Apollo Group (NASDAQ: APOL):

Earnings Estimates (High/Mean/Low): $1.57/$1.55/$1.54

Investors will be looking for insight into ongoing regulatory hearings when APOL reports Q3 earnings Wednesday afternoon.  The for-profit education industry has come under fire recently from several angles, including Wall St., as more than a few well-known investors, including Jim Chanos, ripped the industry at the ballyhooed Ira W. Sohn conference last month.  The fact that companies like APOL receive upwards of 90% of their profits from Title IV student loans yet foster exceedingly high dropout rates and all the while invest in marketing/sales rather than education doesn’t exactly bode well for the industry.  However, they do have the one thing that can help save any industry, no matter how unethical its pursuits, a robust DC lobbying effort.  With strong forces on both sides of the fence, it’s hard to tell how this will shake out.  But come Aug/Sept, we should know for sure whether Congress is going to come down on the industry.

Until then, we’ll have to settle for Wednesday’s earnings report.  Barring a significant beat or miss on EPS, any post-report movement in shares is likely to be based on management’s commentary on the regulatory situation.  As you can see from the chart below, shares have been hammered over the past two months, falling nearly 35% to $43.75 from an April 22nd high of $66.69.  Considering the steepness of the drop, some on the Street may be looking for a bounce, but this may also be a classic value trap, as the passage of any reform bill would move shares significantly lower still.  Nonetheless, if you’re looking to play a binary event, APOL, as well as competitors Corinthian Colleges (NASDAQ: COCO), Devry (NYSE: DV), etc., will all move significantly one way or the other once this situation has come full circle.

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I can’t get to China anytime in the near future. But a friend of mine, Connell McShane, was just there. I caught up with him for some quick insights into what he sees on the ground in China.

Damien Hoffman: Connell, many people such as Jim Chanos are beating the drum about a property bubble in China. Do you see signs of the market rolling over, or is it still inflating?

Connell McShane: From all the signs we have seen, the market is still inflating. Although, some locals are starting to worry that’s about to change.

I spoke with a real estate agent who says prices in his Shanghai neighborhood are up 30% since last Fall. He told me he expects the new property laws — making it more challenging to get a mortgage on a second or third home — to lead to a cooling off in the market.

I also met a guy who lives in a Shanghai high-rise and owns three other apartments that he rents out. At one point, he owned as many as 12 apartments. Although these stories sound quite similar to the U.S. housing bubble, there are some key differences. Chinese people generally have much more equity in their homes and the mortgage market here is much more traditional and less risky.

Damien: Earth Day was last week. Is China starting to deal with many of its pollution issues?

Connell: This is my first time here so I don’t really have a good perspective. I can say I didn’t have any trouble breathing in Shanghai or anything like that. I’m writing this on the way to Beijing, so I’m not sure about that city. The one thing I noticed is that there are so many motorcycles on the road, and many of them are electric for what it’s worth.

Damien: In your estimation, is the global recession affecting the Chinese the same as Americans? What are some of the differences?

Connell: It seems much different. As I mentioned earlier, people here tend to be savers so they have big cash cushions. And even though the consumer is an emerging presence, it’s nowhere near as dominant as in the U.S.

Damien: What are a few of your other most keen observations on the ground in China?

Connell: This may sound overly simple, but there are just SO MANY PEOPLE. I think it speaks to the potential of this country as many of those people are quickly climbing the social ladder.

The challenges will be political. The government still controls a lot of what happens here and we have had trouble accessing certain website and news articles, which is apparently quite common here.

We will see how China progresses with these types of issues, and there may be some hiccups in areas like real estate. But the long term story of growth and opportunity is still very compelling.

Damien: Thanks for taking the time Connell.

Connell: Anytime.

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All investment managers use the media to talk their book. With that caveat aside, Jim Chanos has been ubiquitous over the past several weeks. He’s going to need much more help if he plans to defeat the Chinese government’s media machine.

Apparently, Chanos is beating his drum that China’s real estate market is in a bubble. Fair enough. Even China bull Jim Rogers agrees. However, there is something comical about one man pushing this hard to pop a bubble which is being controlled by the powerhouse Chinese Government.

In case you have been living in a cave which does not have access to the financial media, here is a summary of Chanos’ mantra from his recent appearance on Fox Business:

“China is in the midst of a world class property boom. It is leading to the economic growth we are seeing. Almost half of their GDP is coming from that.”

There you have it. If you agree, start throwing darts at the China bubble.

Today we post part two of our three-part Q&A session with famed short-seller Jim Chanos.

Of late, Chanos is known for his contrarian stance on China, and his bet that the country is experiencing a massive property bubble.  That is what we focus on today.

(Click here to read part one of the interview. Click here for part three.)

———————–

Business Insider: So moving on to China…

Jim Chanos: Yup!

BI: You’re short China, it’s a big thing…

JC: We’re not actually short China. We are short entities that are selling into China.

BI: Ah, OK.

JC: There is a big misconception that has been posted out there, but our China call is a simple one: there’s a property bubble going on. I’m not making a call on the Chinese economy, although it will have a problem when the property bubble bursts. We’re not making a call on the currency on whether it’ll appreciate or, god forbid, depreciate. What we’re simply saying is you are seeing an epic building boom in China and more interestingly, an epic high-rise building boom in China.

It’s not just high speed rail and airports and new roads. That’s only a very small part of their infrastructure spending. This is primarily a story about people putting up high rise office buildings and condos in the big cities. That’s what it is.

So when you look at it like that, the data supports it. I mean, people have taken a shot at us because “Mr. Chanos has never been to mainland China.” Well hell, I didn’t work at Enron either. Or “Oh, but he doesn’t speak Mandarin.”

Whatever. It doesn’t matter. Using the Chinese government’s own numbers as well as some western entities that are on the ground there, the numbers are what they are. The square footage being built is what it is. You can see it when you go there. It is a high-rise construction boom.

So when you look at it through that prism, you can begin to make some assessments. We’ve seen similar bubbles in Dubai, Miami – scores of other entities have gone through this and it never ends well.

Now, the real argument in China seems to be – the argument I think carries the most water for the China bulls – is somehow the government is going to be able to manage this. That they’re going to let the air out of the bubble gently. That 9 guys who sit on the central committee of the country who got us into this mess are going to get us out of this mess. I wouldn’t want to bet on that.

BI: Right.

JC: History tells us that it’s a bad bet. And that somehow the government will, if I overpay for a condo, somehow bail me out. And again, I generally think that that’s a bad bet. Whether you’re Chinese or American, it doesn’t matter; it’s a bad bet almost anywhere.

The Chinese bubble has its own interesting set of anecdotes and circumstances and one of the more interesting ones from our perspective as a westerner is that when people were buying 2 and 3 condos in Miami for example, they would rent the 2nd or 3rd condo to try and get some rental income. In China, that’s not the case.

BI: People are just buying.

JC: They’re empty shells. When you buy a condo, you’re getting an empty shell and nothing more. By and large most of the developments are 1100 square foot boxes. And they [the owners] don’t rent them because people want to keep them basically as pristine as possible for when they flip them because new is better than old. So ironically, you have people that are buying multiple condos here to speculate who are carrying themselves – there’s no rental income.

The other interesting thing about the boom here is that it is completely high end. When people talk to me about China’s “migration of people” into the cities and the population and blah blah blah, and the growth of the economy, I said “That’s all and good but they’re putting up the equivalent of New York City highrises at almost New York City prices for a populous that is 1/10th of that per-capita income.” So this building boom is aimed at: A) the corporate market, corporate highrises and office buildings or B) very high end of the residential market. It’s not the masses – it’s for people speculating.

BI: I’ve heard that a lot of families in China are maxing out as much as they can in terms of credit and borrowing in order to get into this.

JC: They have to! Keep in mind that the average median income in China, and it’s only slightly higher in the cities, is something like $3500 per person. Typical second-tier city real-estate prices have now gone above $100 a square foot. So a typical 100 square meter condo is probably going to cost you after all your expenses (if you build it out to live) $120,000 to $140,000 US. Well say you’re a dual income couple and you make $7000 to $10,000 a year total. OK? Even if you put down the 20% down that everyone’s pointing to, that’s 20% on your purchase price. You’re still paying mortgage interest of probably … 60 to 100% of your income, pretax.

BI: Pretax?

JC: Pretax. And that’s not super high end – that’s an urban couple, dual-wage earners in a second-tier city. So it’s already getting to the absurd in terms of prices relative to incomes. And the problem is construction is 50-60% of China’s GDP. And of that, the vast majority is this type of construction. There’s going to be a real brick wall here being hit at 200 MPH – it’s just a matter of when.

BI: So when do you see the bubble bursting for China?

JC: Well, always with these things, we’re often early and it appears we’re early here too. But the good news  for office building bubbles is that they’re pretty tangible. So when you see the apartments stop selling, when you stop seeing foundations being laid, and holes in the ground, when you see the cranes not going up anymore, buildings being half-complete – that’ll tell you you’re at the end.

Check out Chanos’s thoughts on China, Enron, and the state of the market at Business Insider >

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Note: The commentary that follows has been taken from Jim Chanos’ speech to a group of investors, on the subject of China’s economy.  The video of this speech can be viewed below.

Hedge fund manager Jim Chanos has generated some controversy over the past few months because he has had the temerity to argue that China is experiencing an asset bubble.  Skeptics argue that he misunderstands the nature of the Chinese economy.

There are four main parts to his argument:

•    GDP drives economic activity.
•    Local party bosses have an incentive to game the system
•    Real estate speculation
•    Overbuilding of industrial and commercial real estate

Let’s take these arguments one by one.

1) GDP drives economic activity

In most industrialized countries, GDP is what Chanos calls a residual: it is the result of economic activity.  But in China, GDP growth is seen as sacrosanct, and Beijing sets a GDP growth target every year.  Local party bosses act to ensure that they meet this target.

2) Local party bosses have an incentive to game the system

Since GDP growth is explicitly stated as a public policy, local political bosses have an incentive to make sure that they contribute to the country’s efforts to meet the GDP target growth rate.  In practice, this means that local municipalities can, for example, meet revenue targets by selling off land to developers.  Party bosses have an incentive to sell as much land as possible, regardless of whether doing so creates too much supply.

3) Real estate speculation

One of the main arguments advanced against Chanos’ China thesis is that real estate speculators in China have to have more equity than do their American counterparts. The implication is that China won’t suffer from a meltdown of real estate.  But this argument, while possibly correct, misses Chanos’ larger point.  Speculators in Beijing buy up multiple apartments, seeing them as a store of value, akin to commodities like gold or palladium.

Implicit in this practice is the notion that there is a greater fool down the line.  Treating real estate as a store of value, rather than an investment that produces real or imputed monthly cash flows in the form of rent defies economic logic.

4) Overbuilding of commercial and residential real estate

Perhaps the most interesting statistic cited by Chanos is that there is 2.6 billion square meters (30 billion square feet) of non-residential construction under development across China.  To put this number in context, that is enough square feet to give every person in China a 5 foot by 5 foot cubicle.  The inference here is that non-residential construction supply will outstrip demand for a very long time.  Basic economics says that if supply exceeds demand, prices (rents) will trend down.

The other consideration here is the annual maintenance expense for these tens of billions of square feet.  Not only will rents go down over time as demand fails to meet supply, but maintenance expenses for vacant office buildings and industrial parks very quickly adds up and acts as a drag on the economy.  Capital used to maintain unoccupied buildings does not grow an economy.

What do these arguments imply?

These four arguments present a pretty compelling thesis about China, and it’s not a pretty one.  Chanos notes that two very different economists, Paul Krugman and Milton Friedman (no relation to this author), have argued that economies grow over time because outputs, not inputs, increase.

But, China has thus far repeated the economic history of the Soviet Union 50 years ago: a massive infusion of capital into a previously capital-poor country has induced millions of rural citizens to move to cities, become educated, and industrialize the economy.  Those are all the inputs.  But the problem, according to Chanos, is the law of diminishing returns.

At some point, those inputs reach a theoretical maximum: there is only so much moving of people from rural areas to cities and educating of the citizenry to be done before real economic growth (i.e., increased output) has to occur.  Else all the growth is illusory.

What do you think about Chanos’ argument? Let us know in the comments below or click here to share your thoughts in our new Forum …