In an earlier post, I tried to get a handle on Imagine’s spending on facilities.

Six Imagine-run schools utilizing facilities owned by EPT in St. Louis will close at the end of the school year. I was interested in seeing how EPT would address this in their first quarter report for 2012. The 10-Q is available here and the recent conference call is available here.

Below is what EPT had to say about Imagine and the closure of schools in their 10-Q:

Subsequent to March 31, 2012, the Missouri Board of Education voted to close five of the public charter schools located in St. Louis, which are owned by us and operated by Imagine, due to academic underperformance. Additionally, a public charter school owned by us and operated by Imagine located in Marietta, Georgia was closed this past year and we expect one located in Mableton, Georgia and two located in Kansas City, Missouri to close at the end of this school year. We have assessed the impact of these closings on our investment in a direct financing lease with Imagine and have determined that no impairments exist and that these events are not expected to impact our ability to collect payments from Imagine under their master lease with us. This assessment considered the cross-default nature of the master lease, the ability of Imagine per the terms of the master lease to exchange the closed properties for properties that are acceptable to us (i.e. unoccupied schools for occupied schools that are acceptable from an underwriting basis), the excess cashflow that Imagine generates at the parent level and our $16.4 million letter of credit from Imagine. Imagine is current on all payments under the master lease of 27 public charter schools at this time and we do not anticipate any delay in future payments.

The topic of Imagine dominated the conference call. Below is a transcription of EPT CEO David Brain discussing the issue:

Now in education, our charter public school portfolio will continue to perform well with the strong enrollment increase as we reported to you earlier for the ’11-’12 school year. As mentioned in our last call though, we do have a cloud in this otherwise sunny picture of performance. Due to a variety of factors including academic performance issues, it appears Imagine will lose a number of its charters for the coming school year. Greg has more on this, but I want to make the point that due to the financial strength of Imagine, the master lease structure of our investments, the potential for substitute properties with a large-scale operator, and our additional credit support in the form of a letter of credit, we do not expect this to interrupt or disrupt our rental income at all for the current or coming school years. Once again, it’s not an ideal set of circumstances, but it is encouraging to see that our portfolio is able, even with adversity, to perform acceptably. We have constructed our investments throughout our portfolios with multi-unit master lease and cross-default features to prevent some individual weak spots from affecting our income streams. Further, in this instance, we have substantial letter of credit support that can be called upon. I want to reaffirm that we do not expect any reduction in our rental revenue for our charter public school investments this year or in the immediate future. We may allow our client to substitute properties as contemplated in their arrangements, but this will only serve to improve our portfolio’s strength. We’ll keep you posted on these events if they take place.

Here is what COO Greg Silvers had to say about education:

With regard to our education portfolio, we continue to be very positive on the public charter school opportunity that has recently passed a significant milestone of enrollment in excess of two million students. However, we were disappointed that Imagine’s poor performance has jeopardized their charter status in nine of our locations. The total exposure is approximately $78 million of carrying value, however we have already started the process of swapping certain schools for performing assets. Given that these assets represent approximately 10% of Imagine’s total school portfolio, Imagine has the capacity and cashflow to service the assets until they transition to a new charter or new operator. As a result of Imagine’s positive cashflow, their ability to substitute properties or operators as well as the credit support features of our transaction, including the master lease structure and letter of credit, we do not anticipate any financial impact from this situation. The facilities involved are quality educational buildings and we’re actively working to substitute other quality collateral with Imagine or substitute other operators to put these assets into use. Given that these closures were brought about by academic rather than financial performance, we have taken steps to strengthen and increase our evaluation and monitoring of academic performance. We continue to believe that public charter schools that deliver a quality academic experience and operate in a financially responsible manner are very solid investments for EPR with attractive risk-adjusted yields. As I indicated previously, we continue to look for ways to increase both the geographic and operator diversity and this quarters investments, which I’ll detail in a minute, continue on this path.

To summarize, EPT isn’t too bothered by the closings because the closing schools can be swapped for other schools run by Imagine as part of the master lease, Imagine can continue paying for the facilities if a school doesn’t occupy the building, or another operator can be found. According to the comments from EPT, Imagine’s income at the parent (i.e. management organization) level combined with a line of credit assuages any worries about the closings and Imagine’s ability to make future payments.

EPT took calls from investors after the half hour presentation. Nearly every call-in asked about Imagine. I’ve transcribed one brief back-and-forth between Conor Fennerty of Goldman Sachs and EPT’s COO Greg Silvers. It’s worth listening to the entire Q&A session, but I’ve chose to look at these three questions from Fennerty since they touch on the main issues. The conversation below begins at the 31:15 mark and ends at approximately the 34:45 mark:

Conor Fennerty

I guess coming back to the charter school, you know, what gives you guys comfort that these problems are confined to these kind of select, I think you mentioned 9 or 10 schools?

Greg Silvers

Well I think the issue, I think, Conor, you know, and I- I-…  As we’ve said, I think part of the issue is specifically to academics. I think you, when you see, if you follow what’s going on in St. Louis, the issue is not the financial capacity of the schools. The schools, as David said, actually grew in enrollment. We went, we had actually a close to 10% enrollment growth in St. Louis last year. So we have demand for the charter school space. What we have is this operator in this scenario with these principals and these teachers who are not delivering the academic quality that they need to be whereas if you, we can look at the rest of our schools and see that academic progress, they’re not similarly situated. So we do not think this is across the board a systemic problem, but it is more that we can identify it with specific schools.

Fennerty

Okay, but isn’t that a little worrisome that, you know, in theory one of the best operators is having academic issues? ‘Cause isn’t that the kind of core, kind of crux of the argument behind charter schools?

Silvers 

I think if, this is the point we would make, and we can talk about this as much as you want, is when, what we would agree with you is that Imagine is clearly probably the, has the best balance sheet in the space. However, we have, we have… come to understand that they need to have, do some work on their academics. And therefore, you know, we have increased our underwriting and our focus on that to validate those processes as we acquire new assets and you see when we introduce BASIS and some of the other operators the quality academic performance that they have. So when we defined Imagine as one of the better operators, when we came into this space, Conor, we came in with what we thought was a beachhead operator who had a strong balance sheet that can provide across the (?) portfolio and had a substantial as I said cashflow to withstand any sort of issues. That’s proven to be true. Now have they expanded potentially a little too fast and got into some things that stretched their resources and they need to improve that? No doubt. Have we learned as part of the process that we needed to refine our underwriting and do a better job on academic evaluations? No doubt. But I think, again, as we structured the deal, everything continues to work, we do not think we’re gonna have any hiccups in our financial payment responsibility from Imagine and that we will go forward and continue to be very positive on the category.

Fennerty

Okay. And not to beat a dead horse, but just, you mentioned kind of strengthening your academic controls, your academic underwriting, I mean is that looking at the operator’s kind of national performance or how can you kind of get comfortable at the local level or is it more getting comfortable with the operator?

Silvers

It’s all of the above what you said. It’s looking at their national performance, it’s actually evaluating their local board and seeing if they have the right people on their board to have an academic focus and do they have the right sort of individuals from a governance perspective who not only focus on the business side of it but also focus on the academic side of it. So we’ve got some best practices that have, that we’ve been part of, being shared by us by the national charter alliance that we’re trying to make sure we find those in all of our developments. (End transcription)

I’m going to focus on two issues that come up during the presentations by Brain and Silvers, the 10-Q, and Q&A exchange between Fennerty and Silvers:

• Why did the St. Louis schools close? and
• Is the closure of the St. Louis schools indicative of larger issues?

These two issues come up multiple times during the conference call and deserve a bit more attention.

Why did the St. Louis schools close?

Different people are saying different things about why the St. Louis schools will be closed at the end of the year.

Here is what COO Greg Silvers says about the closures (emphasis mine):

Given that these closures were brought about by academic rather than financial performance, we have taken steps to strengthen and increase our evaluation and monitoring of academic performance.

Here is what CEO David Brain says during his introduction (emphasis mine):

Due to a variety of factors including academic performance issues, it appears Imagine will lose a number of its charters for the coming school year.

Here is how EPT describes the St. Louis closures in their 10-Q (emphasis mine):

Subsequent to March 31, 2012, the Missouri Board of Education voted to close five of the public charter schools located in St. Louis, which are owned by us and operated by Imagine, due to academic underperformance.

Brain suggests a “variety of factors including academic performance” contributed to the closure, but the comments from Silvers and the 10-Q suggest it was simply a matter of academic performance.

Yet the suggestion that this was simply a matter of academic achievement runs counter to statements from the Missouri Department of Elementary and Secondary Education. DESE looked at three of the St. Louis charter schools¹ and suggested revoking the charter at the end of the year. Among the reasons offered:

Not only have the three charter LEAs operated with deficit budgets, the schools have been questionable stewards of Missouri tax dollars. A comparison of costs for instructional and administrative functions with the state average, finds that the three charter LEAs spend significantly less on instruction and significantly more on administrative functions than those charter schools in Chart 17 below. Administrative costs statewide for LEAs are close to eight percent. For the three charter LEAs, administrative costs are close to 30 percent. Instructional costs statewide for LEAs are close to 52 percent. For the three charter LEAs, instructional costs are around 30 percent.

A comparison of instructional costs for the charter LEAs in St. Louis shows that the three Imagine charter LEAs are significantly below the other charter LEAs, as shown in Chart 18. A comparison of costs associated with building operations with other charter LEAs reflects high percentages for such services as well, as shown in Chart 19. (p. 18)

From the same report:

The three charter LEAs and their administration have failed to maintain sufficient fiscal control of the LEAs, leading to deficit spending over a number of years. These factors, along with a failure to respond to frequent audit findings, raise significant questions regarding to the future solvency of the Imagine charter schools. (p. 21)

This information wasn’t hidden in an obscure report to the State Board of Education. From a Missouri DESE press release:

This decision to close the three Imagine Academies is due to their ongoing poor academic performance and fiscal management.

And from the Missouri Charter Public School Association (also posted in the St. Louis Beacon):

The reasons given for closure of the Imagine schools were their ongoing poor academic performance and fiscal management. In September the Missouri Charter Public School Association called attention to these areas, questioning whether perhaps they were related to issues with the management company, Imagine Schools, and not the staff within the schools.

Why did EPT’s leadership focus on the academic struggles and only make a possible reference to something related to financial management issues? My hunch is that EPT’s leadership focuses almost exclusively on enrollment numbers (which are tied to revenues) and the occupancy levels of a school as measures of financial success. They want schools that are full with lots of students. Growth is good. This makes sense, at least to a point, but it neglects to look at the issues being raised by DESE – the very kinds of issues that can lead to an authorizer revoking a charter.

Is the closure of the St. Louis schools indicative of larger issues?

A few investors asked if the St. Louis situation was indicative of bigger problems for Imagine. Here is part of Silvers’ response to Fennerty’s query (see above):

What we have is this operator in this scenario with these principals and these teachers who are not delivering the academic quality that they need to be whereas if you, we can look at the rest of our schools and see that academic progress, they’re not similarly situated. So we do not think this is across the board a systemic problem, but it is more that we can identify it with specific schools.

A few investors asked about this very issue: is there concern about Imagine’s academics performance? EPT’s leadership didn’t present any evidence about the academic achievement at other schools, only said it wasn’t a systematic problem. The fact that this question came up a few times makes me wonder if investors are not aware of the publicly-available metrics used to evaluate schools.

There are generally two main measures of school quality, albeit not very good ones: AYP and various state systems. I pulled together AYP and state measures (where I could find them) for the EPT portfolio of Imagine-run schools²:

[EPT's portfolio includes 27 schools total. I excluded MO schools since they are closing at the end of the school year.]

Keep in mind that these accountability systems are pretty crude and often are biased against schools serving a high percentage of struggling students. Just want to be clear here: I’m not suggesting these are good measures of a quality education, just suggesting these are measures that, fortunately or unfortunately, are used to evaluate the quality of a school. And these measures are often used to inform issues like whether or not a charter is renewed.

Just a few days after EPT released first quarter results, an education reform organization in favor of expanding charter schools,The Mind Trust, called for the closure of three Imagine-run schools in Indiana. EPT owns all three of those schools.

A presentation from March of 2012 posted on the company’s website indicates education investments (i.e. charter schools) comprise approximately 10% of EPT’s portfolio. Revenue from Imagine totaled over $7 million, or 9% of EPT’s total revenue, for the first three months of 2012. Imagine was the third largest source of revenue for EPT during these three months³.

In the conference call, ETP suggested that 3-7 facilities currently owned by Imagine could be traded for the Missouri facilities. Maybe EPT and Imagine can swap facilities and continue rolling along. But what happens if more of those charters are forced to close? Will Imagine and EPT be able to find enough suitable properties? EPT sure seems confident that things will look good in the future, or as Silvers put it, EPT remains “very positive on the category.”