Mr. Market can be a really tough teacher sometimes. Little eCollege (NASDAQ:ECLG) hasn't yet opened its testing book, sharpened its pencil, or even taken a seat at its desk -- and its already been marked with a failing grade on Monday's final exam.

Wall Street Wisdom:

  • General consensus. Five analysts follow eCollege. Four of them rate the stock a buy, and one a sell. No middle ground here, folks.
  • Revenues. Fourth-quarter revenues are expected to rise 21% year over year to top $29.7 million.
  • Earnings. In sharp contrast, profits are set to fall off a cliff. Analysts predict an 83% drop to $0.14 per share.

Margin watch:
The question then, is why? Almost across the board, eCollege's margins appear to be booming. Although its rolling gross numbers are down a bit over the past 18 months, operating profitability is up more than 50% and net margins have expanded nearly tenfold. So what gives?

Margins %

6/04

9/04

12/04

3/05

6/05

9/05

Gross

50.6

48

47.6

48

48.1

48.6

Op.

8.1

8.6

9.3

9.5

11.1

12.4

Net

2.3

2.4

21.7

21.3

21.8

22
All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ending in the named months.

Foolish forensics:
It's simple, really. The reason that eCollege's quarterly profits will be down so very much, year over year, is that last year's Q4 was exceptionally good for eCollege. This year's will be just average. Last year, you see, the company benefited from a massive $18.7 million tax credit in the fourth quarter, the effects of which are now apparent on its rolling numbers for the past four quarters. Tomorrow, that supercharged boost to eCollege's GAAP bottom line disappears, and it's back to business as usual for the company's net.

So what's a Fool do to make sense of these GAAP goings-on? Put the accounting profits to the side for a moment, and focus instead on the firm's cash profits. From that point of view, eCollege generated $6.6 million in free cash flow over the past nine months. That's a decline from the $8.5 million generated in the first three quarters of 2004.

So it seems that eCollege's rising revenues aren't paying off in the form of more cash in the till. While I wouldn't worry overmuch if we hear tomorrow that eCollege's profits did indeed plunge 82%, I would be concerned if free cash flow continues to come in 22% weaker than it did last year.

Fool contributor Rich Smith does not own shares of any company named above.