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eCollege Flunked

At first glance, it didn't look like the kind of earnings report that would spark a sell-off.

When eCollege (Nasdaq: ECLG  ) reported its Q2 2006 results Wednesday, the first numbers that investors would ordinarily look to, sales and earnings, appeared to be just fine. Sales, at $28.3 million, rose 23%, and profits came in at $0.07 per share on a GAAP basis. Adjusting for the expensing of stock options, goodwill, and the like, the net bounced up to $0.15 per share. What's wrong with that?

Not much, but then again, that wasn't what spooked the market. Wall Street was already looking ahead to Q3 and Q4, to see whether the education software company would raise its guidance as competitor (and Motley Fool Hidden Gems pick) Blackboard (Nasdaq: BBBB  ) had the day before. That's when eCollege's problems began.

In the "Third Quarter 2006 Financial Guidance" section of its earnings release, management warned that revenues this quarter would max out at $30.2 million. Strong growth in eLearning, combined with low-to-no growth in Enrollment, was expected to generate no more than 14% growth in total -- a far cry from the 22% that Wall Street had projected. And that, dear Fools, is how a short-term growth slowdown of a mere eight percentage points turned into a 38% rout of eCollege's market cap on Thursday.

The underlying cause of the muted Q3 expectations -- and therefore, of the stock-price collapse -- lies within the Enrollment Division, so let's take a closer look at that one. Enrollment, which helps eCollege's clients recruit new students (for example, by running their Internet- and direct mail-advertising), suffered margin compression caused by "the increasing sophistication and complexity of our customers' direct mail programs." Perhaps more disturbingly, managment advised that it has been "seeing reductions in marketing spending by some existing customers." Not only will the company likely miss estimates in the current quarter, it will probably miss them again in Q4.

Employing the incredible visionary powers of 20-20 hindsight, I have to wonder whether this was predictable. Some months ago, during the college admissions application season, America's newspapers were filled with stories of how it had become harder than ever to get into a "name" college this year; so many students were applying to multiple colleges that the schools were swamped with applicants. In a situation like that one, it seems only logical that schools might rethink spending a lot of money to attract even more applicants.

Obvious in retrospect? Yeah, well, that's the way 20-20 hindsight works.

If they're in the same business, why is eCollege lagging the S&P 500, while rival Blackboard is beating it? Read up on Blackboard's competitive advantages in the June 2005 issue of Hidden Gems. Take a free trialfree trial of the service and getfull access to this and all other issues in our archives.

Fool contributorRich Smithdoes not own shares of any company named above.

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