect to have no significant continuing involvement with the entities after they have been sold. Historically, the Gibbs division campuses have been included in the Gibbs segment, and the campuses of McIntosh College, Brooks College, and Lehigh Valley College have been included in the Colleges segment.

We believe that the schools and campuses within the Sale Group meet the criteria necessary for such entities to qualify as assets held for sale under the specific provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). Accordingly, the results of operations of the schools and campuses within the Sale Group are reflected as discontinued operations in our consolidated statements of income for all periods presented. Additionally, in accordance with SFAS 144, as we expect to complete the Sale Plan within a year, assets and liabilities of the schools and campuses within the Sale Group are reflected as current assets held for sale and current liabilities held for sale on our consolidated balance sheet as of March 31, 2007, and December 31, 2006.

Under SFAS 144, the net assets of assets held for sale are required to be recorded on the balance sheet at estimated fair value, less costs to sell. Accordingly, during the fourth quarter of 2006, we recorded a charge of approximately $9.8 million, net of income tax benefit of $5.2 million, to reduce the carrying value of the net assets of our schools and campuses held for sale to estimated fair value, less costs to sell. Based on our estimation of fair value and costs to sell as of March 31, 2007, we concluded that no additional adjustment to the carrying value of the net assets of our schools and campuses held for sale was necessary.

32




Results of Discontinued Operations

Combined summary results of operations for the Sale Group, which are reflected as discontinued operations in our unaudited condensed consolidated statements of income for the three months ended March 31, 2007 and 2006, were as follows:

 

 

For the Three Months
Ended March 31,

 

 

 

2007

 

2006

 

 

 

(In thousands)

 

Revenues

 

$

36,409

 

$

43,989

 

Loss before income tax

 

(7,090

)

(20,510

)

Income tax benefit

 

(2,517

)

(7,671

)

Loss from discontinued operations

 

$

(4,573

)

$

(12,839

)

 

Loss from discontinued operations for the three months ended March 31, 2006, includes a goodwill impairment charge related to the Gibbs division of $6.5 million, net of income tax benefit of $3.9 million, and depreciation expense of $2.0 million, net of income tax benefit of $1.2 million. Loss from discontinued operations during the first quarter of 2007 includes no goodwill impairment charge and, in accordance with SFAS 144, no depreciation expense.

Assets and Liabilities Held for Sale

Assets and liabilities classified as held for sale on our unaudited condensed consolidated balance sheets as of March 31, 2007, and December 31, 2006, include the following:

 

 

March 31,
2007

 

December 31,
2006

 

 

 

(In thousands)

 

Assets:

 

 

 

 

 

Cash and cash equivalents

 

$

2,414

 

$

1,758

 

Receivables

 

5,113

 

5,595

 

Prepaid expenses

 

3,716

 

3,050

 

Inventories

 

486

 

326

 

Deferred income tax assets

 

7,622

 

7,622

 

Other current assets

 

442

 

857

 

Total current assets

 

$

19,793

 

$

19,208

 

Property and equipment, net

 

38,587

 

38,269

 

Goodwill

 

145

 

145

 

Deferred income tax assets—long term

 

1,856

 

7,338

 

Other assets

 

4,074

 

4,211

 

Total assets

 

$

64,455

 

$

69,171

 

Liabilities:

 

 

 

 

 

Accounts payable

 

$

1,284

 

$

2,216

 

Accrued payroll and related benefits

 

1,357

 

1,082

 

Accrued other

 

14,683

 

15,481

 

Deferred tuition revenue

 

5,974

 

6,492

 

Total current liabilities

 

$

23,298

 

$

25,271

 

Deferred rent obligations

 

8,710

 

8,431

 

Total liabilities

 

$

32,008

 

$

33,702

 

 

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13.          REGULATION OF THE U.S. POST-SECONDARY EDUCATION INDUSTRY

Many of our students require assistance in financing their education. For this reason, all of our schools offer financial aid programs and financing options. A majority of students who attend our U.S.-accredited schools are eligible to participate in some form of government-sponsored financial aid program. Our schools also participate in a number of state financial aid programs and offer private funding options. Our schools that participate in federal financial aid programs are subject to extensive regulatory requirements imposed by federal and state government agencies, including the ED, and other standards imposed by educational accrediting bodies.

Nature of Federal Support for Postsecondary Education in the United States

The U.S. government provides a substantial portion of its support for postsecondary education in the form of Title IV Program grants, loans and work-study programs to students who can use those funds to finance certain expenses at any institution that has been certified as eligible by the ED. These federal programs are authorized by the HEA. Generally, financial aid administered under Title IV Programs is awarded on the basis of financial need, which is generally defined under the HEA as the difference between the cost of attending an institution and the amount a student can reasonably be expected to contribute to that cost. Among other things, recipients of Title IV Program funds must maintain a satisfactory grade point average and progress in a timely manner toward completion of their program of study.

Students at our schools may receive grants, loans, and work-study opportunities to fund their education under the following Title IV Programs, although not all of our schools participate in each of these programs:

Federal Family Education Loan (“FFEL”) Program.   Loans under the FFEL program are made by banks and other lending institutions directly to our students or their parents. If a student or parent defaults on a FFEL program loan, repayment is guaranteed by a federally recognized guaranty agency, which is then reimbursed by the ED. Our schools and students use a wide variety of lenders and guaranty agencies and have not experienced difficulties in identifying lenders and guaranty agencies willing to make and guarantee FFEL program loans. The two primary types of loans obtained by students at our schools under the FFEL program are Stafford loans and PLUS loans for parents.

Stafford loans, which may either be subsidized or unsubsidized, are loans made directly to our students by financial institutions that participate in the FFEL program. Students who have a demonstrated financial need are eligible to receive a subsidized Stafford loan, with the ED paying the interest on this loan while the student is enrolled at least half-time in school and during the first six months after leaving school. Students who do not demonstrate financial need are eligible to receive an unsubsidized Stafford loan. The student is responsible for paying the interest on an unsubsidized Stafford loan while in school and after leaving school, although actual interest payments generally may be deferred by the student until after he or she has left school. Students who are eligible for a subsidized Stafford loan may also receive an unsubsidized Stafford loan.

A student is not required to meet any specific credit scoring criteria to receive a Stafford loan, but any student with a prior Stafford loan default or who has been convicted under federal or state law of selling or possessing drugs while receiving federal aid may not be eligible for a Stafford loan. The ED has established maximum annual borrowing limits with respect to Stafford loans, and these annual limits are generally less than the tuition costs at our U.S. schools.

A PLUS loan is a loan made directly by financial institutions to the parents of our dependent students. Parents who have an acceptable credit history can borrow under a PLUS loan to pay the educational expenses of a child who is a dependent student enrolled at least half-time at our U.S. schools. The amount of a PLUS loan cannot exceed the student’s cost of attendance less all other financial aid received.

34




Federal Grants.   Title IV Program grants are generally made to our students under the Federal Pell Grant (“Pell”) program and the Federal Supplemental Educational Opportunity Grant (“FSEOG”) program. The ED makes Pell grants up to a maximum amount of $4,050 per award year to students who demonstrate financial need. This amount will increase to $4,310 per award year effective with the 2007-2008 award year, which commences on July 1, 2007. FSEOG program awards are designed to supplement Pell grants up to a maximum amount of $4,000 per award year for the neediest students. An institution is required to make a 25% matching contribution for all federal funds received under the FSEOG program.

Federal Work-Study (“FWS”) Program.   Generally, under the FWS program, federal funds are used to pay 75% of the cost of part-time employment of eligible students to perform work for the institution or certain off-campus organizations. The remaining 25% is paid by the institution or the student’s employer. In select cases, these federal funds under the FWS program are used to pay 100% of the cost of part-time employment of eligible students.

Federal Perkins Loan (“Perkins”) Program.   Perkins loans are made from a revolving institutional account, 75% of which is capitalized by the ED and the remainder of which is funded by the institution. Each institution is responsible for collecting payments on Perkins loans from its former students and lending those funds to currently enrolled students. Currently, only one of our schools participates in the Perkins program.

Academic Competitiveness Grant (ACG.)   The Academic Competitiveness Grant (ACG) is available to students who have successfully completed a rigorous High School program (as defined by the Secretary of Education.) The ACG provides funds for the first and second academic year of undergraduate study. To be eligible, a student must be enrolled full-time, must be a United States citizen, and must be receiving a Federal Pell Grant. Second year students must also have a cumulative grade point average of at least 3.0 on a 4.0 scale.

The National Science and Mathematics Access to Retain Talent Grant (SMART.)   The Smart Grant will provide funds for each of the third and fourth years of undergraduate study. To be eligible, a student must be enrolled full-time, must be a United States citizen, must be eligible for a Federal Pell Grant, and must be enrolled in a physical, life or computer sciences, mathematics, technology, engineering, or in a foreign language program determined critical to national security, as defined by the Secretary of Education. Students must also maintain a cumulative grade point average of at least 3.0 on a 4.0 scale.

ED Regulation of Federal Student Financial Aid Programs

To participate in the Title IV Programs, an institution must be authorized to offer its programs of instruction by the relevant education agencies of the state in which it is located, accredited by an accrediting agency recognized by the ED, and certified as eligible by the ED. The ED will certify an institution to participate in Title IV Programs only after the institution has demonstrated compliance with the HEA and the ED’s extensive regulations regarding institutional eligibility. An institution must also demonstrate its compliance with these requirements to the ED on an ongoing basis. These standards are applied primarily on an institutional basis, with an institution defined as a main campus and its additional campus locations, if any.

As previously disclosed, the ED notified us in June 2005 that it was reviewing our previously announced restated consolidated financial statements and our annual compliance audit opinions for the years 2000 through 2003. At the same time, the ED also advised us that it was evaluating pending program reviews that have taken place at certain of our schools. The ED indicated that until these matters were addressed to its satisfaction, it would not approve any new applications by us for pre-acquisition review or change of ownership. The ED further advised us that during this period, it would not approve applications

35




for any additional branch campuses. On January 22, 2007, we received a notice from the ED that it had lifted the growth restrictions that it imposed in June 2005.

See Note 7 “Commitments and Contingencies—Federal Regulatory Actions” of these notes to our consolidated financial statements for further discussion of this matter.

State Authorization for U.S. Institutions.   State licensing agencies are responsible for the oversight of educational institutions, and continued approval by such agencies is necessary for an institution to operate and grant degrees or diplomas to its students. Moreover, under the HEA, approval by such agencies is necessary to maintain eligibility to participate in Title IV Programs. As a result, we are subject to extensive regulation in each of the states in which our schools operate campuses and in other states in which our schools recruit students. Currently, each of our U.S. campuses is authorized by its applicable state licensing agency or agencies.

The level of regulatory oversight varies substantially from state to state. In certain states in which we operate, our campuses are subject to licensure by an agency that regulates proprietary institutions and also by a separate higher education agency. State laws establish standards for, among other things, student instruction, qualifications of faculty, location and nature of facilities, and financial policies. State laws and regulations may limit our campuses’ ability to operate or to award degrees or diplomas or offer new degree programs. If any one of our campuses were to lose state authorization, it would be unable to offer educational programs, and students attending the campus would not be eligible to participate in Title IV Programs. Such severe penalties would require us to close a campus if it were to lose state authorization. See Note 7 “Commitments and Contingencies—State Regulatory Actions” of these notes to our consolidated financial statements for a further discussion of state regulatory matters currently affecting us and our schools.

Accreditation for U.S. Institutions.   Accrediting agencies also are responsible for overseeing educational institutions, and, under the HEA, continued approval by an accrediting agency recognized by the ED is necessary for an institution to maintain eligibility to participate in Title IV Programs. Accreditation is a non-governmental process through which an institution submits to a qualitative review by an organization of peer institutions. Accrediting agencies primarily examine the academic quality of the institution’s instructional programs, and a grant of accreditation is generally viewed as confirmation that an institution’s programs meet generally accepted academic standards. Accrediting agencies also review the administrative and financial operations of the institutions they accredit to ensure that each institution has sufficient resources to perform its educational mission. Accrediting agencies must adopt specific standards in connection with their review of postsecondary educational institutions to be recognized by the ED. All of our U.S. campuses except Kitchen Academy in Sacramento, California are accredited by one or more accrediting agencies recognized by the ED.

Accrediting agency oversight may occur at several levels. An accrediting agency may place an institution on “Reporting” status to monitor one or more specified areas of performance. An institution placed on Reporting status is required to report periodically to its accrediting agency on its performance in the specified areas and to continue to submit such periodic reports for a specified period, which is generally one year, after which the institution is re-evaluated. An accrediting agency may place an institution on “Warning” status if it determines that the institution may be in danger of failing to comply with the accreditation requirement, or it may place an institution on “Probation” status if it determines that an institution appears to be deficient with regard to such requirement. In either instance, the institution is given a prescribed period to demonstrate that it has rectified the deficiency, which period may subsume two or more years. When accrediting agencies determine that a serious deficiency may exist, it may direct an institution to “Show Cause” as to why its accreditation should not be terminated. An institution under Show Cause is required to satisfy its accrediting agency within a prescribed period, generally less than one year, that it has satisfactorily resolved the deficiency. See Note 7 “Commitments

36




and Contingencies—Accrediting Body Actions” of these notes to our consolidated financial statements for further discussion of accreditation matters currently affecting us and our schools.

Legislative Action.   The U.S. Congress must periodically reauthorize the HEA and other laws governing Title IV Programs and annually determines the funding level for each Title IV Program. In December 2005, Congress temporarily extended the provisions of the HEA, pending completion of the reauthorization process or further extensions of the HEA. In February 2006, as part of the Deficit Reduction Act of 2005, Congress made certain changes in the HEA that had been reflected in the HEA reauthorization bills. The changes enacted eliminate certain restrictions on online programs, increase, beginning in 2007, student loan limits for the first two academic years of a student’s program of study, and other technical changes. In September 2006, Congress temporarily extended the provisions of the HEA, pending completion of the reauthorization process or further extensions of the HEA.

It is possible that Congress will not make further changes to the HEA during 2007 and, instead, extend current law, including the changes made as part of the Deficit Reduction Act of 2005. If Congress does address reauthorization, there may be certain further legislative changes. However, at this time, we cannot determine the scope, content, or effect of such changes. Any action by Congress that significantly reduces Title IV Program funding or the ability of our schools or students to participate in Title IV Programs could have a material adverse effect on our student population, financial condition, results of operations, and cash flows. Legislative action may also require us to modify our practices for our schools to comply fully with applicable requirements. The adoption of any such modifications could result in additional administrative costs, which could have a material adverse effect on our financial condition, results of operations, and cash flows

Student Loan Default Rates.   An institution may lose eligibility to participate in some or all Title IV Programs if the rates at which former students default on the repayment of their federally-guaranteed or federally-funded student loans exceed specified percentages. An institution’s cohort default rate under the FFEL program is calculated on an annual basis as the rate at which student borrowers scheduled to begin repayment of their loans in one federal fiscal year default on those loans by the end of the next federal fiscal year.

An institution whose cohort default rates equal or exceed 25% for three consecutive years will no longer be eligible to participate in the FFEL or Pell programs for the remainder of the federal fiscal year in which the ED determines that such institution has lost its eligibility and for the two subsequent federal fiscal years. An institution whose cohort default rate under the FFEL program for any federal fiscal year exceeds 40% will no longer be eligible to participate in the FFEL program for the remainder of the federal fiscal year in which the ED determines that the institution has lost its eligibility and for the two subsequent federal fiscal years. An institution whose cohort default rate under the FFEL program equals or exceeds 25% for any one of the three most recent federal fiscal years, or whose cohort default rate under the Perkins loan program exceeds 15% for any year, may be placed on provisional certification status by the ED for up to four years.

All of our schools have implemented student loan default management programs aimed at reducing the likelihood of our students’ failure to repay their loans in a timely manner. Those programs emphasize the importance of students’ compliance with loan repayment requirements and provide for extensive loan counseling, methods to increase student persistence and completion rates and graduate employment rates, and proactive borrower contacts after students cease enrollment. If any of our schools were to lose eligibility to participate in Title IV Programs due to student loan default rates being higher than the ED’s tolerable thresholds and we could not arrange for adequate alternative student financing sources, we would most likely have to close those schools, which could have a material adverse effect on our student population, financial condition, results of operations, and cash flows.

37




As of March 31, 2007, four of our schools had student borrowers who entered repayment in the 2003-2004 award year, the most recent year for which we have calculated and reported Perkins loan default rates to the ED. The Perkins loan cohort default rates for these four schools ranged from 11.43% to 66.67%. One of our schools, Brown College, currently participates in Title IV Programs under provisional certification due to the ED’s Perkins loan default rate criteria. CTU is our only school that continues to participate in the Federal Perkins Loan program and it had a Perkins loan cohort default rate of 11.43% for students who were scheduled to begin repayment in the 2003-2004 federal award year.

All of our schools participate in the FFEL program, with the exception of our Kitchen Academy campuses, and none of our participating schools had a FFEL cohort default rate of 25% or greater during any of the last three federal fiscal years.

Financial Responsibility Standards.   To participate in Title IV Programs, an institution must satisfy specific measures of financial responsibility as prescribed by the ED. The ED evaluates institutions for compliance with these standards each year, based on the annual audited financial statements of an institution or its parent corporation, and following a change of control of an institution. With respect to our schools, it has been the ED’s practice to measure financial responsibility on the basis of the financial statements of both our individual schools and CEC on a consolidated basis.

To be considered financially responsible, an institution must, among other things, (i) have sufficient cash reserves to make required refunds, (ii) be current on its debt payments, (iii) meet all of its financial obligations, and (iv) achieve a “composite score” of at least 1.50 based on the institution’s annual financial statements. The ED calculates an institution’s composite score, which may range from -1.00 to 3.00, based on a combination of financial measures designed to establish the adequacy of an institution’s capital resources, its financial viability, its ability to support current operations, and its ability to generate a profit. An institution that does not meet the ED’s minimum composite score of 1.0 may demonstrate its financial responsibility in one of several ways, including posting a letter of credit in favor of the ED in an amount equal to at least 50% of Title IV Program funds received by the institution during its prior fiscal year or posting a letter of credit in an amount equal to at least 10% of Title IV Program funds received by the institution during its prior fiscal year and agreeing to certain additional requirements for the receipt of Title IV Program funds, including, in certain circumstances, receipt of Title IV Program funds under an agreement other than the ED’s standard advance funding arrangement.

Currently, none of our schools are required to post a letter of credit or accept other conditions on its participation in Title IV Programs due to failure to satisfy the ED’s financial responsibility standards.

Return and Refunds of Title IV Program Funds.   An institution participating in Title IV Programs must correctly calculate the amount of unearned Title IV Program funds that were disbursed to students who withdrew from educational programs before completing the programs, and must return those funds in a timely manner. Institutions have historically been required to return such funds within 30 days of the date the institution determines that the student has withdrawn, but, based upon changes to the HEA in 2006, the deadline to return such funds has been changed to 45 days for any student who withdrew from school on or after July 1, 2006. An institution that is found to be in non-compliance with ED refund requirements for either of the last two completed fiscal years must post a letter of credit in favor of the ED in an amount equal to 25% of the total Title IV Program refunds paid by the institution during its prior fiscal year. Due to non-compliance with ED refund requirements at 14 of our schools, we had posted a total of $3.9 million in letters of credit in favor of the ED as of March 31, 2007.

Change of Ownership or Control.   When an institution undergoes a change of ownership resulting in a change of control, as that term is defined by the state in which it is located, its accrediting agency and the ED, it must secure the approval of those agencies to continue to operate and to continue to participate in Title IV Programs. If the institution is unable to re-establish state authorization and accreditation requirements and satisfy other requirements for certification by the ED, the institution may lose its

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authority to operate and its ability to participate in Title IV Programs. An institution whose change of ownership or control is approved by the appropriate authorities is nonetheless provisionally recertified by the ED for a period of up to three years. Transactions or events that constitute a change of control by one or more of the applicable regulatory agencies, including the ED, applicable state agencies, and accrediting bodies, include the acquisition of an institution from another entity or significant acquisition or disposition of an institution’s equity. It is possible that some of these events may occur without our control. Our failure to obtain, or a delay in obtaining, a required approval of any change in control from the ED, applicable state agencies, or accrediting agencies could impair our ability or the ability of the effected schools to participate in Title IV Programs. If we were to undergo a change of control and a material number of our schools failed to obtain the required approvals from applicable regulatory agencies in a timely manner, our student population, financial condition, results of operations, and cash flows could be materially adversely affected.

When we acquire an institution that is eligible to participate in Title IV Programs, that institution undergoes a change of ownership resulting in a change of control as defined by the ED. Each of our acquired schools in the U.S. has undergone a certification review under our ownership and has been certified to participate in Title IV Programs on a provisional basis. Currently, seven of our schools participate in Title IV Programs under provisional certification due to the ED’s change of ownership criteria. The potential adverse effects of a change of control under ED regulations may influence future decisions by us and our stockholders regarding the sale, purchase, transfer, issuance, or redemption of our common stock.

Opening New Schools, Start-up Branch Campuses, and Adding Educational Programs.   The HEA generally requires that proprietary institutions be fully operational for two years before applying to participate in Title IV Programs. However, an institution that is certified to participate in Title IV Programs may establish a start-up branch campus and participate in Title IV Programs at the start-up branch campus without reference to the two-year requirement if the start-up branch campus has received all of the necessary state and accrediting agency approvals, has been reported to the ED, and meets certain other criteria as defined by the ED. Nevertheless, under certain circumstances, such a start-up branch campus may also be required to obtain approval from the ED to be able to participate in Title IV Programs. Similarly, an institution that is eligible to participate in Title IV Programs may generally add a new educational program and disburse Title IV Program funds to students enrolled in that new program without ED approval if the new program leads to an associate level or more advanced degree and the institution already offers programs at that level, or if the new program prepares students for gainful employment in the same occupation or a related occupation as an educational program that has previously been designated as an eligible program at the institution and meets minimum length requirements. Otherwise, the institution must obtain the ED’s approval before it may disburse Title IV Program funds to students enrolled in the new program.

In addition to ED regulation, certain of the state and accrediting agencies with jurisdiction over our schools have requirements that may affect our ability to open a new school, open a start-up branch campus of one of our existing schools, or begin offering a new educational program at one of our schools. If we establish a new school, add a new branch start-up campus, or expand program offerings at any of our schools without obtaining the required approvals, we would likely be liable for repayment of Title IV Program funds provided to students at that school or branch campus or enrolled in that educational program, and we could also be subject to sanctions. Also, if we are unable to obtain the approvals from the ED, applicable state regulatory agencies, and accrediting agencies for any new schools, branch campuses, or program offerings where such approvals are required, or to obtain such approvals in a timely manner, our ability to grow our business would be impaired and our financial condition, results of operations, and cash flows could be materially adversely affected.

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On January 22, 2007, we received a notice from the ED that it had lifted the growth restrictions that it imposed in June 2005, which had restricted our ability to open additional domestic campuses. This notice was preceded by the ED’s approval during 2006 of applications for IADT campus locations in San Antonio, Texas and Sacramento, California to participate in Title IV Programs.

As of March 31, 2007, seven of our campuses are in the start-up stage. We define start-up campuses as branch campuses that have been instructing students for less than 12 months, including those campuses that have not yet opened for instruction. Start-up campuses included in our Culinary Arts segment as of March 31, 2007, include LCB Dallas, TX; LCB Boston, MA; and our Kitchen Academy campuses in St. Peters, MO; Seattle, WA; and Sacramento, CA. Start-up campuses included in our Academy segment as of March 31, 2007, include IADT Sacramento, CA and IADT San Antonio, TX.

Our LCB Boston, MA and LCB Dallas, TX, campuses and our Kitchen Academy campuses located in St. Peters, MO; and Seattle, WA, will begin enrolling students during 2007. Our Kitchen Academy campus located in Sacramento, CA, has been instructing students since February of 2007. Our IADT San Antonio, TX, campus began instructing students in April of 2007, and our IADT Sacramento, CA, campus is currently enrolling students for an anticipated May 2007 start.

“90-10 Rule.”   Under a provision of the HEA commonly referred to as the “90-10 Rule,” a proprietary institution would no longer be eligible to participate in Title IV Programs if, on a cash accounting basis, it derived more than 90% of its revenue, as defined pursuant to applicable ED regulations, for any fiscal year from Title IV Programs. An institution that violates this 90-10 Rule becomes ineligible to participate in Title IV Programs as of the first day of the fiscal year following the fiscal year for which it is in violation of the rule and is unable to apply to regain its eligibility until the next fiscal year. If an institution violated the 90-10 Rule and became ineligible to participate in Title IV Programs but continued to disburse Title IV Program funds, the ED would require the institution to repay all Title IV Program funds received by the institution after the effective date of the loss of eligibility.

Administrative Capability.   ED regulations specify extensive criteria that an institution must satisfy to establish that it has the requisite administrative capability to participate in Title IV Programs. These criteria relate to, among other things, institutional staffing, operational standards, timely submission of accurate reports to the ED, and various other procedural matters. If an institution fails to satisfy any of the ED’s criteria for administrative capability, the ED may require the repayment of Title IV Program funds disbursed by the institution, require the institution to receive Title IV Program funds under an agreement other than the ED’s standard advance funding agreement while being provisionally certified, or commence a proceeding to impose a fine or limit, suspend, or terminate the participation of the institution in Title IV Programs.

Restrictions on Payment of Commissions, Bonuses, and Other Incentive Payments.   An institution participating in Title IV Programs may not provide any commission, bonus, or other incentive payment based directly or indirectly on success in securing enrollments or financial aid to any person or entity engaged in any student recruitment or admission activity or in making decisions regarding the awarding of Title IV Program funds. The ED’s laws and regulations regarding this rule do not establish clear criteria for compliance in all circumstances. If the ED determined that an institution’s compensation practices violated these standards, the ED could subject the institution to monetary fines, penalties or other sanctions.

Eligibility and Certification Procedures.   Under the provisions of the HEA, an institution must apply to the ED for continued certification to participate in Title IV Programs at least every six years or when it undergoes a change of control, as discussed above. The ED may place an institution on provisional certification status if it finds that the institution does not fully satisfy all required eligibility and certification standards. Provisional certification does not generally limit an institution’s access to Title IV Program

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funds. The ED may withdraw an institution’s provisional certification without advance notice if the ED determines that the institution is not fulfilling all material requirements. In addition, an institution must obtain ED approval for certain substantial changes in its operations, including changes in an institution’s accrediting agency or state authorizing agency or changes to an institution’s structure or certain basic educational features.

Currently, 11 of our schools remain on provisional certification with the ED. Five of our schools are on provisional certification because the initial period of their provisional certification following a change in control has not expired, three schools are on provisional certification due to ongoing ED program reviews, one school is on provisional certification due to administrative capability and unresolved audit liabilities, one school is on provisional certification due to late refunds of Title IV Program funds, and one school is on provisional certification due to its Federal Perkins Loan default rate.

Compliance with Federal Regulatory Standards and Effect of Federal Regulatory Violations

We and our schools are subject to and have pending audits, compliance reviews, inquiries, investigations, claims of non-compliance, and lawsuits by the ED and other state regulatory agencies, accrediting agencies, present and former students and employees, shareholders, and other third parties that may allege violations of statutes, regulations, accreditation standards, or other regulatory requirements applicable to us or our schools. The HEA also requires that an institution’s administration of Title IV Program funds be audited annually by an independent accounting firm and that the resulting audit report be submitted to the ED for review.

If the results of any such audits, reviews, investigations, claims, or actions are unfavorable to us, we may be required to pay monetary damages or be subject to fines, operational limitations, loss of federal funding, injunctions, additional oversight and reporting, or other civil or criminal penalties. In addition, if the ED or another regulatory agency determined that one of our schools improperly disbursed Title IV Program funds or violated a provision of the HEA or the ED’s regulations, that school could be required to repay such funds, and could be assessed an administrative fine. We have several such matters pending against us or one or more of our schools. See Note 7 “Commitments and Contingencies—Federal, State, and Accrediting Body Regulatory Actions” of these notes to our consolidated financial statements for a detailed discussion of certain of these matters.

14.          RECENT ACCOUNTING PRONOUNCEMENTS

FIN 48

In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), which is an interpretation of SFAS No. 109, Accounting for Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS 109 and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in an income tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 31, 2006.

We adopted the provisions of FIN 48 on January 1, 2007, the beginning of our 2007 fiscal year. As of January 1, 2007, our consolidated balance sheet included an accrual for uncertain income tax obligations of $24.9 million. We did not record any cumulative effect adjustment to retained earnings in connection with our adoption of FIN 48. The accrual for uncertain income taxes did not change materially from January 1, 2007, to March 31, 2007. While we expect that the accrual for uncertain income taxes will change during the next twelve months, we do not believe that the change will have a significant impact on our consolidated financial position or results of operations. The total amount of unrecognized income tax benefits that, if recognized, would reduce income tax expense is approximately $24.9 million.

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We classify interest expense accrued in connection with unrecognized tax benefits as interest expense in our consolidated statement of income, and we classify income tax penalties incurred as income tax expense in our consolidated statement of income. Such classifications are consistent with classifications reflected in our prior period financial statements. As of January 1, 2007, our consolidated balance sheet included an income tax liability of approximately $19.6 million and a liability for income tax interest and penalties of approximately $5.3 million. Our liability for income tax  interest and penalties did not change materially from January 1, 2007, to March 31, 2007.

All federal income tax returns of Career Education Corporation and its subsidiaries for periods through 2004 are closed.

State income tax returns are generally subject to examination for a period of three to five years after the filing of the respective return. The state impact of any federal changes remains subject to examination by various states for a period of up to one year after formal notification to the states. Various state income tax returns are currently subject to examination, administrative appeals, or litigation.

SFAS 159

In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). SFAS 159 provides guidance with respect to presentation and disclosure requirements for reporting financial assets and liabilities at fair value. SFAS 159 does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in SFAS No. 157, Fair Value Measurements (“SFAS 157”) and in SFAS No. 107, Disclosures about Fair Value of Financial Instruments (“SFAS 107”). SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We are currently in the process of assessing the impact of SFAS 159 but do not believe that our adoption of the standard will have a material impact on our consolidated financial statements.

SFAS 157

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurement and accordingly, does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We are currently in the process of assessing the impact of SFAS 157 but do not believe that our adoption of the standard will have a material impact on our consolidated financial statements.

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Item 2.                        Management’s Discussion and Analysis of Financial Condition and Results of Operations

The discussion below contains “forward-looking statements,” as defined in Section 21E of the Securities Exchange Act of 1934, as amended, that reflect our current expectations regarding our future growth, results of operations, cash flows, performance and business prospects, and opportunities, as well as assumptions made by, and information currently available to, our management. We have used words such as “anticipate,” “believe,” “plan,” “expect,” “intend,” “will,” and similar expressions, but these words are not the exclusive means of identifying these forward-looking statements. These statements are based on information currently available to us and are subject to various risks, uncertainties, and other factors, including, but not limited to, those discussed in Part II, Item 1 “Risk Factors” in this Quarterly Report on Form 10-Q, that could cause our actual growth, results of operations, cash flows, performance and business prospects, and opportunities to differ materially from those expressed in, or implied by, these statements. Except as expressly required by federal securities laws, we undertake no obligation to update such factors or to publicly announce the results of any of the forward-looking statements contained herein to reflect future events, developments, or changed circumstances, or for any other reason.

INTRODUCTION

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to assist the reader in better understanding our business, results of operations, financial condition, changes in financial condition, critical accounting policies and estimates, and significant developments. MD&A is provided as a supplement to, and should be read in conjunction with, our unaudited condensed consolidated financial statements and the accompanying notes thereto appearing elsewhere herein. This section is organized as follows:

·       Our Business—an overview of our business, a discussion of current business and industry opportunities, challenges, business acquisitions, risks, and a discussion of significant developments affecting our business.

·       Results of Operations—an analysis and comparison of our consolidated results of operations for the three months ended March 31, 2007 and 2006, as reflected in our unaudited condensed consolidated statements of income.

·       Liquidity, Financial Position, and Capital Resources—a discussion of our primary sources and uses of cash for the three months ended March 31, 2007 and 2006, a discussion of selected changes in our financial position, and a summary of our future contractual obligations.

OUR BUSINESS

Overview

We are a dynamic educational services company committed to quality, career-focused learning and led by passionate professionals who inspire individual worth and lifelong achievement. Since our founding in 1994, we have progressed rapidly toward our goal of becoming the world’s leading provider of quality educational services. We are one of the world’s leading on-ground providers of private, for-profit, postsecondary education and have a substantial presence in online education. Our schools and universities prepare students for professionally and personally rewarding careers through the continuing operation of 75 on-ground campuses located throughout the United States and in France, Canada, Italy, and the United Kingdom and two fully-online academic programs.

We evaluate our business based on our operating segments, which we define as our operating divisions. Each of our school and university operating divisions represents a group of for-profit, postsecondary schools that offer a variety of degree and non-degree academic programs and are differentiated based on a variety of criteria including, but not limited to, brand name, academic offerings,

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and geographic location. We have six reportable segments, including the Academy segment, the Colleges segment, the Culinary Arts segment, the Health Education segment, the International segment, and the University segment.

The Academy segment includes our International Academy of Design and Technology (“IADT”) campuses that collectively offer academic programs primarily in the career-oriented discipline of visual communications and design technologies in a classroom setting.

The Colleges segment includes schools that collectively offer academic programs in our core career-oriented disciplines of business studies, health education, information technology, and visual communications and design technologies in a classroom or laboratory setting.

The Culinary Arts segment includes our Le Cordon Bleu and Kitchen Academy schools that collectively offer culinary arts programs in the career-oriented disciplines of culinary arts, baking and pastry arts, and hotel and restaurant management primarily in a classroom or kitchen setting.

The Health Education segment primarily includes our Sanford-Brown schools that collectively offer academic programs in the career-oriented disciplines of health education, business studies, visual communications and design technologies, and information technology in a classroom or laboratory setting.

The International segment includes our INSEEC Group schools and Istituto Marangoni schools located in France, Italy, and the United Kingdom, which collectively offer academic programs in the career-oriented disciplines of business studies, health education, and visual communication and technologies in a classroom or laboratory setting.

The University segment includes our American Intercontinental University (“AIU”) and Colorado Technical University (“CTU”) universities that collectively offer academic programs in the career-oriented disciplines of business studies, visual communication and design technologies, health education, information technology, criminal justice, and education in an online, classroom, or laboratory setting.

The student population of each of our reporting segments as of April 30, 2007 and 2006, was as follows:

 

 

Student Population As of April 30,

 

 

 

2007

 

2006

 

 

 

 

 

 

 

University segment

 

42,200

 

44,000

 

Health Education segment

 

12,200

 

10,900

 

Culinary Arts segment

 

10,500

 

10,600

 

Academy segment

 

9,000

 

9,100

 

Colleges segment

 

7,500

 

9,000

 

International segment

 

6,200

 

4,300

 

Total CEC

 

87,600

 

87,900

 

 

As discussed above, our University segment schools’ offer fully-online academic programs. As of April 30, 2007 and 2006, our University segment schools’ had 30,600 and 31,500 students enrolled, respectively, in fully-online academic programs.

For a detailed discussion of the seasonality of the results of operations for our schools’ campuses, see Note 11 “Segment Reporting” of the notes to our unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q.

First Quarter 2007 Overview.   We have taken a number of significant positive steps during the first quarter of 2007, particularly with regard to our senior management and certain legal and regulatory matters.

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On March 6, 2007, we announced the appointment of Gary E. McCullough as our new President and Chief Executive Officer. Gary brings to Career Education a broad range of experience in operations and brand management, including significant experience managing operations in highly regulated industries.

During the first quarter of 2007, we experienced a number of favorable regulatory and legal outcomes. The U.S. Department of Education (“ED”) notified us in a January 19, 2007, letter that it had lifted restrictions it imposed in June 2005 that had prevented us from acquiring domestic schools and opening additional branch campuses of our existing domestic schools. In addition, in March 2007, the United States District Court for the Northern District of Illinois dismissed the Amended Complaint in McSparran v. Larson, et al, a shareholder derivative suit, and, in April 2007, the court dismissed the Third Amended Consolidated Complaint in the In re Career Education Corporation Securities Litigation, a securities class action suit. Also, the U.S. Department of Justice in Chicago notified us on April 19, 2007, that it was declining prosecution and closing its grand jury investigation of us. See Note 7 “Commitments and Contingencies” of the notes to our unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for further discussion of these developments. The resolution of these important matters enables us to more effectively focus our time, efforts, and resources on the strategic development of our business to the benefit of our students and stakeholders.

Total revenue from continuing operations during the first quarter of 2007 was $424.0 million, a decrease of $60.6 million, or 12.5%, from total revenue during the first quarter of 2006 of $484.6 million. Operating income from continuing operations during the first quarter of 2007 was $48.2 million, a decrease of $51.5 million, or 51.6%, from operating income from continuing operations during the first quarter of 2006 of $99.7 million. Income from continuing operations, net of tax, during the first quarter of 2007 was $34.6 million, or $0.36 per diluted share, compared to income from continuing operations, net of tax, during the first quarter of 2006 of $65.5 million, or $0.65 per diluted share, a decrease of $30.9 million, or 47.2%.

During 2006, a majority of our campuses experienced decreases in student starts, student population, revenue, and operating results. The weak 2007 carry-in student population, relative to our 2006 carry-in population, caused primarily by poor 2006 student start performance had a significant adverse impact on first quarter 2007 revenue and operating profits, resulting in significant declines in revenue and operating profits relative to first quarter 2006 results.

Declines in student starts, student population, and revenue experienced in recent periods have been influenced by a number of factors, including, but not limited to, (1) the continued Probation status of our AIU schools, (2) general competitive pressures for student leads and enrollments experienced by some of our schools, (3) the ED’s general restrictions on our ability to open new branch campuses during 2005 and 2006, (4) the continued negative impact of legal and regulatory matters, and (5) the related negative publicity and negative press coverage regarding us and certain of our schools. We believe that these factors  have adversely impacted the rate at which our leads for prospective students convert into enrolled students (“conversion rate”) and the rate at which our enrolled students start school (“start rate”).

However, notwithstanding the continuing impact on student population and revenue of the factors discussed above, we believe that student population at many of our campuses has begun to stabilize, due primarily to strengthening of recent student start performance and improvement in student retention.

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Income from continuing operations as a percentage of total revenue from continuing operations declined from 20.6% during the first quarter of 2006 to 11.4% during the first quarter of 2007. The decrease in continuing operating profit margin percentage during the first quarter of 2007 was primarily attributable to:

·       An unfavorable segment revenue mix change resulting in disproportionately larger revenue declines in our University segment, which has historically produced the highest operating profit margin percentages;

·       A decrease in operating profit margin percentage generated by our University segment, driven primarily by (1) a decline in revenue, caused, in part, by the Probation status of our University segment schools and reductions of the prices of our AIU Online associate degree programs, (2) an increase in administrative expenses, and (3) the disproportionate growth of CTU Online, which operates at a lower operating profit margin percentage than does AIU Online;

·       Increased occupancy expense and other fixed costs as a percentage of revenue due to declines in revenue, attributable primarily to the weak 2007 carry-in population discussed above.

The adverse impact on continuing operating profit margin percentage of the factors noted above was offset, in part, by a decrease in bad debt expense as a percentage of revenue.

Full-Year 2007 Outlook.   We expect 2007 to be a period of transition and development. While our results continue to be negatively affected by a number of near-term factors, we have taken steps during the fourth quarter of 2006 and the first quarter of 2007 to address these issues and better position the company to achieve its long-term potential. We have executed on several measures as part of a strategic plan to better focus our business, increase efficiency and profitability, and ensure that the company’s priorities align with those of our students. These initiatives include the following:

·       We are completing a corporate realignment conceived to facilitate more consistent customer-focused decision making by reducing redundancies and streamlining the decision making process.

·       We have developed an Online Service Center to leverage significant online and on-ground capabilities to provide students at certain of our schools with more flexible educational delivery options. Through the service center, the technology that AIU Online and CTU Online currently use will enable us to make online and flexible education available at our schools. As a service provider, the service center will offer customization to meet the varying needs of our students and the varying curricula of our individual schools. The ability to offer flexible educational delivery combined with a large number of and variety of our brick-and-mortar campuses further distinguishes us in the marketplace, enabling us to provide students with more choices to learn in ways that fit their particular lifestyles.

·       We have introduced measures that we believe will have a positive impact on admissions productivity, including a supplemental compensation program for admission representatives, extended payment plans for students, a process for better qualification of leads, and a greater focus on referrals.

·       We continue to focus on building our strengths in “careers of passion.” On November 15, 2006, we announced our intention to sell 13 schools and campuses, including our entire Gibbs segment and select schools in the Colleges segment. By focusing on areas where we have the greatest competitive advantages and proven success, we believe we can more effectively prepare students for careers they are passionate about through our high-quality boutique schools, gold-standard brands, and flexible student-centered product offerings.

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·       We are continuing to open start-up campuses and have completed an international acquisition in the first quarter of 2007.

·       We will continue to evaluate individually the pricing of each of our programs at each of our schools to ensure that the prices of our academic offerings are properly aligned with perceived value, identified price sensitivities, and competitive forces.

·       We will continue to evaluate the alternative financing options that we and our lenders make available to prospective students. We will strive to provide greater flexibility in alternative financing options to give prospective students diverse and affordable options to finance the cost of their education.

Current Business and Industry Opportunities, Challenges and Risks

In addition to the risk factors discussed in Part I, Item 1A of our Annual Report on Form 10-K for our fiscal year ended December 31, 2006, we have identified a number of key factors and trends related to our business and industry that represent opportunities, challenges, and risks.

SACS Probation Status of AIU.   As previously disclosed, on December 6, 2005, the Commission on Colleges of the Southern Associations of Colleges and Schools (“SACS”) placed AIU on “Probation” status for one year pending AIU’s satisfactory remediation of certain accreditation deficiencies with regard to SACS Principles of Accreditation. This action followed a July 2005 SACS special committee visit of AIU that resulted in a report identifying specific recommendations. In October 2006, a SACS special committee completed site visits of selected AIU campuses. At SACS’ December 11, 2006, meeting, SACS extended AIU’s Probation status through December 2007. Under SACS’s rules, an institution may remain on Probation status only for two consecutive years, after which SACS must either lift the Probation or remove the institution from membership.

This action has had, and will continue to have, a disruptive effect on operations of AIU and our business generally, including, the diversion of significant time and attention of AIU’s senior management, which adversely affected our results of operations for 2006, and which we expect will adversely affect our results of operations in 2007.

AIU remains accredited during this probationary period and is committed to resolving all issues identified by SACS. We cannot predict SACS’ future accreditation actions, and unfavorable outcomes would have a material adverse effect on our growth prospects, student population, financial condition, results of operations, and cash flows.

U.S. Department of Education Review.   As previously disclosed, the U.S. Department of Education (“ED”) notified us in June 2005 that it was reviewing our previously announced restated consolidated financial statements and our annual compliance audit opinions for the years 2000 through 2003. At the same time, the ED also advised us that it was evaluating four pending school program reviews that were conducted at certain of our schools, three of which were completed and closed during 2006. The ED indicated that until these matters were addressed to its satisfaction, it would not approve any new applications by us for pre-acquisition review or change of ownership. The ED further advised us that, during the review period, it would not approve applications for any additional branch campuses, which the ED generally refers to in its regulations as “additional locations.”

In a November 6, 2006, meeting, officials of the ED informed us that it would select 10 to 12 of our institutions for program reviews to be conducted before it would consider lifting the restrictions on new applications described above. During the months of November and December, 2006 and January and February, 2007, the ED conducted site visits at ten of our institutions as part of such program reviews.

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The ED notified us in a January 19, 2007, letter that, based upon the preliminary results of these programs reviews, it would remove the growth restrictions that it imposed in June 2005. The ED stated that any subsequent request by us to expand our operations would be considered in accord with the ED’s standard operating procedures. The ED emphasized that the removal of the growth restrictions should not be construed to suggest that any Title IV compliance issues identified had been resolved or that program reviews currently in process would be concluded.

The ED’s restriction of our ability to open new branch campuses prohibited our ability during 2006 and the second half of 2005 to pursue domestic expansion opportunities in underserved or emerging markets.

Sales Plan for Certain of Our Schools and Campuses.   On November 14, 2006, our Board of Directors approved a plan to sell 13 of our schools and campuses (the “Sales Plan”). The Sales Plan includes the anticipated sale of our nine Gibbs campuses, which collectively comprised our entire Gibbs reportable segment, McIntosh College (“McIntosh”), Lehigh Valley College (“Lehigh”), and Brooks College (“Brooks”), including Brooks’ Long Beach, California and Sunnyvale, California campuses. McIntosh, Lehigh, and Brooks were previously components of our Colleges reportable segment.

While we believe that each of the campuses included in the Sales Plan is a valuable asset with effective academic programs, we do not believe that our continued operation of these campuses is consistent with our near-term and long-term strategic goals. We will continue to reasonably invest in the campuses included in the Sales Plan in preparation for a sale. We believe that the Sales Plan is a critic