** **

**UNITEDSTATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

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**FORM10-K**

** **

**ANNUAL REPORT**

 

**(MarkOne)**

**ý****                                ****ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For thefiscal year ended December 31, 2004**

 

**OR**

 

**o****                                ****TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For thetransition period from                 to                **

 

**Commission file****number 1-13144**

 

**ITT EDUCATIONAL SERVICES,INC.**

(Exact name of registrant as specified in its charter)

 
| **Delaware**                                                               | ** ** | **36-2061311**                       |
|----------------------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization)            |       | (I.R.S. Employer Identification No.) |
|                                                                       |       |                                 |
| **13000 North Meridian Street  Carmel, Indiana**                           | ** ** | **46032-1404**                       |
| (Address of principal executive offices)                                   |       | (Zip Code)                           |
|                                                                       |       |                                 |
| Registrant’s telephone number, including area code **(317) 706-9200** |
|                                                                       |       |                                 |
| Securities registered pursuant to Section 12(b)  of the Act:          |

 
| **Title of each class**                                           | ** ** | **Name of each exchange on which registered** |
|-------------------------------------------------------------------|------------|-----------------------------------------------|
| **COMMON STOCK, $.01 PAR VALUE**                                  | ** ** | **NEW YORK STOCK EXCHANGE, INC.**             |
|                                                              |       |                                          |
| Securities registered pursuant to Section 12(g)  of the Act: |
| **NONE**                                                          |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes  o    No  ý

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K.  ý

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theAct).Yes  ý     No  o

 

**$1,723,418,237**

 

Aggregate market value of the voting stock held by nonaffiliates of theregistrant based on the last sale price for such stock at June 30, 2004(assuming solely for the purposes of this calculation that all Directors andexecutive officers of the registrant are “affiliates”).

 

**46,114,797**

 

Number of shares of Common Stock, $.01 par value,outstanding at February 28, 2005.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the followingdocuments have been incorporated by reference into this Annual Report on Form10-K

 
| **IDENTITY OF DOCUMENT**                                                                  | ** ** | **PARTS OF FORM 10-K INTO WHICH  DOCUMENT IS  INCORPORATED** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| Definitive Proxy Statement for the Annual Meeting of  Shareholders to be held May 3, 2005 |       | PART III                                                     |       |

 

 

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**ITT EDUCATIONAL SERVICES, INC.**

**Carmel, Indiana**

 

**Annual Report to Securities and ExchangeCommission**

**December 31, 2004**

 

**PART I**

 

**Item****1.**           **BUSINESS.**

 

*Forward-LookingStatements: All statements, trend analyses and other information contained inthis report that are not historical facts are forward-looking statements withinthe meaning of the safe harbor provision of the Private Securities LitigationReform Act of 1995 and as defined in Section 27A of the Securities Act of1933 and Section 21E of the Securities Exchange Act of 1934.Forward-looking statements are made based on our management’s currentexpectations and beliefs concerning future developments and their potential effectson us. You can identify these statements by the use of words such as “could,” “should,”“would,” “may,”  “will,” “project,” “believe,”“anticipate,” “expect,” “plan,” “estimate,” “forecast,” “potential,” “intend,” “continue,”and “contemplate,” as well as similar words and expressions. Forward-lookingstatements involve risks and uncertainties and do not guarantee futureperformance.  We cannot assure you thatfuture developments affecting us will be those anticipated by ourmanagement.  Among the factors that couldcause actual results to differ materially are the following:*

 

•                  *business**conditions and growth in the postsecondary educationindustry and in the general economy;*

•                  *changes in federal and state governmental regulationswith respect to education and accreditation standards, or the interpretation orenforcement thereof, including, but not limited to, the level of governmentfunding for, and our eligibility to participate in, student financial aidprograms utilized by our students;*

•                  *effects of any change in our ownership resulting in achange in control, including, but not limited to, the consequences of suchchanges on the accreditation and federal and state regulation of ourinstitutes;*

•                  *our**ability to implement our growth strategies;*

•                  *receptivity**of students and employers to our existing programofferings and new curricula;*

•                  *loss**of lender access to our students for student loans;*

•                  *the effects of the U.S. Department of Justice (“DOJ”)investigation of us, which could result in monetary fines or penalties or othersanctions imposed on us (including our loss of eligibility to participate instudent financial aid programs) that could materially adversely affect ourfinancial condition and results of operations;*

•                  *the results of the U.S. Securities and ExchangeCommission (“SEC”) inquiry into the allegations being investigated by the DOJ,which could result in the restatement of our financial statements, monetaryfines or penalties or other sanctions that could materially adversely affectour financial condition and results of operations; and*

•                  *the results of the securities class action,shareholder derivative and books and records inspection lawsuits filed againstus, which, if adversely determined, could have a material adverse effect on ourfinancial condition and results of operations.*

 

*Readers are also directed to other risks and uncertainties discussed in other documents we file with the SEC.  We undertake no obligation to update or revise any forward-looking information, whether as a result of new information, future developments or otherwise.*

 

*Youshould keep in mind the following points as you read this report:*

 

•                  *References in thisdocument to “we,” “us,” “our” and “ITT/ESI” refer to ITT Educational Services,Inc. and its subsidiaries.*

•                  *Theterms “ITT Technical Institute” or “institute” (in singular or plural form)refer to an individual school owned and operated by ITT/ESI, including itslearning sites, if any. The terms “institution” or “campus group” (in singularor plural form) mean a main campus and its additional locations, branchcampuses and/or learning sites, if any.*

 

1

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**Background**

** **

We area Delaware corporation incorporated in 1946. Our principal executive offices are located at 13000 North MeridianStreet, Carmel, Indiana 46032-1404, and our telephone number is (317)706-9200.  From 1966 until our initialpublic offering on December 27, 1994, we were wholly owned by ITTCorporation, formerly a Delaware corporation and now known as ITT Industries,Inc., an Indiana corporation (“Old ITT”). On September 29, 1995, ITT Corporation, a Nevada corporation (“ITT”),succeeded to the interests of Old ITT in the beneficial ownership of 83.3% ofour common stock.  Public offerings ofour common stock by ITT in June 1998 and February 1999 and ourrepurchase of 1,500,000 shares of our common stock from ITT in February 1999completely eliminated ITT’s beneficial ownership of any of our common stock.

 

**Overview**

 

We area leading provider of technology-oriented postsecondary degree programs in theUnited States based on revenue and student enrollment.  As of December 31, 2004, we wereoffering associate, bachelor and master degree programs and non-degree diplomaprograms to more than 40,000 students. We currently have 77 institutes locatedin 30 states. Each of our institutes is (a) authorized by the applicableeducation authorities of the states in which they operate and recruit and (b)accredited by an accrediting commission recognized by the U.S. Department ofEducation (“ED”). We design our education programs, after consultation withemployers, to help graduates prepare for careers in various fields involvingtheir areas of study. As of December 31, 2004, more than 99% of ourprogram offerings were degree programs, and we were seeking authorization toaward a degree in the remaining programs. We have provided career-orientededucation programs since 1969 under the “ITT Technical Institute” name, and ourinstitutes have graduated over 185,000 students since 1976.

 

In2004, we opened new institutes and began using learning sites.  A learning site is an institute locationwhere educational activities are conducted and student services are providedaway from the institute’s campus.  Weplan to open three or four new institutes and add up to four new learning sitesto existing institutes in the remainder of 2005.  In 2004, we developed several new residenceand online bachelor and associate degree programs.  At the end of 2004, all of our residenceassociate degree and bachelor degree programs were being taught on athree-day-per-week class schedule or under our hybrid education deliverymodel, pursuant to which certain program courses are taught in residence oncampus and others are taught online over the Internet (the “Hybrid DeliveryModel”).  In 2004, we expanded the use ofthe Hybrid Delivery Model to most of our institutes.  In 2004, we also expanded our alliance withan international educator in China, pursuant to which more of our curricula areoffered to students in China either by us through online programs offered overthe Internet or by the international educator through residence programs undera license to use our curricula.  Weintend to continue expanding by opening new institutes, adding learning sitesto existing institutes, offering a broader range of both residence and onlineprograms at our existing institutes and pursuing new and expanded allianceswith both domestic and international educators. We also intend to further expand our Hybrid Delivery Model by teachingmore of the courses in each of our programs online over the Internet and fewercourses in residence on campus.

 

**BusinessStrategy**

 

Ourstrategy is to pursue multiple opportunities for growth. We are implementing agrowth strategy designed to increase revenue and operating efficiencies byincreasing the number and types of program offerings and student enrollment atexisting institutes, opening new institutes across the United States, addinglearning sites to existing institutes, licensing the use of our curricula tothird parties and offering our curricula in international markets. Theprincipal elements of this strategy include the following:

 

***Enhance Results at the Institute Level.***

 

*IncreaseEnrollments at Existing Institutes.*  We intend to increaserecruiting efforts aimed at enrolling more working adults at our existinginstitutes. In addition, we believe that current demographic and employmenttrends will allow us to enroll a greater number of recent high schoolgraduates.

 

*BroadenAvailability of Current Program Offerings.*We intend tocontinue expanding the number of program offerings at our existing institutes.Our objective is to offer multiple programs at each institute. Our 77institutes provide significant potential for the introduction of existingprograms to a broader number of institutes. We believe that introducing new programs at existing institutes willattract more students. In 2004, we added a total of 164

 

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programofferings among 41 existing institutes, and in 2005 we intend to add a total ofapproximately 76 program offerings among 29 existing institutes.

 

*Developor Acquire Additional Programs.*We plan to introduce bothresidence and online programs in additional fields of study and at differentlevels.  In 2004, we developed:

 

•                  two newresidence bachelor degree programs;

•                  two newonline bachelor degree programs;

•                  three newresidence associate degree programs; and

•                  three newonline associate degree programs.

 

In 2005, we intend toincrease the number of our institutions that offer the master, bachelor andassociate degree programs developed in 2004. We also intend to develop additional degree programs of study in 2005 andbegin offering those programs at one or more of our institutes. The new degreeprograms are expected to involve disciplines in drafting and design, businessor criminal justice, and be at the associate, bachelor and master degreelevels.  We intend to develop both aresidence and online version of many of the new programs planned for 2005, andwe expect that most, if not all, of the residence versions of these programswill be taught under our Hybrid Delivery Model. We believe that introducing new programs and making our programs moreconvenient for students can attract a broader base of students,motivate current students to extend their studies and help us improve theutilization of our facilities.

 

*ExtendTotal Program Duration*.  In 2004, we increased the number ofour institutes that offer bachelor degree programs from 51 to 52.  In 2005, we intend to increase the number ofour institutes that offer bachelor degree programs to 54.  The average combined total program time thatgraduates of one or more of our programs were enrolled has increased over timeas a result of:

 

•                  a portion ofthe graduates of our associate degree programs enrolling in bachelor degreeprograms at our institutes;

•                  a decrease in the average number ofcredit hours taken each academic quarter by full-time students in our residencedegree programs of study as a consequence of our conversion to athree-day-per-week class schedule (from a five-day-per-week classschedule) in those programs;

•                  theelimination of shorter, non-degree programs; and

•                  theincreased duration of some of our associate degree programs from 18 months to24 months.

 

We expect that theaverage combined total program time of our students will increase further as weincrease the number of our institutes offering bachelor degree programs, we addadditional bachelor degree programs at our institutes and we expand our onlinecurricula offerings to include additional master degree programs.

 

*ImproveStudent Outcomes.*We strive to improve the graduation andgraduate employment rates of our undergraduate students by providing academicand career services and dedicating administrative resources to those services.

 

***Geographically Expand Our Institutes and Program Offerings. ***We plan to add newinstitutes and new learning sites to existing institutes at locationsthroughout the United States. Using our proprietary methodology, we determinelocations for new institutes and learning sites of existing institutes based ona number of factors, including demographics and population and employmentgrowth. We opened four new institutes in 2002 and three new institutes in2003.  In 2004, we opened two newinstitutes and added one learning site to our existing institutes.  We plan to open three or four new institutesand add up to four new learning sites to existing institutes in the remainderof 2005.  We will also continue toconsider acquiring schools.  We currentlyoffer at least one of our online bachelor degree programs in 47 states.  We intend to expand the number of our onlineprograms offered in each state in 2005. We also expanded our alliance with aninternational educator in China in 2004, pursuant to which more of ourcurricula are offered to students in China either by us through online programsoffered over the Internet or by the international educator through residenceprograms under a license to use our curricula.

 

***Increase Margins By Leveraging Fixed Costs atInstitute and Headquarters Levels. ***Ourefforts to optimize school capacity and class size have allowed us to increasestudent enrollment without incurring a proportionate increase in fixed costs atour institutes.  We believe that ouronline programs and Hybrid Delivery Model will help us to improve theutilization of our facilities by eliminating student usage of our facilitieswith respect to our online program offerings and reducing student usage of ourfacilities with respect to our Hybrid Delivery Model.  In addition, we have realized substantialoperating efficiencies by centralizing management functions and implementingoperational

 

3

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uniformityamong our institutes.  We will continueto seek to improve margins by increasing enrollments and revenue withoutincurring a proportionate increase in fixed costs, and by reducing our variablecosts.

 

**Programs ofStudy**

 

As of December 31,2004, we were offering:

 

•                  17 degree programs and severaldiploma programs in various fields of study;

•                  programs involving informationtechnology (“IT”), electronics technology and drafting and design at all of ourinstitutes, except one;

•                  a programinvolving business at 50 of our institutes; and

•                  a programinvolving criminal justice at 40 of our institutes.

 

The table below setsforth information regarding the programs of study we were offering as of December 31,2004.

 
| ** **                                             | ** ** | **Number of Institutes Offering  the Programs at  December 31, 2004** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **Master  Degree**                                                         | ** ** | **Bachelor  Degree** | ** ** | **Associate  Degree** | ** ** | **Diploma (1)** | ** ** |
| **School of Business**                                 |       |                                                                       |       |   |   |   |   |   |   |
| Business Administration (2)                            |       | 1                                                                          | (3)        | 40 |   | 2 |   | — |   |
| Business Accounting Technology (2)                     |       | —                                                                     |       | 40 |   | 2 |   | — |   |
| Technical Project Management (2)                       |       | —                                                                     |       | 50 |   | — |   | — |   |
| **School of Criminal Justice**                         |       |                                                                       |       |   |   |   |   |   |   |
| Criminal Justice (2)                                   |       | —                                                                     |       | 38 |   | 2 |   | — |   |
| **School of Drafting and Design**                      |       |                                                                       |       |   |   |   |   |   |   |
| Computer Drafting and Design                           |       | —                                                                     |       | — |   | 70 |   | 2 |   |
| Digital Entertainment and Game Design                  |       | —                                                                     |       | 45 |   | — |   | — |   |
| Industrial Design                                      |       | —                                                                     |       | 3 |   | — |   | — |   |
| Multimedia (4)                                         |       | —                                                                     |       | — |   | 76 |   | — |   |
| **School of Electronics Technology**                   |       |                                                                       |       |   |   |   |   |   |   |
| Computer and Electronics Engineering Technology        |       | —                                                                     |       | — |   | 76 |   | — |   |
| Electronics and Communications Engineering  Technology |       | —                                                                     |       | 49 |   | — |   | — |   |
| Industrial Automation Engineering Technology           |       | —                                                                     |       | 6 |   | — |   | — |   |
| **School of Information Technology**                   |       |                                                                       |       |   |   |   |   |   |   |
| Computer Network Systems (4)                           |       | —                                                                     |       | — |   | 77 |   | — |   |
| Data Communication Systems Technology                  |       | —                                                                     |       | 48 |   | — |   | — |   |
| Information Systems Security (2)                       |       | —                                                                     |       | 50 |   | — |   | — |   |
| Software Applications and Programming (4)              |       | —                                                                     |       | — |   | 74 |   | 2 |   |
| Software Engineering Technology                        |       | —                                                                     |       | 45 |   | — |   | — |   |
| Web Development (4)                                    |       | —                                                                     |       | — |   | 74 |   | 2 |   |

 

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(1)                                  Wehave submitted, or are in the process of submitting, the requisite applicationsto the applicable state education authorities for approval to offer the diplomaprograms identified in this column as associate degree programs at each of theaffected ITT Technical Institutes.

(2)                                  Residenceand online programs. Our institute in Indianapolis is the only institute thatpresently offers online programs.

(3)                                  Onlineprogram.

(4)                                  Dependingon the location of the ITT Technical Institute, this program of study may havebeen approved by the applicable state education authority(ies)either as a separate program or as one of as many as four disciplines withinone program of study.  For purposes ofthis table, this program is considered to be a separate program of study atevery ITT Technical Institute where it was taught.

 

As of December 31,2004, approximately 37% of our students were enrolled in IT programs,approximately 29% were enrolled in electronics technology programs,approximately 28% were enrolled in drafting and design programs, approximately3% were enrolled in business programs and approximately 3% were enrolled incriminal justice programs.  We design ourprograms to help graduates prepare for careers in various fields involvingtheir education by offering students a broad-based foundation in a variety ofskills used in those fields.  Graduatesof our IT programs have obtained a variety of entry-level positions in variousfields involving IT, such as network administration, technical support, networktechnology and systems technology. Graduates of our electronics technology programs have obtained a varietyof entry-level positions in various fields involving electronics, such aselectronics product design and fabrication, communications, computertechnology, industrial electronics, instrumentation, telecommunications andconsumer electronics. Graduates of our drafting and design programs haveobtained a variety of entry-level positions in various fields involvingdrafting and design, such as computer-aided drafting, electrical andelectronics drafting,

 

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mechanicaldrafting, architectural and construction drafting, civil drafting, interiordesign, landscape architecture and multimedia communications.  Graduates of our business programs areexpected to obtain a variety of entry-level positions in various types ofbusinesses involving the subject matter of their programs of study.  Graduates of our criminal justice programsare expected to obtain a variety of entry-level positions involving criminaljustice in both the private and public sectors.

 

Wegenerally organize the academic schedule for programs of study offered atour institutes on the basis of four 12-week academic quarters in a calendaryear, with new students beginning at the start of each academic quarter.Students can complete our associate degree programs in eight academic quarters,bachelor degree programs in at least 12 academic quarters and master degreeprogram in seven academic quarters. We typically offer classes in mostresidence programs in four to five hour sessions three days a week (or two daysa week under the Hybrid Delivery Model with one course taught online over theInternet most academic quarters), Monday through Saturday.  Depending on student enrollment, classsessions are generally available in the morning, afternoon and evening. Each ofour courses that is taught online over the Internet isdelivered through an asynchronous learning network and has a prescribed schedule forcompletion of the coursework.  The class schedule forour residence courses and the coursework completion schedule for ouronline courses generally provide students with the flexibility to pursueemployment opportunities concurrently with their studies. Based on studentsurveys, we believe that a substantial majority of our students work at leastpart-time during their programs of study.

 

Mostof our programs of study blend traditional academic content with appliedlearning concepts and have the objective of helping graduates begin to preparefor a changing economic and technological environment. A significant portion ofmost programs offered at our institutes involves practical study in a labenvironment.

 

Thecontent of most courses in each program of study is substantially standardizedamong our institutes to provide greater uniformity and to better enablestudents to transfer, if necessary, to other institutes offering the sameprograms with less disruption to their education. We regularly review eachcurriculum to respond to changes in technology and industry needs. Each of ourinstitutes has established an advisory committee for each field of study, whichis comprised of representatives of local employers. These advisory committeesassist our institutes in assessing and updating curricula, equipment andlaboratory design. In addition to courses directly related to a student’sprogram of study, our programs also include general education courses, such aseconomics, mathematics, communications and sociology.

 

Tuitionfor a student entering an undergraduate residence program in December 2004for 36 quarter credit hours (the minimum course load of a full-time student foran academic year at traditional two- and four-year colleges) is $13,248 for allof our undergraduate residence programs, except as adjusted in some states toreflect applicable taxes and fees.  Wetypically adjust the tuition for our programs of study at least annually.  The majority of students attending residence programsat our institutes lived in that institute’s metropolitan area prior toenrollment. We do not provide any student housing.

 

**StudentRecruitment**

 

Westrive to attract students with the motivation and ability to complete thecareer-oriented educational programs offered by our institutes. To generateinterest among potential students, we engage in a broad range of activities toinform potential students and their parents about our institutes and theprograms they offer. These activities include television, Internet and othermedia advertising, direct mailings and high school visits.

 

Wecentrally coordinate and develop our advertising. We direct our televisionadvertising at both the national market and the local markets in which ourinstitutes are located. Our television commercials generally include a tollfree telephone number and a website address for direct responses andinformation about the location of our institutes in the area.  We place our Internet advertising on websitesvisited by different groups of potential postsecondary students. We centrallyreceive, track and forward responses to our television and Internet advertisingto the appropriate institute representatives to contact prospective studentsand schedule interviews. We target our direct mail campaigns at differentgroups of potential postsecondary students, including, among others, highschool students and working adults. We centrally receive, track and forwardresponses to direct mail campaigns to the appropriate institute representativesto contact prospective students and schedule interviews.

 

Weemploy a director of recruitment at each of our institutes, who reports to thedirector of that institute. We centrally establish recruiting policies andprocedures, as well as standards for hiring and training salesrepresentatives.  We implement thesepolicies, procedures and standards at the local level.  We employ approximately 900 sales

 

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representativesto assist in local recruiting efforts. These representatives perform most of their services in student recruitmentoffices located at the campus and any learning site of each of ourinstitutes.  Our sales representatives,along with other employees, also make presentations to students at highschools. These presentations promote our institutes and obtain informationabout high school juniors and seniors who may be interested in attending ourinstitutes.

 

Localsales representatives of an institute pursue expressions of interest frompotential students for our residence programs of study by contactingprospective students and arranging for interviews at the campus or any learningsite of that institute. We have designed these interviews to establish aprospective student’s qualifications, academic background, interests,motivation and goals for the future. Occasionally, we also pursue expressions of interest from students forour residence programs of study by contacting them and arranging for theirattendance at an informational seminar providing information about theinstitute and its programs.  We pursueexpressions of interest from potential students for our online programs ofstudy by providing program and resource information on our website and throughtelephone calls, electronic mail and the mail.

 

Studentrecruitment activities are subject to substantial regulation at both the stateand federal level. Most states have bonding and licensing requirements thatapply to many of our representatives and other employees involved in studentrecruitment. Our Vice President, Recruitment and the directors of field recruitmentand training oversee the implementation of recruitment policies and procedures.In addition, our compliance department generally reviews student recruitingpractices relating to student presentations and the execution and completion ofenrollment agreements at each of our institutes on an annual basis.

 

**StudentAdmission and Retention**

 

Westrive to admit incoming students who have the ability to complete their chosenprograms of study. We require all applicants for admission to any of ourinstitutes’ programs of study to have a high school diploma or a recognizedequivalent and, depending on the program of study and the institute, applicantsmay also be required to pass an admission examination or possess a designatednumber of credit hours or degree with a specified overall cumulative gradepoint average from an accredited postsecondary educational institution.  Our student demographics as of December 31,2004, were as follows:

 
| **Student Demographics** | ** ** | **Approximate Percent  of Student Census** | ** ** |
|--------------------------|------------|--------------------------------------------|------------|
| Age                      |       |                                       |       |
| 19 or less               |       | 20                                         | %          |
| 20 through 24            |       | 39                                         | %          |
| 25 through 30            |       | 23                                         | %          |
| 31 or over               |       | 18                                         | %          |
| Gender                   |       |                                       |       |
| Male                     |       | 81                                         | %          |
| Female                   |       | 19                                         | %          |
| Race                     |       |                                       |       |
| Caucasian                |       | 55                                         | %          |
| Minority (1)             |       | 45                                         | %          |

 

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(1)          Basedon applicable federal classifications.

 

Thefaculty and staff at each of our institutes strive to help students overcomeobstacles to the completion of their programs of study. As is the case in otherpostsecondary institutions, however, students often fail to complete theirprograms for a variety of personal, financial or academic reasons. Studentwithdrawals prior to program completion not only affect the students, they alsohave a negative regulatory, financial and marketing effect on the institute. Tominimize student withdrawals, each of our institutes devotes staff resources toassist and advise students regarding academic and financial matters. Weencourage academic advising and tutoring in the case of students experiencingacademic difficulties. We also offer assistance and advice to students in ourresidence programs who are looking for part-timeemployment and housing. In addition, we consider factors relating to studentretention in the performance evaluation of all of our instructors and most ofthe managers of our institutes.

 

In December 2002,we discontinued admitting new students at two of our ITT Technical Institutes:one in Hayward, California and the other in Santa Clara, California.  All formal operations at each of those twoinstitutes

 

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finallyceased at the end of 2004, but we are continuing to provide career services tothe graduates of the programs of study at those institutes.  The cessation of operations at those twoinstitutes did not have a material adverse effect on our financial condition,results of operations or cash flows.

 

**GraduateEmployment**

 

Webelieve that the success of our graduates who begin their careers in fieldsinvolving their programs of study is critical to the ability of our institutesto continue to recruit students. We try to obtain data on the number ofstudents employed following graduation. The reliability of such data dependslargely on information that students and employers report to us. Based on thisinformation, we believe that approximately 69% of the Employable Graduates (asdefined below) from our institutes’ programs during 2003 obtained employment orwere already employed by April 30, 2004 in positions that required thedirect or indirect use of skills taught in their programs of study.  Employable Graduates include all of thegraduates from our institutes, except for those graduates who:

 

•                  have been admitted into otherprograms of study at postsecondary educational institutions that are scheduledto begin within one academic year following their graduation;

•                  possessed visas that did not permitthem to work in the United States following their graduation;

•                  were personally suffering from ahealth condition that prevented them from working;

•                  were actively engaged in U.S.military service; or

•                  moved out of the Continental UnitedStates with a spouse or parent who was actively engaged in U.S. militaryservice.

 

The definition ofEmployable Graduates is based on the information that our institutes arerequired to report to their accrediting commission, and this information isused, in part, by their accrediting commission to evaluate the student outcomesof our institutes.

 

Eachof our institutes employs personnel to offer its students and graduates careerservices. These persons assist in job searches and solicit employmentopportunities from employers. In addition, certain courses in our undergraduateprograms of study include instruction on job search techniques, the use ofrelevant reference materials, the composition of resumes and letters ofintroduction and the appropriate preparation, appearance and conduct forinterviews.

 

Basedon information from graduates and employers who responded to our inquiries, weestimate that the reported annualized salaries initially following graduationaveraged approximately $26,940 for the Employable Graduates of our institutes’programs who graduated in 2003 and obtained employment or were already employedby April 30, 2004 in fields involving skills taught in their programs ofstudy.  The calculation of this amountexcludes any reported annualized initial salaries above $60,000.  The average annual salary initially followinggraduation for our Employable Graduates may vary significantly among ourinstitutes depending on local employment conditions and each EmployableGraduate’s background and prior work experience. Initial employers ofEmployable Graduates from our institutes’ programs include small, medium andlarge companies.

 

**Faculty**

 

Wehire faculty members in accordance with criteria established by us, theaccrediting commission that accredits our institutes and the state educationauthorities that regulate our institutes. We hire faculty with related workexperience and/or academic credentials to teach most technical subjects.Faculty members at each institute typically include the chairperson for eachschool of study and various categories of instructors. Our institutes currentlyemploy a total of approximately 1,200 full-time and 1,600 part-time or adjunctfaculty members.

 

**Administrationand Employees**

 

Eachof our institutes is administered by a director who has overall responsibilityfor the management of the institute. The administrative staff of each institutealso includes a director of recruitment, a director of career services, adirector of finance, a dean and a registrar. We employ approximately 175 peopleat our corporate headquarters in Carmel, Indiana. We currently haveapproximately 3,800 full-time and 2,400 part-time employees at our institutesand corporate headquarters. In addition, we currently employ approximately 175students as laboratory assistants and in other part-time positions. None of ouremployees are represented by labor unions.

 

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Ourheadquarters provides centralized services to all of our institutes in thefollowing areas:

 

•                  accounting

•                  marketing

•                  publicrelations

•                  curriculadevelopment

•                  managementinformation systems

•                  purchasing

•                  legal

•                  regulatory

•                  legislativeaffairs

•                  real estate

•                  humanresources

•                  compliance/internalaudit

 

Inaddition, national managers of each of the following major institute functionsreside at our headquarters and develop policies and procedures to guide thesefunctions at our institutes:

 

•                  recruiting

•                  finance

•                  academicaffairs

•                  career  services

•                  library

 

Managerslocated at our headquarters monitor the operating results of each of ourinstitutes and periodically conduct on-site reviews.

 

**Competition**

 

Thepostsecondary education market in the United States is highly fragmented andcompetitive with no private or public institution enjoying a significant marketshare. Our institutes compete for students with graduate, bachelor andassociate degree-granting institutions, which include nonprofit public andprivate colleges and for-profit institutions, as well as with alternatives tohigher education such as military service or immediate employment. We believecompetition among educational institutions is based on:

 

•                  the qualityand reliability of the institution’s programs and student services;

•                  theperceived reputation of the institution and its programs and student services;

•                  the cost ofthe institution’s programs;

•                  theemployability of the institution’s graduates;

•                  the abilityto provide easy and convenient access to the institution’s programs andcourses;

•                  the qualityand experience of the institution’s faculty; and

•                  the timerequired to complete the institution’s programs.

 

Certain public andprivate colleges may offer programs similar to those offered by our institutesat a lower tuition cost due in part to government subsidies, foundation grants,tax deductible contributions or other financial resources not available tofor-profit institutions. Other for-profit institutions offer programs thatcompete with those of our institutes. Certain of our competitors in both thepublic and private sectors have greater financial and other resources than wedo.

 

**Federal and OtherFinancial Aid Programs**

** **

In2004, we indirectly derived approximately 69% of our revenue determined on anaccrual accounting basis (or 66% determined on a cash accounting basis asdefined by the ED’s regulations) from the federal student financial aidprograms under Title IV (the “Title IV Programs”) of the Higher Education Actof 1965, as amended (the “HEA”).  Ourinstitutes’ students also rely on unaffiliated private loan programs, familycontributions, personal savings, employment, state financial aid programs,scholarships and other resources to pay their educational expenses. Students atour institutes receive grants, loans and other aid to fund the cost of their educationunder the following Title IV Programs:

 

•                  the FederalFamily Education Loan (the “FFEL”) program, which accounted in aggregate forapproximately 56% of our revenue in 2004;

•                  the FederalPell Grant (the “Pell”) program, which accounted in aggregate for approximately13% of our revenue in 2004;

•                  the WilliamD. Ford Federal Direct Loan (the “FDL”) program, which accounted in aggregatefor a negligible portion of our revenue in 2004;

 

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•                  the Federal Work-Study (the “Work-Study”)program, which makes federal funds available to provide part-time employment tostudents and under which our institutes employed approximately 350 students andpaid $1,885,315 in student wages in 2004; and

•                  the FederalSupplemental Educational Opportunity Grant (the “SEOG”) program, whichaccounted in aggregate for a negligible portion of our revenue in 2004.

 

TheWork-Study and SEOG programs each require our institutions to make a 25%matching contribution for all of the federal funds the institution receivesfrom the ED under those programs. In 2004, our 25% matching contributionamounted to $637,078 for the Work-Study program and $86,898 for the SEOGprogram.

 

In2004, we indirectly derived approximately 3% of our revenue from state studentfinancial aid programs.  In 2004, we alsoindirectly derived approximately 25% of our revenue from unaffiliated, privateloan programs that were made available to eligible students at various ITTTechnical Institutes to help fund a portion of the students’ cost of education.We have no financial responsibility with respect to any loans made to studentsor their parents under those programs, except for $976,000 of loans made in themid-1990’s for which we have guaranteed repayment to the lender if theborrowers fail to pay. We have reserved $944,000 for our guarantee obligationwith respect to those loans and, as a result, we do not believe that suchguarantee will result in a material adverse effect on our financial condition,results of operations or cash flows.

 

**Highly-RegulatedIndustry**

 

We are subject toextensive regulation by the ED, the state education authorities (the “SEAs”)and the Accrediting Council for Independent Colleges and Schools (the “ACICS”)that accredits our institutes.  Thestatutes, regulations and standards applied by the ED, the SEAs and the ACICSare periodically revised and the interpretations of existing requirements areperiodically modified.  We cannot predictwith certainty how all of the statutes, regulations and standards applied bythe ED, the SEAs and the ACICS will be interpreted.

 

At the federallevel, the HEA and the regulations promulgated thereunder by the ED set forthnumerous and complex standards that institutions must satisfy in order toparticipate in Title IV Programs.  Toparticipate in Title IV Programs, an institution must receive and maintainauthorization by the appropriate SEAs, be accredited by an accreditingcommission recognized by the ED and be certified as an eligible institution bythe ED.  The purpose of those standardsis to limit institutional dependence on Title IV Program funds, preventinstitutions with unacceptable student loan default rates from participating inTitle IV Programs and, in general, require institutions to satisfy certaincriteria related to educational value, administrative capability and financialresponsibility.  All of our ITT TechnicalInstitutes currently participate in Title IV Programs.  In 2004, we indirectly derived approximately69% of our revenue determined on an accrual accounting basis (or 66% determinedon a cash accounting basis as defined by the ED’s regulations) from Title IVPrograms.  Most of the ED’s requirementsare applied on an institutional basis, with an institution defined by the ED asa main campus and its additional locations, if any.  Under the ED’s regulations, an additionallocation is any location away from the main campus that offers at least 50% ofan entire educational program and obtains the necessary authorization of theapplicable SEAs and accrediting commission. Twenty-nine of our 77 institutes are main campuses and the remaining 48of our institutes are additional locations. Each of the learning sites of our institutes is also an additionallocation under the ED’s regulations.  TheHEA standards require an institution to obtain and periodically renew itscertification by the ED as an “eligible institution” that has been authorizedby the relevant SEAs and accredited by an accrediting commission recognized bythe ED.

 

At the state level,we currently operate one or more institutes in 30 states and our institutesrecruit students in the remaining 20 states and the District of Columbia. Eachof our institutes must be authorized by the applicable SEAs to operate andgrant degrees or diplomas to their students. The state laws and regulations that we must comply with in order toobtain authorization from the SEAs are numerous and complex.  Currently, each of our institutes hasreceived authorization from one or more SEAs. In addition, some states require an institute to be in operation for aperiod of up to two years before such institute can be authorized to grantdegrees.  Institutes that confer bacheloror master degrees must, in most cases, meet additional regulatory standards.Raising the curricula of our existing institutes to the bachelor and/or masterdegree level requires the approval of the SEAs and the ACICS. State educationlaws and regulations affect our operations and may limit our ability tointroduce degree programs or to obtain authorization to operate in some states.If any one of our institutes lost its state authorization, the institute wouldbe unable to offer postsecondary education and we would be forced to close theinstitute. Closing one of our institutes for any reason could have a materialadverse effect on our financial condition, results of operations and cashflows.

 

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Stateauthorization and accreditation by an accrediting commission recognized by theED are required for an institution to become and remain eligible to participatein Title IV Programs. In addition, some states require institutions operatingin the state to be accredited as a condition of state authorization.  All of our institutes are accredited by theACICS, which is an accrediting commission recognized by the ED.  The HEA specifies a series of criteria thateach recognized accrediting commission must use in reviewing institutions. Forexample, accrediting commissions must assess the length of each academicprogram offered by an institution in relation to the objectives of the degreesor diplomas offered. Further, accrediting commissions must evaluate eachinstitution’s success with respect to student achievement, as measured by ratesof program completion, passing of state licensing examinations and jobplacement.  During 2004, the ACICS evaluated 44 of ourinstitutes for initial grants of accreditation or the renewal of their currentgrants of accreditation.  As of the endof 2004, the ACICS had granted initial accreditation to two institutes, hadreaccredited 29 institutes, and had deferred the decision on whether toreaccredit 13 institutes.  Under ACICSstandards, deferring the decision on whether to reaccredit a school extends theschool’s current grant of accreditation for a period of time to allow theschool to address any items on which the ACICS seeks additional informationfrom, or action by, the school. None of our institutes is on probation with the ACICS, but 14 institutesare subject to graduate placement reporting by the ACICS. Under the ACICSstandards, an institute that is subject to a financial or outcomes review(including graduate placement reporting) must periodically report its resultsin such areas to the ACICS and obtain permission from the ACICS prior toapplying to add a new program of study or establish a branch campus or learningsite.  We do not believe that theselimitations will have a material adverse effect on our expansion plans.  The loss of accreditation by one of ourexisting institutes or the failure of a new institute to obtain fullaccreditation:

 

•                  would make only the affectedinstitute ineligible to participate in Title IV Programs, if the affectedinstitute was an additional location;

•                  would make the entire campus groupineligible to participate in Title IV Programs, if the affected institute was amain campus; and

•                  could have a material adverse effecton our financial condition, results of operations and cash flows.

 

The statutes, regulationsand standards applied by the ED, the SEAs and the ACICS cover the vast majorityof our operations, including our educational programs, facilities,instructional and administrative staff, administrative procedures, marketing,recruiting, financial operations and financial condition.  Those requirements also affect our ability toopen or acquire additional institutes and learning sites, add new, or expandour existing, educational programs and change our corporate structure andownership.  If our institutes failed tocomply with any of the statutes, regulations or standards applied by the ED,the SEAs or the ACICS, those authorities could:

 

•                  impose monetary fines and/orpenalties;

•                  terminate or limit our institutes’operations and/or ability to grant degrees and diplomas;

•                  revoke or restrict our institutes’accreditation;

•                  limit, terminate or suspend ourinstitutes’ eligibility to participate in Title IV Programs or any statefinancial aid programs;

•                  require our institutes to repay TitleIV Program funds and/or state financial aid;

•                  subject our institutes to heightenedcash monitoring by the ED;

•                  transfer our institutes from the ED’sadvance system of receiving Title IV Program funds to its reimbursement system,under which a school must disburse its own funds to students and document thestudents’ eligibility for Title IV Program funds before receiving such fundsfrom the ED; and

•                  subject us or our institutes to othercivil and criminal penalties.

 

Each of these sanctions could adversely affect ourfinancial condition, results of operations and cash flows and imposesignificant operating restrictions upon us. If the ED terminates an institution’s participation in Title IVPrograms, the institution in most circumstances must wait 18 months beforerequesting a reinstatement of its participation.  If any sanction substantially limited ourinstitutes’ participation in Title IV Programs or required the repayment of asubstantial sum of Title IV Program funds that our institutes disbursed inprior years, we would be materially adversely affected, even if we couldarrange or provide alternative financing sources or repay those funds.  If an institute lost its eligibility toparticipate in Title IV Programs and we could not arrange for alternativefinancing sources for the students attending that institute, we would probablyhave to close that institute.

 

The internal auditfunction of our compliance department reviews our institutes’ compliance withTitle IV Program requirements and conducts an annual compliance review of eachof our institutes. The review addresses numerous compliance areas, includingstudent tuition refunds and return of Title IV Program funds, student academicprogress,

 

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student admission, graduate employment, studentattendance, student financial aid applications, implementation of prior auditrecommendations and a general review of student recruiting practices relatingto student presentations and the execution and completion of enrollmentagreements.  Each of our institutes’administration of Title IV Program funds must also be audited annually by anindependent accounting firm, and the resulting audit report must be submittedto the ED for review.

 

Due to thehighly-regulated nature of the postsecondary education industry, we may besubject from time to time to audits, reviews, inquiries, investigations, claimsof non-compliance or lawsuits by federal and state governmental agencies, theACICS or third parties, which may allege violations of statutes, regulations oraccreditation standards or common law causes of action (collectively, “Claims”).  If the results of any Claims are unfavorableto us, we may be required to pay money damages or be subject to fines,penalties, injunctions, terminations, limitations, debarments, additionaloversight and reporting, other civil and criminal penalties or other censurethat could have a material adverse effect on our financial condition, resultsof operations and cash flows.  Even if wesatisfactorily resolve the issues raised by a Claim, we may have to expendsignificant amounts of money and devote significant management resources, whichcould have a material adverse effect on our financial condition, results ofoperations and cash flows.  Inparticular, the DOJ investigation and resulting securities class action,shareholder derivative and books and records inspection lawsuits currentlypending against us and certain of our current and former officers and directorshave demanded significant management time and financial resources to resolveand defend and have had a material adverse effect on our financialcondition.  Adverse publicity regardingany Claims could also negatively affect our business.

 

The following are some ofthe significant factors related to our highly-regulated industry:

 

***Legislative Action*.**Political and budgetary concerns significantly affect Title IV Programs. TheU.S. Congress must reauthorize the HEA approximately every six years, and thelast reauthorization occurred in October 1998.  The U.S. Congress began the process ofreviewing and reauthorizing the HEA in 2003, a process that may be concluded in2005.  There has been extensivediscussion about various possible changes to the HEA, but we cannot predict whatchanges the U.S. Congress will ultimately make. In addition, the U.S. Congress determines federal appropriations forTitle IV Programs on an annual basis. The U.S. Congress can also make changesin the laws affecting Title IV Programs in those annual appropriations billsand in other laws it enacts between the HEA reauthorizations.  Since a significant percentage of our revenueis indirectly derived from Title IV Programs, any action by the U.S. Congressthat significantly reduces Title IV Program funding or the ability of ourinstitutes or students to participate in Title IV Programs could have amaterial adverse effect on our financial condition, results of operations andcash flows.

 

If oneof our institutes lost its eligibility to participate in Title IV Programs, orif Congress significantly reduced the amount of available Title IV Programfunding, we would try to arrange or provide alternative sources of financialaid for that institute’s students. There are a number of private organizationsthat provide loans to students. Although we believe that one or more privateorganizations would be willing to provide loans to students attending one ofour institutes, we cannot assure you that this would occur or that the interestrate and other terms of such loans would be as favorable as for Title IVProgram loans. In addition, the private organizations could require us toguarantee all or part of this assistance and we might incur other additionalcosts. If we provided more direct financial assistance to our students, wewould incur additional costs and assume increased credit risks.

 

Legislativeaction may also increase our administrative costs and burden and require us toadjust our practices in order for our institutes to comply fully with thelegislative requirements, which could have a material adverse effect on ourfinancial condition or results of operations.

 

***Student Loan Defaults*.**Under the HEA, an institution may lose its eligibility to participate in someor all Title IV Programs, if the rates at which the institution’s studentsdefault on their federal student loans exceed specified percentages. The EDcalculates these rates on an institutional basis, based on the number ofstudents who have defaulted, not the dollar amount of such defaults. The EDcalculates an institution’s cohort default rate on an annual basis as the rateat which borrowers scheduled to begin repayment on their loans in one yeardefault on those loans by the end of the next year.  Each institution participating in the FFELand/or FDL programs receives a FFEL/FDL cohort default rate for each federalfiscal year (i.e., October 1st through September 30th)based on defaulted FFEL and FDL program loans. An institution whose FFEL/FDLcohort default rate is: (a) 25% or greater for three consecutive federal fiscalyears loses eligibility to participate in the FFEL, FDL and Pell programs forthe remainder of the federal fiscal year in which the ED determines that theinstitution has lost its eligibility and for the two subsequent federal fiscalyears; or (b) greater than 40% for one federal fiscal year loses eligibility toparticipate in the FFEL and FDL programs for the remainder of the federalfiscal year in which the ED determines that the institution has lost itseligibility and for

 

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thetwo subsequent federal fiscal years. An institution can appeal this loss ofeligibility.  During the pendency of anysuch appeal, the institution remains eligible to participate in the FFEL, FDLand Pell programs.  If an institutioncontinues its participation in the FFEL and/or FDL programs during the pendencyof any such appeal and the appeal is unsuccessful, the institution must pay theED the amount of interest, special allowance, reinsurance and any relatedpayments paid by the ED (or which the ED is obligated to pay) with respect tothe FFEL and FDL program loans made to the institution’s students or theirparents that would not have been made if the institution had not continued itsparticipation (the “Direct Costs”). If a substantial number of our campusgroups were subject to losing their eligibility to participate because of theirFFEL/FDL cohort default rates, the potential amount of the Direct Costs forwhich we would be liable if our appeals were unsuccessful would prevent us fromcontinuing some or all of the affected campus groups’ participation in the FFELand/or FDL programs during the pendency of those appeals.

 

Ourcampus groups’ FFEL/FDL cohort default rates ranged from:

 

•                  4.5% to 17.5% for the 2000 federalfiscal year;

•                  4.9% to 12.7% for the 2001 federalfiscal year; and

•                  2.1% to 12.1% for the 2002 federalfiscal year, the most recent year for which the ED has published FFEL/FDLofficial cohort default rates.

 

Our campus groups’FFEL/FDL preliminary cohort default rates ranged from 4.4% to 14.9% for the2003 federal fiscal year, which preliminary rates were issued by the ED in February 2005.

 

If aninstitution’s FFEL/FDL cohort default rate is 25% or greater in any of thethree most recent federal fiscal years, or if its cohort default rate for loansunder the Perkins program exceeds 15% for any federal award year, the ED mayplace that institution on provisional certification status. A federal awardyear is July 1 through June 30. Nineteen of our campus groups (consisting of 43 institutes) had a cohortdefault rate under the Federal Perkins Loan (the “Perkins”) program in excessof 15% for students who were scheduled to begin repayment in the 2001/2002federal award year and went into default by June 30, 2003 (the most recentyear for which the ED has published Perkins cohort default rates).  When all of the ITT Technical Institutecampus groups were recertified by the ED to participate in Title IV Programsduring 2003, the reason given by the ED for placing two of our campus groups(consisting of three institutes) on provisional certification was their Perkinscohort default rate.  We recentlysubmitted to the ED our institutions’ Perkins cohort default rates for studentsscheduled to begin repayment in the 2002/2003 federal award year, but thoserates have not yet been accepted or published by the ED.  Our reported data for that year show that 19of our campus groups (consisting of 50 institutes) had a Perkins cohort defaultrate in excess of 15% for that year.  See“— Administrative Capability” and “— Eligibility and Certification Procedures.”  We no longer participate in the Perkinsprogram.

 

Theservicing and collection efforts of student loan lenders and guaranty agencieshelp to control our FFEL/FDL cohort default rates. We are not affiliated withany student loan lenders or guaranty agencies. We supplement their efforts byattempting to contact students to advise them of their responsibilities and anydeferment or forbearance for which they may qualify.

 

***Financial ResponsibilityStandards*.** The HEA and its implementingregulations prescribe specific financial responsibility standards that aninstitution must satisfy to participate in Title IV Programs.  The ED evaluates institutions for compliancewith these standards each year, based on the institution’s annual auditedfinancial statements, as well as following any change of control of theinstitution and when the institution is reviewed for recertification by theED.  The most significant financialresponsibility measurement is the institution’s composite score, which iscalculated by the ED based on three ratios:

 

•                  the equityratio, which measures the institution’s capital resources, ability to borrowand financial viability;

•                  the primaryreserve ratio, which measures the institution’s ability to support currentoperations from expendable resources; and

•                  the netincome ratio, which measures the institution’s ability to operate at a profit.

 

The ED assigns a strengthfactor to the results of each of these ratios on a scale from negative 1.0 topositive 3.0, with negative 1.0 reflecting financial weakness and 3.0reflecting financial strength. The ED then assigns a weighting percentage toeach ratio and adds the weighted scores for the three ratios together toproduce a composite score for the institution. The composite score must be atleast 1.5 for the institution to be deemed financially responsible by the EDwithout the need for further oversight. We have calculated that our campus groups’ composite score, based on our

 

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fiscalyear consolidated financial statements at the parent company level, was 2.9 in2004 and 2.8 in 2003.  In evaluating aninstitution’s compliance with the financial responsibility standards, the ED mayexamine the financial statements of the individual institution, the institution’sparent company, or any party related to the institution.  Historically, the ED has evaluated thefinancial condition of our institutions on a consolidated basis based on ourfinancial statements at the parent company level.  If the ED determines that an institution doesnot satisfy the ED’s financial responsibility standards, the institution mayestablish its financial responsibility on one of several alternative bases,including posting a letter of credit in an amount equal to a specifiedpercentage of the total Title IV Program funds received by the institutionduring the institution’s most recently completed fiscal year and, in somecases, agreeing to receive Title IV Program funds under an arrangement otherthan the ED’s standard advance funding arrangement while being provisionallycertified.  Based on our currentunderstanding of how the ED applies its financial responsibility standards, wedo not believe that these standards will have a material adverse effect on ourfinancial condition, results of operations or expansion plans.

 

***Return of Funds for WithdrawnStudents*.** The HEA and its implementing regulationsimpose limits on the amount of Title IV Program funds withdrawing students canuse to pay their education costs (the “Return Policy”). The Return Policypermits a student to use only a pro rata portion of the Title IV Program fundsthat the student would otherwise be eligible to use, if the student withdrawsduring the first 60% of any period of enrollment. For our institutes, a periodof enrollment is generally an academic quarter. The institution must return tothe appropriate lenders or the ED any Title IV Program funds that theinstitution receives on behalf of a withdrawing student in excess of the amountthe student can use for such period of enrollment.  If the excess funds are not properlycalculated and timely returned, we may have to post a letter of credit in favorof the ED or be otherwise sanctioned by the ED. An institution is required to post a letter of credit with the ED in anamount equal to 25% of the total dollar amount of unearned Title IV Programfunds that the institution was required to return with respect to withdrawnstudents during its most recently completed fiscal year, if the institution wasfound in an audit or program review to have untimely returned unearned Title IVProgram funds with respect to 5% or more of the students in the audit orprogram review sample of withdrawn students, in either of its two most recentlycompleted fiscal years.  No audit orreview has found that any of our institutes was violating the ED’s standard onthe timely return of unearned Title IV Program funds.  The requirement to post a letter of credit orother sanctions by the ED could increase our cost of regulatory compliance andadversely affect our results of operations.

 

Thestandards of most of the SEAs and the ACICS limit a student’s obligation fortuition and fees to an institution, if a student withdraws from the institution(the “Refund Policy”).  The specificstandards vary among the SEAs.  Dependingon when a student withdraws during an academic quarter and the applicableRefund Policy, in many instances the student remains obligated to the ITTTechnical Institute for some or all of the student’s education costs that werepaid by the Title IV Program funds returned under the Return Policy.  In these instances, many withdrawing studentsare unable to pay all of their education costs, unless the students have accessto other sources of financial aid.  Wehave arranged for unaffiliated private funding sources to offer eligiblestudents loans that can help replace any Title IV Program funds that arereturned if any of those students withdraw. We believe that other unaffiliated private funding sources would also bewilling to make these types of loans available to our students, but we cannotassure you of this.  If these types ofloans were unavailable, we could be unable to collect a significant portion ofmany withdrawing students’ education costs that would have been paid by theTitle IV Program funds that were returned, which could have a material adverseeffect on our results of operations and cash flows.

 

***The “90/10” Rule.*****Under a provision of the HEA commonly referred to as the “90/10”Rule, a for-profit institution becomes ineligible to participate in Title IVPrograms if, on a cash accounting basis, the institution derives more than 90%of its applicable revenue for a fiscal year from Title IV Programs. If any ofour campus groups violated the 90/10 Rule for any fiscal year, it would beineligible to participate in Title IV Programs as of the first day of thefollowing fiscal year and would be unable to apply to regain its eligibilityuntil the next fiscal year. Furthermore, if one of our campus groups violatedthe 90/10 Rule and became ineligible to participate in Title IV Programs butcontinued to disburse Title IV Program funds, the ED would require theinstitution to repay, with limited exceptions, all Title IV Program fundsdisbursed by the institution after the effective date of the loss ofeligibility. For our 2004 fiscal year, none of our campus groups derived morethan approximately 75% of its revenue on a cash accounting basis from Title IVPrograms, with a range from approximately 58% to approximately 75%.  We regularly monitor compliance with thisrequirement to minimize the risk that any of our campus groups would derivemore than the maximum allowable percentage of its applicable revenue from TitleIV Programs for any fiscal year.  If acampus group appeared likely to approach the maximum percentage threshold, wewould consider making changes in student financing to comply with the 90/10Rule.

 

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***Restrictions onDistance Education Programs***.  The HEA and its implementing regulationsprovide for differing restrictions on the number of course offerings andstudents that can be enrolled via distance education (including courses offeredonline over the Internet), depending on the nature ofthe institution’s program offerings.  TheED’s regulations state that an institution is not eligible to participate inTitle IV Programs, if more than 50% of its courses are offered throughcorrespondence, which is defined to include courses taught throughtelecommunications, such as distance education courses in certaincircumstances.  The number of studentsenrolled in courses offered through distance education at our institutions willnot impact an institution’s eligibility to participate in Title IV Programs, solong as the institution offers more residence courses than distance educationcourses during a federal award year.  Forthe 2003/2004 federal award year, none of our institutions offered more than28% of their courses through distance education.

 

***Administrative Capability.*****The HEA directs the ED to assess the administrativecapability of each institution to participate in Title IV Programs. EDregulations require each institution to satisfy a series of separate standardsthat demonstrate administrative capability. Failure to satisfy any of thestandards may lead the ED to find the institution ineligible to participate inTitle IV Programs or to place the institution on provisional certification as acondition of its participation.  Aviolation of these requirements could also subject the institution to otherpenalties.

 

Onestandard that applies to programs with the stated objective of preparingstudents for employment requires the institution to show a reasonablerelationship between the length of the program and the entry-level jobrequirements of the relevant field of employment.  Other standards provide that an institutionlacks administrative capability if its FFEL/FDL cohort default rate equals orexceeds 25% for any of the three most recent federal fiscal years for whichsuch rates have been published, or if its Perkins cohort default rate exceeds15% for any federal award year.  If aninstitution’s administrative capability is impaired solely because its FFEL/FDL and/or Perkins cohort default rates exceed thepercentages specified above, the institution can continue to participate inTitle IV Programs, but the ED may place the institution on provisionalcertification.

 

Nineteenof our campus groups (consisting of 43 institutes) had a Perkins cohort defaultrate in excess of 15% for the most recent federal award year for which suchrates have been published. When all of the ITT Technical Institute campusgroups were recertified by the ED to participate in Title IV Programs during2003, the reason given by the ED for placing two of our campus groups(consisting of three institutes) on provisional certification was their Perkinscohort default rate. See “— Student Loan Defaults” and “— Eligibility andCertification Procedures.”  We no longerparticipate in the Perkins program.

 

***Compensation of Recruitment,Admission and Financial Aid Employees.***  The HEA prohibits an institution thatparticipates in Title IV Programs from providing any commission, bonus or otherincentive payment based directly or indirectly on success in securingenrollments or financial aid to any person or entity engaged in any studentrecruitment or admission activity or in making decisions regarding the awardingof Title IV Program funds.  Prior to November 2002,the ED’s regulations implementing this provision of the HEA repeated almostverbatim the language of the HEA, and the ED’s interpretations of thisprovision were inconsistent and generally not publicly disseminated.  In November 2002, after re-examiningCongress’ original intent and purposes in enacting this HEA provision, the EDrevised its regulations to clarify its interpretation of this provision and setforth 12 types of activities and payment arrangements that an institution maycarry out without violating this provision (the “Safe Harbors”).  One of the Safe Harbors permits the paymentof fixed compensation, such as a fixed annual salary or hourly wage, so long asthe fixed compensation is not adjusted up or down more than twice during any12-month period, and any adjustment to the fixed compensation is not basedsolely on the number of students recruited, admitted, enrolled or awardedfinancial aid.  Prior to the ED’srevision of its regulations in November 2002, we believe that wecompensated our employees involved in student recruitment, admissions,enrollment or financial aid in accordance with this Safe Harbor.  Subsequent to the ED’s revision of itsregulations in November 2002, we believe that we have compensated theapplicable employees in accordance with this Safe Harbor and other SafeHarbors, but the ED has stated that it will no longer review and approveindividual schools’ compensation plans.

 

***Additional Locations andPrograms.*****Our expansionplans assume we will be able to continue to obtain the necessary ED, ACICS andSEA approvals to establish new institutes, add learning sites to our existinginstitutes and expand the program offerings at our existing institutes. From2002 through 2004, we established nine new institutes and one learning site,all of which are participating in Title IV Programs, and added 469 programs atour existing institutes.  Each of theinstitutes and learning sites added from 2002 through 2004 constitutes anadditional location under the ED’s regulations.

 

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TheHEA requires a for-profit institution to operate for two years before it canqualify to participate in Title IV Programs. If an institution that iscertified to participate in Title IV Programs establishes an additionallocation and receives all of the necessary SEA and accrediting commissionapprovals for that location, that additional location can participate in TitleIV Programs immediately upon being reported to the ED, unless the institutionwill offer at least 50% of an entire educational program at that location andany one of the following restrictions applies, in which case the ED mustapprove the additional location before it can participate in Title IV Programs:

 

•                  theinstitution is provisionally certified to participate in Title IV Programs (See“— Eligibility and Certification Procedures”);

•                  theinstitution receives Title IV Program funds under the ED’s reimbursement orcash monitoring payment method;

•                  the institution acquired the assetsof another institution that provided educational programs at that locationduring the preceding year and participated in Title IV Programs during thatyear;

•                  the institution would be subject toloss of eligibility to participate in Title IV Programs, because the additionallocation lost its eligibility to participate in Title IV Programs as a resultof high FFEL/FDL cohort default rates; or

•                  the EDpreviously notified the institution that it must apply for approval toestablish an additional location.

 

TheHEA and applicable regulations permit students to use Title IV Program fundsonly to pay the cost associated with enrollment in an eligible program offeredby an institution participating in Title IV Programs. Generally, an institutionthat is eligible to participate in Title IV Programs may add a new educationalprogram without the ED’s approval, if that new program: (a) leads to anassociate level or higher degree and the institution already offers programs atthat level; or (b) prepares students for gainful employment in the same or arelated occupation as an educational program that has previously beendesignated as an eligible program at the institution and meets minimum lengthrequirements.  Otherwise, the institutionmust obtain the ED’s approval before it may disburse Title IV Program funds tostudents enrolled in the new program.  Ifan institution erroneously determines that a new educational program iseligible for Title IV Program funding, the institution would likely be liablefor repayment of the Title IV Program funds provided to students in thateducational program.  Based on ourcurrent understanding of how the ED regulations will be applied, we do notbelieve that these limitations will have a material adverse effect on our expansionplans.

 

TheACICS accreditation standards generally permit an institution’s main campus toestablish branch campuses, and both the institution’s main campus and branchcampuses to establish learning sites. Our institutes that are treated as branch campuses under the ACICSaccreditation standards are treated as additional locations of the main campusunder the ED’s regulations.  Anylocations of one of our main or branch campuses that are located away from themain or branch campus are treated as learning sites of that main or branchcampus under the ACICS accreditation standards, but the ED’s regulations treateach learning site as an additional location of the main campus.  The process of obtaining any required ACICSauthorizations can also delay our opening new institutes, adding learning sitesor offering new programs.  In certaincircumstances, the ACICS standards may limit our ability to establish branchcampuses and learning sites and expand the programs offered at an institute,which could have a material adverse effect on our expansion plans.

 

Thelaws and regulations in most of the states in which our institutes are locatedtreat each of our institutes as a separate, unaffiliated institution and do notdistinguish between main campuses and additional locations or branch campuses,although many states recognize other institute locations within the state whereeducational activities are conducted and/or student services are provided aslearning sites, teaching sites, satellite campuses, or otherwise.  In some states, the requirements to obtainstate authorization limit our ability to establish new institutes, add learningsites and offer new programs. The process of obtaining any required stateauthorizations can also delay our opening new institutes, adding learning sitesor offering new programs. In certain circumstances, the state laws andregulations in effect in the states where we are located or anticipateestablishing a new location may limit our ability to establish new institutesand learning sites and expand the programs offered at an institute, which couldhave a material adverse effect on our expansion plans.

 

***Eligibility and CertificationProcedures.*****The HEA andits implementing regulations require each institution to periodically reapplyto the ED for continued certification to participate in Title IV Programs. TheED recertifies each institution deemed to be in compliance with the HEA and theED’s regulations for a period of six years or less. Before that period ends,the institution must apply again for recertification.  The current ED certifications of ourinstitutes range from three years to six years and expire over the period from March 31,2006 to September 30, 2009.

 

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The EDmay place an institution on provisional certification for a period of threeyears or less, if it finds that the institution does not fully satisfy all theeligibility and certification standards. If an institution successfullyparticipates in Title IV Programs during its period of provisionalcertification but fails to satisfy the full certification criteria, the ED mayrenew the institution’s provisional certification. The ED may revoke aninstitution’s provisional certification without advance notice, if the EDdetermines that the institution is not fulfilling all materialrequirements.  If the ED revokes aninstitution’s provisional certification, the institution may not apply forreinstatement of its eligibility to participate in Title IV Programs for atleast 18 months.  If the ED does notrecertify the institution following the expiration of its provisionalcertification, the institution loses eligibility to participate in Title IVPrograms until the institution reapplies to participate and the ED certifies theinstitution to participate. The ED may also more closely review an institutionthat is provisionally certified, if it applies for approval to open a newlocation or offer a new program of study that requires approval, or makes someother significant change affecting its eligibility. Provisional certificationdoes not otherwise limit an institution’s access to Title IV Programfunds.  During 2003, two of our campusgroups (consisting of three institutes) were provisionally certified toparticipate in Title IV Programs, because their Perkins cohort default rateexceeded 30%.  We no longer participatein the Perkins program and our students have not received any loans under thePerkins program since 2001.

 

***Title IV Program FundsManagement.*****ED regulationsgovern how an institution participating in Title IV Programs requests,maintains, disburses and otherwise manages Title IV Program funds. Theseregulations require institutions to disburse all Title IV Program funds bypayment period. For our institutes, the payment period is an academic quarter.These regulations affect the timing of our receipt and disbursement of Title IVProgram funds and prescribe time frames within which our campus groups mustnotify Title IV Program fund recipients of certain information and return anyundisbursed Title IV Program funds.

 

***Predominant Use of One Lender andOne Guaranty Agency*.**** **Our students have traditionally receivedtheir FFEL program loans from a limited number of lending institutions.  For example, in our 2004 fiscal year, onelender provided approximately 97%of the FFEL program loans that our students received and one student loanguaranty agency guaranteed almost 100% of the FFEL program loans made to our students.  We do not believe that either our primarylender or our primary guaranty agency intends to withdraw from the student loanfield or reduce the volume of loans it makes or guarantees in the nearfuture.  If FFEL program loans by ourprimary lender or guarantees of those loans by our primary guaranty agency weresignificantly reduced or no longer available, we believe that we would be ableto identify other lenders and guaranty agencies to make and guarantee thoseloans for our students, because the student loan industry is highly competitiveand we are frequently approached by other lenders and guaranty agencies seekingour business.  If we were unable totimely identify other lenders and guaranty agencies to make and guarantee FFELprogram loans for our students, that could delay our students’ receipt of theirloans, increase our receivables, cause our student population to decrease andhave a material adverse effect on our financial condition, results ofoperations and cash flows.

 

***Change in Control.***  TheED, the ACICS and most of the SEAs have laws, regulations and/or standards(collectively “Regulations”) pertaining to the change in ownership and/orcontrol (collectively “change in control”) of institutions, but those Regulationsdo not uniformly define what constitutes a change in control. The ED’s Regulationsdescribe some transactions that constitute a change in control, including thetransfer of a controlling interest in the voting stock of an institution or theconsolidated corporation of which the institution is a part.  Under the ED’s Regulations, a change incontrol of a publicly traded corporation, such as us, occurs when: (a) there isan event that obligates the corporation to file a Current Report on Form 8-Kwith the SEC disclosing a change in control; or (b) the corporation has ashareholder that owns or controls at least 25% of the total outstanding votingstock of the corporation and is the largest shareholder of the corporation, andthat shareholder ceases to own or control at least 25% of such stock or ceasesto be the largest shareholder, but this measure does not include a shareholderwhose sole ownership of the corporation’s voting stock is held as a U.S.institutional investor, in mutual funds, through a profit-sharing plan or in anEmployee Stock Ownership Plan. Most of the SEAs include the sale of acontrolling interest of common stock in the definition of a change in control.The ACICS defines a change in control of a publicly traded corporation toinclude, among other things:

 

•                  a change in50% or more of the voting members of the corporation’s board of directors inany rolling, 12-month period;

•                  a change in the number of votingmembers of the corporation’s board of directors in any rolling, 12-month periodthat allows a group of directors to exercise control who could not exercise controlbefore the change;

•                  theacquisition of 50% or more of the total outstanding voting shares of thecorporation by any entity; or

•                  anytransaction that is deemed by an appropriate governmental agency to constitutea change in control.

 

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The change in controlRegulations adopted by the ED, the ACICS and the SEAs are subject to varyinginterpretations as to whether a particular transaction constitutes a change incontrol.

 

When achange in control occurs under the ED’s Regulations, an institution’seligibility to continue to participate in Title IV Programs is subject toreview and the institution could lose its eligibility, with the result that theinstitution would no longer be able to authorize or, with limited exceptions,disburse Title IV Program funds to its students.  If an institution timely submits a materiallycomplete application following a change in control, the ED may provisionallycertify the institution for a temporary period following a change in control,pending a review by the ED to determine whether to reinstate the institution’sparticipation in Title IV Programs.  TheED’s determination depends on whether the institution, under its new ownershipand control, complies with specified ED requirements for institutionaleligibility.  Following a change incontrol of an institution, the ED may also impose restrictions on the growth ofthat institution, including expansion through new additional locations or newprograms of study.

 

TheACICS will not reaccredit an institution following a change in control untilthe institution submits an application for reaccreditation, which requiresdocumentation that the institution has been reauthorized or continues to beauthorized by the appropriate SEA or SEAs. The ACICS standards provide that,generally within five business days after an institution documents that it hasbeen reauthorized or continues to be authorized by the appropriate SEA or SEAsfollowing a change in control, the ACICS will determine whether to temporarilyreinstate the institution’s accreditation for an undefined period to allow forthe completion and review of the application.

 

Manyof the SEAs require that a change in control of an institution be approvedbefore it occurs in order for the institution to maintain its SEAauthorization. Other SEAs will only review a change in control of aninstitution after it occurs.

 

Achange in control could occur as a result of future transactions in which we orour institutes are involved, such as some corporate reorganizationsand some changes in our board of directors. If a future transaction results in a change in control of us or ourinstitutes, we believe that we would be able to obtain all necessary approvalsfrom the ED, the SEAs and the ACICS. We cannot assure you, however, that allsuch approvals could be obtained, or could be obtained in a timely manner thatwould not delay the availability of Title IV Program funds, prevent somestudents from receiving Title IV Program funds or include limitations thatcould restrict our growth and expansion plans. A material adverse effect on our financial condition, results ofoperations and cash flows would result if we had a change in control and amaterial number of our institutes:

 

•                  failed to timely obtain the approvalsof the SEAs required prior to or following a change in control;

•                  failed to timely regain accreditationby the ACICS or have their accreditation temporarily continued or reinstated bythe ACICS;

•                  failed to timely regain eligibility toparticipate in Title IV Programs from the ED or receive temporary certificationto continue to participate in Title IV Programs pending further review by theED; or

•                  were subjected by the ED torestrictions that severely limited for a substantial period of time the numberof new additional locations and/or new programs of study that are eligible toparticipate in Title IV Programs.

 

**Shareholder Information**

** **

Wemake the following materials available free of charge through our website atwww.ittesi.com as soon as reasonably practicable after such materials areelectronically filed with or furnished to the SEC under the Securities ExchangeAct of 1934, as amended (the “Exchange Act”):

 

•                  our annualreports on Form 10-K and all amendments thereto;

•                  our quarterlyreports on Form 10-Q and all amendments thereto;

•                  our currentreports on Form 8-K and all amendments thereto; and

•                  variousother filings that we make with the SEC.

 

Wealso make the following materials available free of charge through our websiteat www.ittesi.com:

 

•                  ourCorporate Governance Guidelines;

•                  the charterfor each of the Audit, Compensation, and Nominating and Corporate GovernanceCommittees of our Board of Directors; and

•                  our Code ofBusiness Conduct and Ethics (“Code”).

 

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Wewill provide a copy of the following materials without charge to anyone whomakes a written request to our Investor Relations Department at ITT EducationalServices, Inc., 13000 North Meridian Street, Carmel, Indiana 46032-1404 or bye-mail through our website at www.ittesi.com:

 

•                  our annualreport on Form 10-K for the year ended December 31, 2004, excludingcertain of its exhibits;

•                  ourCorporate Governance Guidelines;

•                  the charterfor each of the Audit, Compensation and Nominating and Corporate GovernanceCommittees of our Board of Directors; and

•                  the Code.

 

Wealso intend to promptly disclose on our website any amendments that we make to,or waivers for our Directors or executive officers that we grant from, theCode.

 

**Risk Factors**

** **

*Inaddition to the other information contained in this report, you should considercarefully the following risk factors in evaluating us and our business beforemaking an investment decision with respect to any shares of our commonstock.  This report contains certainstatements that constitute “forward-looking statements” within the meaning of Section 27Aof the Securities Act (and Section 21E of the Exchange Act).  Those forward-looking statements are based onthe beliefs of, as well as assumptions made by and information currentlyavailable to, our management.  Allstatements which are not statements of historical fact are intended to beforward-looking statements.  Theforward-looking statements contained in this report reflect our or ourmanagement’s current views and are subject to certain risks, uncertainties andassumptions, including, but not limited to, those set forth in the followingRisk Factors.  Should one or more ofthose risks or uncertainties materialize or should underlying assumptions proveincorrect, our actual results, performance or achievements in 2005 and beyondcould differ materially from those expressed in, or implied by, thoseforward-looking statements.*

 

***Risks Related toOur Highly-Regulated Industry.***

 

*Failure of our institutes to complywith the extensive regulatory requirements for school operations could resultin financial penalties, restrictions on our operations, loss of federal andstate financial aid funding for our students or loss of our authorization tooperate our institutes.* In 2004, we indirectly derived approximately 69% of our revenuedetermined on an accrual accounting basis (or 66% determined on a cashaccounting basis as defined by the ED regulations) from Title IV Programs.  To participate in Title IV Programs, aninstitution must receive and maintain authorization by the appropriate SEAs, beaccredited by an accrediting commission recognized by the ED and be certifiedas an eligible institution by the ED.  Asa result, our institutes are subject to extensive regulation by the ED, theSEAs and the ACICS, which is an accrediting commission recognized by theED.  These regulatory requirements coverthe vast majority of our operations, including our educational programs,facilities, instructional and administrative staff, financial operations andfinancial condition, student recruitment, opening of new institutes andlearning sites, changes in corporate structure and ownership, and manyadministrative procedures.  Most EDrequirements are applied on an institutional basis, with an institution definedby the ED as a main campus and its additional locations.  Under the ED’s definition, we have 29 suchinstitutions.  We currently operate oneor more institutes in 30 states and our institutes recruit students in theremaining 20 states.  The ED, the SEAsand the ACICS periodically revise their requirements and modify theirinterpretations of existing requirements. We cannot predict with certainty how all of the requirements applied bythese agencies will be interpreted or whether all of our institutes will beable to comply with all of the requirements in the future.

 

If our institutes were to fail to comply with any ofthese regulatory requirements, these agencies could:

 

•                  impose monetary fines or penalties;

•                  require the repayment of fundsreceived under Title IV Programs or state financial aid programs;

•                  placerestrictions on our institutes’ receipt of Title IV Program funds;

•                  limit or terminate our institutes’operations or ability to grant degrees and diplomas;

•                  restrict or revoke our institutes’accreditation;

•                  limit or terminate our institutes’eligibility to participate in Title IV Programs or state financial aidprograms; or

•                  subject us or our institutes to othercivil or criminal penalties.

 

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Each of these sanctions could adversely affect ourfinancial condition, results of operations and cash flows and imposesignificant operating restrictions on us. If any of our institutes lost its state authorization, the institutewould be unable to offer postsecondary education and we would be forced toclose the institute.  If any of ourinstitutes lost its accreditation, it would lose its eligibility to participatein Title IV Programs.  If any of ourinstitutes lost its eligibility to participate in Title IV Programs, and wecould not arrange for alternative financing sources for the students attendingthat institute, we could be forced to close the institute.  Closing any of our institutes could have amaterial adverse effect on our financial condition, results of operations andcash flows.  See “— Highly-RegulatedIndustry.”

 

The following are some ofthe specific risk factors related to our highly-regulated industry:

 

*Action by the U.S. Congress torevise the laws governing the federal student financial aid programs or reducefunding for those programs could reduce our student population and increase ourcosts of operation.* The U.S. Congress must periodicallyreauthorize the HEA and other laws governing Title IV Programs, and annuallydetermine the funding level for each Title IV Program.  Congress began the process of reviewing andreauthorizing the HEA in 2003 and may conclude the process in 2005, which willlikely result in numerous changes to the law. Any action by the U.S. Congress that significantly reduces Title IVProgram funding or the ability of our institutes or students to participate inTitle IV Programs could have a material adverse effect on our financialcondition or results of operations. Congressional action may also require us tomodify our practices in ways that could result in our administrative costsincreasing and our profit margin decreasing, which could have a materialadverse effect on our financial condition, results of operations and cashflows.

 

If one of our institutes lost its eligibility toparticipate in Title IV Programs, or if Congress significantly reduced theamount of available Title IV Program funding, we would try to arrange foralternative sources of financial aid for that institute’s students.  We cannot assure you that one or more privateorganizations would be willing to provide loans to students attending one ofour institutes, or that the interest rate and other terms of such loans wouldbe as favorable as for Title IV Program loans. In addition, the privateorganizations could require us to guarantee all or part of this assistance andwe might incur other additional costs. If we provided more direct financialassistance to our students, we would incur additional costs and assumeincreased credit risks.  See “— Highly-RegulatedIndustry — Legislative Action.”

 

*One or more of our institutes may lose their eligibility toparticipate in Title IV Programs, if their student loan default rates are toohigh.* An institution may lose its eligibility to participatein some or all Title IV Programs, if the rates at which its students default ontheir federal student loans exceed specified percentages.  An institution whose FFEL/FDL cohort defaultrate is: (a) 25% or greater for three consecutive federal fiscal years loseseligibility to participate in the FFEL, FDL and Pell programs for the remainderof the federal fiscal year in which the ED determines that the institution haslost its eligibility and for the two subsequent federal fiscal years; or (b)greater than 40% for one federal fiscal year loses eligibility to participatein the FFEL and FDL programs for the remainder of the federal fiscal year inwhich the ED determines that the institution has lost its eligibility and forthe two subsequent federal fiscal years. If any of our campus groups lost its eligibility to participate in FFEL,FDL and Pell programs and we could not arrange for alternative financingsources for the students attending the institutes in that campus group, wewould probably have to close those institutes, which could have a materialadverse effect on our financial condition and results of operations.  See “— Highly-Regulated Industry — StudentLoan Defaults.”

 

*We may be required to post a letter of credit or acceptother limitations in order to continue our institutes’ participation in TitleIV Programs, if we or our institutes do not meet the ED’s financialresponsibility standards.* To participate in Title IVPrograms, an institution must satisfy specific measures of financialresponsibility prescribed by the ED.  Themost significant measurement is the institution’s composite score that canrange from a negative 1.0 reflecting financial weakness to a positive 3.0reflecting financial strength.  Thecomposite score must be at least 1.5 for the institution to be deemedfinancially responsible by the ED without the need for further oversight.  Historically, the ED has evaluated thefinancial condition of our institutions on a consolidated basis based on ourfinancial statements at the parent company level.  If the ED determines that an institution doesnot satisfy the ED’s financial responsibility standards, the institution mayestablish its financial responsibility on one of several alternative bases,including posting a letter of credit in an amount equal to a specifiedpercentage of the total Title IV Program funds received by the institutionduring the institution’s most recently completed fiscal year and, in somecases, agreeing to receive Title IV Program funds under an arrangement otherthan the ED’s standard advance funding arrangement while being provisionallycertified.  See “— Highly-RegulatedIndustry — Financial Responsibility Standards.”

 

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*One or more of our institutes may have to post a letter ofcredit or be subject to other sanctions, if they do not correctly calculate andtimely return Title IV Program funds for students who withdraw beforecompleting their program of study.* A school participating inTitle IV Programs must correctly calculate the amount of unearned Title IVProgram funds that was disbursed to students who withdrew from theireducational programs before completing them, and must return those unearnedfunds in a timely manner, generally within 30 days of the date the schooldetermines that the student has withdrawn. If the unearned funds are not properly calculated and timely returned,we may have to post a letter of credit in favor of the ED or be otherwisesanctioned by the ED.  An institution isrequired to post a letter of credit with the ED in an amount equal to 25% ofthe total dollar amount of unearned Title IV Program funds that the institutionwas required to return with respect to withdrawn students during its mostrecently completed fiscal year, if the institution was found in an audit orprogram review to have untimely returned unearned Title IV Program funds withrespect to 5% or more of the students in the audit or program review sample ofwithdrawn students, in either of its two most recently completed fiscalyears.  The requirement to post a letterof credit or other sanctions by the ED could increase our cost of regulatorycompliance and adversely affect our results of operations.  See “— Highly-Regulated Industry — Return ofFunds for Withdrawn Students.”

 

*One or more of our institutes may lose their eligibility toparticipate in Title IV Programs, if the percentage of their revenue derivedfrom those programs is too high.*A for-profit institutionloses its eligibility to participate in Title IV Programs if, on a cashaccounting basis, it derives more than 90% of its applicable revenue for afiscal year from Title IV Programs. If one of our campus groups exceeded thisthreshold but continued to disburse Title IV Program funds, the ED wouldrequire the institution to repay, with limited exceptions, all Title IV Programfunds disbursed by the institution after the effective date of the loss ofeligibility.  If any of our campus groupslost its eligibility to participate in Title IV Programs and we could notarrange for alternative financing sources for the students attending theinstitutes in that campus group, we would probably have to close thoseinstitutes, which could have a material adverse effect on our financialcondition, results of operations and cash flows.  See “— Highly-Regulated Industry — The ‘90/10’ Rule.”

 

*One or more of our institutes may lose their eligibility toparticipate in Title IV Programs, if the institute teaches too many of its coursesthrough distance education.* An institution loses its eligibility to participate in Title IV Programsif more than 50% of its courses are offered through correspondence, which isdefined to include courses taught through telecommunications, such as distanceeducation courses offered online over the Internet.  If any of our campus groups lost itseligibility to participate in Title IV Programs and we could not arrange foralternative financing sources for the students attending the institutes in thatcampus group, we would probably have to close those institutes, which couldhave a material adverse effect on our financial condition, results ofoperations and cash flows.  See “— Highly-RegulatedIndustry — Restrictions on Distance Education Programs.”

 

*We are subject to sanctions if we pay impermissiblecommissions, bonuses or other incentive payments to individuals involved incertain recruiting, admissions or financial aid activities.*  An institution participating in Title IVPrograms may not provide any commission, bonus or other incentive payment baseddirectly or indirectly on success in securing enrollments or financial aid toany person or entity engaged in any student recruitment or admission activityor in making decisions regarding the awarding of Title IV Program funds.  The law and regulations governing thisrequirement do not establish clear criteria for compliance in allcircumstances.  If the ED determined thatan institution’s compensation practices violated these standards, the ED couldsubject the institution to monetary fines or penalties or other sanctions.  Any substantial fine or penalty or othersanction could have a material adverse effect on our financial condition,results of operations and cash flows. See “— Highly-Regulated Industry — Compensation of Recruitment,Admission and Financial Aid Employees.”

 

*We cannot open new institutes or learning sites or offer newprograms if they are not timely approved by our regulators, and we may have torepay Title IV Program funds disbursed to students enrolled at any of thoselocations or in any of those programs if we do not obtain prior approval*.An institution must obtain approvals from the ED, the ACICS and the relevantSEAs to establish new institutes and, in some cases, to add new learning sitesfor existing institutes and to expand program offerings.  The requirements of the ACICS and some SEAslimit our ability to establish new institutes, add learning sites and offer newprograms.  If we established a newinstitute, added a new learning site or expanded program offerings at anyinstitute without obtaining the required approvals, we could be required torepay any Title IV Program funds received by students at that institute or siteor in that program, and could be subject to other sanctions.  Our expansion plans assume that we will beable to continue to obtain the necessary approvals in a timely manner.  If we are unable to obtain the approvals fromthe ED, the ACICS or the relevant SEAs for any new institutes, learning sitesor program offerings where such approvals are required, or to obtain suchapprovals in a timely manner, our ability to open the new institutes, add thenew learning sites or offer the new

 

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programsas planned would be impaired, which could have a material adverse effect on ourfinancial condition, results of operations and cash flows. See “— Highly-RegulatedIndustry — Additional Locations and Programs.”

 

*A high percentage of the Title IV Program loans that ourstudents receive are made by one lender and guaranteed by one guaranty agency.*  Inour 2004 fiscal year, one lender provided approximately 97% of the FFEL program loans that ourstudents received and one student loan guaranty agency guaranteed almost 100% of the FFEL program loans made to ourstudents.  If FFEL program loans by ourprimary lender or guarantees of those loans by our primary guaranty agency weresignificantly reduced or no longer available and we were unable to timelyidentify other lenders and guaranty agencies to make and guarantee FFEL programloans for our students, that could delay our students’ receipt of their loans,increase our receivables, cause our student population to decrease and have amaterial adverse effect on our financial condition, results of operations andcash flows.  See “— Highly-RegulatedIndustry — Predominant Use of One Lender and One Guaranty Agency.”

 

*The ability of the affected institutes to participate inTitle IV Programs or operate may be impaired, if regulators do not timelyapprove a change in control of us or any of our institutes.*  The ED, the ACICS and most of the SEAs haverequirements pertaining to the change in control of institutions, but thoserequirements do not uniformly define what constitutes a change in control andare subject to varying interpretations as to whether a particular transactionconstitutes a change in control. If we or any of our institutes experience achange in control under the standards of the ED, the ACICS or any of the SEAs,we or the affected institutes must seek the approval of the relevant regulatoryagencies.  Transactions or events thatconstitute a change in control for one or more of our regulatory agenciesinclude the acquisition of a school from another entity, significant acquisitionsor dispositions of our common stock and significant changes to the compositionof our Board of Directors.  Some of thesetransactions or events may be beyond our control.  Our failure to obtain, or a delay inobtaining, a required approval of any change in control from the ED, the ACICSor any of the SEAs in states in which our institutes are located could impairour ability or the ability of the affected institutes to participate in TitleIV Programs.  Our failure to obtain, or adelay in obtaining, a required approval of any change in control from the SEAin any state in which we do not have an institute but in which we recruitstudents could require us to suspend our recruitment of students in that stateuntil we receive the required approval. If we had a change in control and a material number of our institutesfailed to obtain the required approvals of the SEAs, the ACICS or the ED in atimely manner, that could have a material adverseeffect on our financial condition, results of operations and cash flows.  See “— Highly-Regulated Industry — Change inControl.”

 

*Government and regulatory agencies and third parties maybring claims or actions against us based on alleged violations of the extensiveregulatory requirements, which could require us to pay monetary damages,receive other sanctions and expend significant resources to defend those claimsor actions.*  Due to thehighly regulated nature of the postsecondary education industry, we are subjectto audits, compliance reviews, inquiries, complaints, investigations, claims ofnon-compliance and lawsuits by federal and state governmental agencies,regulatory agencies, present and former students and employees, shareholdersand other third parties, which may allege violations of any of the regulatoryrequirements applicable to us and our institutes.  If the results of any such claims or actionsare unfavorable to us, we may be required to pay money damages or be subject tofines, operational limitations, loss of federal or state funding, injunctions,additional oversight and reporting or other civil and criminal penalties.  Those penalties could have a material adverseeffect on our financial condition, results of operations and cash flows.  Even if we satisfactorily resolve the issuesraised by any such claims or actions, we may have to expend significantfinancial and management resources from our ongoing business operations toaddress and defend those claims or actions, which could have a material adverseeffect on our financial condition, results of operations and cash flows.  In particular, the DOJ investigation and thesecurities class action, shareholder derivative and books and recordsinspection lawsuits currently pending against us and certain of our current andformer officers and directors have demanded significant management time andfinancial resources to defend and resolve, and have had a material adverseeffect on our financial condition and results of operations.  Adverse publicity regarding such claims andactions could also negatively affect our business.  See “— Highly-Regulated Industry.”

 

*Investigations, claims and actions against companies in ourindustry could adversely affect our business and stock price.*  Our operations and the operations of a numberof other companies in the postsecondary education industry have been subject tointense regulatory scrutiny, especially over the last year.  In some cases, allegations of wrongdoing haveresulted in reviews or investigations by the DOJ, the SEC, theED, the SEAs or other state agencies. These allegations, reviews and investigations of us and other companiesand the accompanying adverse publicity could have a negative impact on ourindustry as a whole and on our stock price.

 

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*Budget constraints in states that provide state financialaid to our students could reduce the amount of such financial aid that isavailable to our students, which could reduce our student population*.  A significant number of states are facingbudget constraints that are causing them to reduce state appropriations in anumber of areas.  Some of those statesprovide financial aid to our students, such as California, Florida, Ohio,Pennsylvania and New York.  Some of thosestates may decide to reduce the amount of state financial aid that they provideto students, but we cannot predict how significant any of those reductions maybe or how long they could last.  If thelevel of state funding for our students decreased and our students were notable to secure alternative sources of funding, our student population could bereduced, which could have a material adverse effect on our results ofoperations.

 

***RisksRelated to Our Business.***

** **

*If we fail to effectively identify, establish and operatenew institutes and learning sites, our growth may be slowed and ourprofitability may be impaired.*  As part of our business strategy, weanticipate opening and operating new institutes and new learning sites toexisting institutes at locations throughout the United States.  Establishing new institutes and learningsites poses challenges and requires us to make investments in management andcapital expenditures, incur marketing and advertising expenses and devote otherresources that are different, and in some cases greater, than those requiredwith respect to the operation of existing institutes.  To open a new institute or learning site, wewould be required to obtain the appropriate approvals from the SEAs and ACICS,which may be conditioned or delayed in a manner that could significantly affectour growth plans.  In addition, to beeligible to participate in Title IV Programs, a new institute or learning sitemay have to be certified by the ED.  Wecannot be sure that we will be able to identify suitable expansionopportunities to help maintain or accelerate our current growth rate or that wewill be able to successfully integrate or profitably operate any new institutesor learning sites.  Any failure by us toeffectively identify, establish and manage the operations of newly establishedinstitutes or learning sites could slow our growth and make any newlyestablished institutes or learning sites more costly to operate than we hadplanned and have a material adverse effect on our results of operations.  See “— Business Strategy — GeographicallyExpand Our Institutes and Program Offerings.”

 

*Our success depends, in part, on our ability to effectivelyidentify, develop, obtain approval to offer and teach new and/or higher-leveldegree programs in a cost-effective and timely manner.*  Part of our business strategy also includesincreasing the number and level of degree programs offered at ourinstitutes.  Developing and offering newdegree programs pose challenges and require us to make investments in researchand development, management and capital expenditures, to incur marketing andadvertising expenses and to devote other resources that are in addition to, andin some cases greater than, those associated with our current programofferings.  In order to offer new andhigher-level degree programs at our institutes, we would be required to obtainthe appropriate approvals from the ED, the SEAs, theACICS and, in certain circumstances, specialized programmatic accreditingagencies, which may be conditioned or delayed in a manner that could significantlyaffect our growth plans.  We cannot besure that we will be able to identify new programs to help maintain oraccelerate our current growth rate, that we will be able to obtain therequisite approvals to offer new and/or higher-level degree programs at ourinstitutes or that students will enroll in any new and/or higher-level degreeprograms that we develop, obtain approval for and offer at our institutes.  Any failure by us to effectively identify,develop, obtain approval to offer and teach new and/or higher-level degreeprograms at our institutes could slow our growth and have a material adverseeffect on our results of operations.  See“— Business Strategy — Enhance Results at the Institute Level.”

 

*Our success depends, in part, on our ability to keep pacewith changing market needs and technology*.  Increasingly, prospective employers of ourgraduates demand that their entry-level employees possess appropriate technicalskills and also appropriate soft skills, such as communication, criticalthinking and teamwork skills.  Theseskills can evolve rapidly in a changing economic and technologicalenvironment.  Accordingly, it isimportant for our programs to evolve in response to those economic andtechnological changes.  The expansion ofour existing programs and the development of new programs may not be acceptedby prospective students or the employers of our graduates.  Even if we are able to develop acceptable newprograms, we may not be able to begin offering these new programs as quickly asrequired by the employers we serve or as quickly as our competitors offersimilar programs.  If we are unable toadequately respond to changes in market requirements due to regulatory orfinancial constraints, unusually rapid technological changes or other factors,our ability to attract and retain students could be impaired and the rates atwhich our graduates obtain jobs involving their fields of study could suffer.

 

*Ourfinancial performance depends, in part, on our ability to continue to developawareness and acceptance of our programs among high school graduates andworking adults. *Theawareness of our programs among high school graduates and working adults isimportant to the success of our institutes. If we were unable to successfully market or

 

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advertiseour programs, our ability to attract and enroll prospective students in ourprograms would be adversely affected and, consequently, our ability to increaserevenue or maintain profitability would be impaired.  The following are some of the factors thatcould prevent us from successfully marketing or advertising our programs:

 

•                  studentdissatisfaction with our programs and services;

•                  employerdissatisfaction with our programs and services;

•                  diminished access to high schoolstudents; and

•                  our failureto maintain or expand our brand or other factors related to our marketing oradvertising practices.

 

*A significant percentage ofprivate student loans received by our students are made by one lender andserviced by one loan servicer.*  In 2004, we indirectlyderived approximately 25% of our revenue from unaffiliated, private loanprograms that were made available to eligible students at our institutes tohelp fund a portion of the students’ cost of education. These private loanprograms are offered by one lender and serviced by one loan servicer. If the lender or loan servicer ended theprograms or reduced the volume of loans made or serviced under the programs inthe near future and we were unable to timely identify other lenders and loanservicers to make and service private loans for our students and their parentson similar terms, our students’ ability to finance their education could beadversely affected, our receivables could increase and our student populationcould decrease, which could have a material adverse effect on our financialcondition, results of operations and cash flows.

 

*Our loss of key personnel could harm our business.*  Our success to date has depended, and willcontinue to depend, largely on the skills, efforts and motivation of ourexecutive officers.  Our success alsodepends in large part upon our ability to attract and retain highly qualifiedfaculty, school administrators and corporate management.  We face competition in the attraction andretention of personnel who possess the skill sets that we seek.  In addition, key personnel may leave us andsubsequently compete against us. Furthermore, we do not currently carry “key man” life insurance.  The loss of the services of any of our keypersonnel, or our failure to attract and retain other qualified and experiencedpersonnel on acceptable terms, could impair ourability to successfully manage our business.

 

In order to supportrevenue growth, we need to hire, retain, develop and train our salesrepresentatives, who are our employees dedicated to student recruitment.  Our ability to develop a strong team of salesrepresentatives may be affected by a number of factors, including:

 

•                  our abilityto timely and effectively train and motivate our sales representatives in orderfor them to become productive;

•                  restrictionson the method of compensating sales representatives imposed by regulatorybodies;

•                  thecompetition we face from other companies in hiring and retaining salesrepresentatives;

•                  our abilityto attract enough prospective students to our program offerings; and

•                  our abilityto effectively manage a multi-location educational organization.

 

If we are unable to hire,retain, develop and train our sales representatives, the effectiveness of ourstudent recruiting efforts would be adversely affected.

 

*Competition could decrease our market share, cause us toreduce tuition or force us to increase spending.*  The postsecondary education market in theUnited States is highly fragmented and competitive with no private or publicinstitution enjoying a significant market share. Our institutes compete forstudents with graduate, bachelor and associate degree-granting institutions,which include nonprofit public and private colleges and for-profitinstitutions, as well as with alternatives to higher education such as militaryservice or immediate employment. We believe competition among educationalinstitutions is based on:

 

•                  the qualityand reliability of the institution’s programs and student services;

•                  theperceived reputation of the institution and its programs and student services;

•                  the cost ofthe institution’s programs;

•                  theemployability of the institution’s graduates;

•                  the abilityto provide easy and convenient access to the institution’s programs andcourses;

•                  the qualityand experience of the institution’s faculty; and

•                  the timerequired to complete the institution’s programs.

 

Certain public andprivate colleges offer programs similar to those offered by our institutes at alower tuition cost due in part to government subsidies, foundation grants, taxdeductible contributions or other financial resources not

 

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availableto for-profit institutions. Other for-profit institutions offer programs thatcompete with those of our institutes. Certain of our competitors in both thepublic and private sectors have greater financial and other resources than wedo.  All of these factors could affectthe success of our marketing efforts and enable our competitors to recruitprospective students more effectively.

 

We maybe required to reduce tuition or increase spending in response to competitionin order to retain or attract students or pursue new market opportunities.  As a result, our financial condition, resultsof operations and cash flows may be negatively affected.  We cannot be sure that we will be able tocompete successfully against current or future competitors or that competitivepressures faced by us will not adversely affect our business, financialcondition, results of operations or cash flows.

 

*High interest rates could adversely affect our ability toattract and retain students.* Interest rates have reached historical lows in recent years, creating afavorable borrowing environment for our students.  Much of the financing our students receive istied to floating interest rates. Therefore, any future increase in interest rates will result in a correspondingincrease in the cost to our existing and prospective students of financingtheir education, which could result in a reduction in the number of studentsattending our institutes and in our revenue. Higher interest rates could also contribute to higher default rates withrespect to our students’ repayment of Title IV Program and private loans.  High default rates may, in turn, adverselyimpact our eligibility to participate in Title IV Programs and/or thewillingness of private lenders to make private loan programs available to ourstudents, which could result in a reduction in the number of students attendingour institutes.

 

*Our quarterly results of operations are likely to fluctuatebased on our seasonal student enrollment patterns.*  In reviewing our results of operations, youshould not focus on quarter-to-quarter comparisons.  Our results in any quarter may not indicatethe results we may achieve in any subsequent quarter or for the full year.  Our quarterly results of operations havetended to fluctuate as a result of seasonal variations in our business,principally due to changes in our total student population.  Our student population varies as a result ofnew student enrollments, graduations and student attrition.  Historically, our revenue in our third andfourth fiscal quarters has generally benefited from increased studentmatriculations.  The number of newstudents entering our institutes tends to be substantially higher in June andSeptember, because of the significant number of recent high school graduatesentering our institutes for the academic quarters beginning in those twomonths. Our institutes’ academic schedule generally does not affect ourincurrence of most of our costs, however, and our costs do not fluctuatesignificantly on a quarterly basis.  Weexpect quarterly fluctuations in results of operations to continue as a resultof seasonal enrollment patterns.  Thesepatterns may change, however, as a result of new institute openings, newprogram offerings and increased enrollment of adult students.  See “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Variations in Quarterly Resultsof Operations.”

 

*Terrorist attacks and other acts of violence or war couldhave an adverse effect on our operations.*  Terrorist attacks and other acts of violenceor war could disrupt our operations. Attacks or armed conflicts that directly impact our physical facilitiesor ability to recruit and retain students could adversely affect our ability todeliver our programs of study to our students and, thereby, impair our abilityto achieve our financial and operational goals. Furthermore, violent acts and threats of future attacks could adverselyaffect the U.S. and world economies. Finally, future terrorist acts could cause the United States to enterinto a wider armed conflict that could further impact our operations and resultin prospective students, as well as our current students and employees,entering military service.  These factorscould cause significant declines in the number of students who attend ourinstitutes and have a material adverse effect on our results of operations.

 

*Anti-takeover provisions in our charter documents and underDelaware law could make an acquisition of us more difficult.*  Certain provisions of Delaware law, ourRestated Certificate of Incorporation and our By-Laws could have the effect ofmaking it more difficult for a third party to acquire, or discouraging a thirdparty from attempting to acquire, control of us.  These provisions could limit the price thatcertain investors might be willing to pay in the future for shares of ourcommon stock.  These provisions ofDelaware law, our Restated Certificate of Incorporation and our By-Laws mayalso have the effect of discouraging or preventing certain types oftransactions involving an actual or threatened change in control of us(including unsolicited takeover attempts), even though such a transaction mayoffer our stockholders the opportunity to sell their stock at a price above theprevailing market price.  Certain of theseprovisions authorize us to issue “blank check” preferred stock, divide ourBoard of Directors into three classes expiring in rotation, require advancenotice for stockholder proposals and nominations, prohibit stockholders fromcalling a special meeting and prohibit stockholder action by writtenconsent.  These provisions may make itmore difficult for

 

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stockholdersto take certain corporate actions and could have the effect of delaying orpreventing a change in control of us.

 

*If we are unable to concludesuccessfully the litigation, governmental investigations and inquiries pendingagainst us, our business, financial condition and results of operations couldcontinue to be adversely affected.*  We are subject to an investigation by theDOJ.  Although no formal charges havebeen filed, we believe that the DOJ is investigating claims alleging, amongother matters, falsification of records relating to student attendance, gradesand academic progress and graduate job placement statistics, and fraudulentmisrepresentations regarding the transferability of credits, graduation ratesand graduates’ salaries.  The costs thatwe have incurred in connection with the DOJ investigation have had a materialadverse effect on our financial condition and results of operations, and wecannot assure you that the ultimate outcome of the DOJ investigation will nothave a further material adverse effect on our financial condition and resultsof operations.

 

TheSEC has also initiated an inquiry into the allegations being investigated bythe DOJ as described in the preceding paragraph.  We cannot assure you that the ultimateoutcome of the SEC inquiry will not have a material adverse effect on ourfinancial condition or results of operations.

 

In addition, the Officeof the Attorney General for the State of California (“CAG”) is investigatingour ITT Technical Institutes in California. We believe that the CAG’s investigation is in response to one or morequi tam actions filed against us under the state and/or federal False ClaimsActs.  The CAG has not asserted anyclaims against us, and we have not been informed of the specific matters thatthe CAG is investigating.  Based on theinformation that the CAG has requested, however, we believe that the CAG isinvestigating, among other matters, whether one or more of our California ITTTechnical Institutes:

 

•                  falsified records relating to studentattendance, grades and academic progress;

•                  falsifiedstudent grade point average calculations used to qualify students for financialaid under the State’s Cal Grant Program; and

•                  retaliated against employees who mayhave complained about those alleged acts.

 

While we cannot assureyou of the ultimate outcome of the CAG investigation, based on the results ofour investigation to date, we do not believe that the CAG investigation and anyqui tam actions that may be associated with the investigation will have amaterial adverse effect on our financial condition, results of operations orcash flows.

 

We andsome of our current and former officers and directors have also been named asdefendants in numerous private securities class action, shareholder derivative,books and records inspection and retirement savings plan class action lawsuitsalleging that we and some of our current and former officers and directors,among other things, made certain material misrepresentations, failed todisclose certain material facts about our condition and prospects, breachedfiduciary duties, violated laws and falsified our records. We cannot predict whatthe outcome of these lawsuits will be. Although the derivative actions are brought nominally on behalf of us,we expect to incur defense costs and other expenses in connection with thederivative lawsuits, and we cannot assure you that the ultimate outcome ofthese or other actions will not have a material adverse effect on our financialcondition or results of operations.  Thecurrent and former executive officers named in one or more of the securitiesclass action, shareholder derivative and retirement savings plan class actionlawsuits described above include: Gene A. Baugh, Rene R. Champagne, Clark D.Elwood, Nina F. Esbin, Eugene W. Feichtner, Martin A. Grossman, Thomas W.Lauer, Kevin M. Modany and Omer E. Waddles.

 

Additionally,in the ordinary conduct of our business, we and our institutes are subject tovarious other lawsuits, investigations and claims, covering a wide range ofmatters, including, but not limited to, claims involving students or graduatesand routine employment matters. It is possible that we may be required to paysubstantial damages or settlement costs in excess of our insurance coverage,which could have a material adverse effect on our financial condition orresults of operation. We have incurred substantial legal costs, and management’sattention and resources have been diverted from our business. See “LegalProceedings.”

 

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**Item 2.**           **PROPERTIES.**

 

As of December 31,2004, we leased some or all of the facilities of 64 of our institutes and theirlearning sites, and we owned some or all of the facilities of 17 of ourinstitutes.  The average remaining leaseterm of our leased facilities is approximately five years.  The leased facilities for our institutesinvolve 72 buildings:

 

•                  two of theseleases are for institutes in their first year of operation as of December 31,2004;

•                  three ofthese leases are for facilities where we plan to open three new institutes in2005;

•                  one of theseleases is for a facility of an institute that we closed at the end of 2004;

•                  one of theseleases is for a learning site in operation;

•                  one of theseleases is for a facility where we plan to open a learning site in 2005; and

•                  eight ofthese leases are for four institutes that each utilize two separate facilities.

 

None of the facilitiesowned by us is subject to a mortgage or other indebtedness.

 

Wegenerally locate our institutes in suburban areas near major populationcenters. We generally house our campus facilities in modern, air conditionedbuildings, which include classrooms, laboratories, student break areas andadministrative offices. Our institutes have accessible parking facilities andare generally near a major highway. The typical lease for our institutes’facilities is for a three to 13 year term. If desirable or necessary, an institute may be relocated to a newfacility reasonably near the existing facility at the end of the lease term.

 

We own our headquartersbuilding in Carmel, Indiana, which represents approximately 43,000 square feetof office space.  In addition, we leaseapproximately 17,200 square feet of office space for our headquarters personnelin two nearby buildings for a two-year lease term expiring in October 2006at one building and a 5.2 year lease term expiring in April 2010 at theother building.

 

**Item 3.**           **LEGALPROCEEDINGS.**

 

We are subject to litigation in the ordinary course ofour business. When we are aware of a claim or potential claim, we assess thelikelihood of any loss or exposure.  Ifit is probable that a loss will result and the amount of the loss can bereasonably estimated, we record a liability for the loss.  Theliability recorded includes probable and estimable legal costs associated withthe claim or potential claim.  Ifthe loss is not probable or the amount of the loss cannot be reasonablyestimated, we disclose the claim if the likelihood of a potential loss isreasonably possible and the amount involved is material.

 

On November 5, 1999, a qui tam action was filedin the United States District Court for the Southern District of Texas by twoformer employees (“relators”) on behalf of themselves and the federalgovernment under the following caption: *United States ex rel. DanGraves and Susan Newman v. ITT Educational Services, Inc., et al.*(the“Graves Action”).  The Graves Actionalleges, among other things, violations of the False Claims Act, 31 U.S.C. § 3730,by us, one of our employees and our registered public accounting firm inconnection with how we compensated our sales representatives. The relators seekvarious forms of recovery on behalf of themselves and the federal government,including: (a) treble the amount of unspecified damages sustained by thefederal government; (b) a civil penalty of up to $10,000 for each violation ofthe False Claims Act; (c) double back pay for Susan Newman; and (d) attorney’sfees, costs and interest.

 

A qui tam action is a civil lawsuit brought by one ormore individuals (a qui tam “relator”) on behalf of the federal or stategovernment for an alleged submission to the government of a false claim forpayment.  A qui tam action is alwaysfiled under seal and remains under seal until the government decides whether tointervene in the litigation.  Whenever arelator files a qui tam action, the government typically initiates aninvestigation in order to determine whether to intervene in thelitigation.  If the governmentintervenes, it has primary control over the litigation.  If the government declines to intervene, therelator may pursue the litigation on behalf of the federal or state governmentand, if successful, receives a portion of the government’s recovery.

 

On May 25, 2001, the DOJ declined to intervene in the GravesAction. On March 31, 2002, the court dismissed all of the claims againstall of the defendants for failure to allege facts sufficient to support theclaims and gave the relators 20 days to file an amended complaint. The relatorsfiled an amended complaint on April 22, 2002 against all of thedefendants. On March 31, 2003, the court issued a final judgment in the GravesAction dismissing with

 

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prejudice all of the relators’claims against us and all of the other defendants for failure to state aclaim.  On April 28, 2003, therelators filed a notice of appeal to the United States Court of Appeals for theFifth Judicial Circuit (“5th Circuit”).  On October 20, 2004, the 5thCircuit affirmed the district court’s judgment that dismissed with prejudiceall of the relators’ claims against us and the other defendants in the GravesAction.  On November 3, 2004, therelators filed a petition with the 5th Circuit requesting arehearing *en banc* of the relators’appeal.  On November 18, 2004, the 5thCircuit denied the relators’ request for a rehearing.  On or about February17, 2005, the relatorsfiled a petition with the U.S. Supreme Court requesting that the Court hear therelators’ appeal of the 5th Circuit’s affirmation of the districtcourt’s judgment dismissing the Graves Action.

 

                OnMarch 4, 2005, we were served with a qui tam action that was filed on April 8,2004 in the United States District Court for the Southern District of Indianaby a former employee ("relator") on behalf of himself and the federalgovernment under the following caption: *United States of Americaex rel. Robert Olson v. ITT Educational Services, Inc. d/b/a ITT TechnicalInstitute* (the "Olson Action"). The relator alleges thatwe violated the False Claims Act, 31 U.S.C. § 3729, *et seq.*,by knowingly making and using false records and statements relating to, amongother things, student recruitment, admission, enrollment, attendance andgrading, graduate placement and course materials in order to fraudulentlyparticipate in the federal student financial aid programs. The complaint seeksan unspecified judgment and attorney's fees and costs. We were served with theOlson Action after the DOJ declined to intervene in the litigation. We intendto defend ourselves vigorously against the allegations made in the complaint.

 

On February 25,2004, federal agents executed search warrants at our corporate headquarters andat ten of our 77 ITT Technical Institutes nationwide.  On that same date, our Directors andexecutive officers and some of our other employees each received a federalgrand jury subpoena that was issued, along with the search warrants, by theU.S. District Court, Southern District of Texas, located in Houston,Texas.  The search warrants and subpoenasseek broad categories of documents, including documents containing informationrelating to our figures and rates for placement, retention, graduation andattendance, recruitment and admissions materials, student grades, graduatesalaries, transferability of credits to other institutions, and personnelrecords.  Although no formal charges havebeen filed, we believe that the DOJ is investigating claims alleging, amongother matters, falsification of records relating to student attendance, gradesand academic progress and graduate job placement statistics, and fraudulentmisrepresentations regarding the transferability of credits, graduation ratesand graduates’ salaries.  We, ourDirectors and our executive officers are continuing to work with the DOJ toresolve its investigation.  The coststhat we have incurred in connection with the DOJ investigation have had amaterial adverse effect on our financial condition and results of operations,and we cannot assure you that the ultimate outcome of the DOJ investigationwill not have a further material adverse effect on our financial condition andresults of operations.

 

On March 4,2004, we were notified by the Fort Worth, Texas regional office of the SEC thatit had initiated an inquiry into the allegations being investigated by the DOJas described in the preceding paragraph. We are cooperating with the SEC in its inquiry.  We cannot assure you, however, that theultimate outcome of the SEC inquiry will not have a material adverse effect onour financial condition or results of operations.

 

In October 2002,the CAG informed us that it had initiated an investigation of our ITT TechnicalInstitutes in California.  We believethat the CAG’s investigation is in response to one or more qui tam actionsfiled against us under the state and/or federal False Claims Acts.  The CAG has not asserted any claims againstus.  Based on the information that theCAG has requested, however, we believe that the CAG is investigating, amongother matters, whether one or more of our California ITT Technical Institutes:

 

•                  falsified records relating to studentattendance, grades and academic progress;

•                  falsifiedstudent grade point average calculations used to qualify students for financialaid under the State’s Cal Grant Program; and

•                  retaliated against employees who mayhave complained about those alleged acts.

 

We are cooperating withthe CAG in its investigation, and we have been conducting our own investigationof the same matters.  While we cannotassure you of the ultimate outcome of the CAG investigation, based on theresults of our investigation to date, we do not believe that the CAGinvestigation and any qui tam actions that may be associated with theinvestigation will have a material adverse effect on our financial condition,results of operations or cash flows.

 

On August 19,2004, a consolidated complaint in a securities class action lawsuit was filedagainst us and ten of our current and former Directors and executive officersin the U.S. District Court for the Southern District of Indiana under thefollowing caption: *City of Austin PoliceRetirement System, Individually And On Behalf Of All Others Similarly Situatedv. ITT Educational Services, Inc., et al.*  This action is a result of the court’s June 18,2004 order to consolidate 13 separate securities class action lawsuits filedfrom February 26, 2004 through April 23, 2004.  The consolidated complaint alleges, amongother things, that the defendants violated Sections 10(b) and 20(a) of theExchange Act, and Rule 10b-5 promulgated thereunder, by engaging in an unlawfulcourse of conduct, pursuant to which the defendants knowingly or recklesslyengaged in acts, transactions, practices and courses of business to concealadverse material information about our financial condition, and that thisconduct operated as a fraud and deceit upon the plaintiffs.  The complaint also alleges that thedefendants made various deceptive and untrue statements of material facts andomitted to state material facts necessary in order to make the statements made,in light of the circumstances under which they were made, not misleading to theplaintiffs, causing the plaintiffs to purchase our securities at artificiallyinflated prices.  The putative classperiod in this action is from October 17, 2002 through

 

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March 8, 2004.  The plaintiffs seek, among other things, anaward of unspecified compensatory damages, interest, costs, expenses andattorney’s fees.  All of the defendantsintend to defend themselves vigorously against the allegations made in thecomplaint.  We cannot assure you, however,that the ultimate outcome of this or other actions (including other actionsunder federal or state securities laws) will not have a material adverse effecton our financial condition or results of operations.

 

On orabout April 29, 2004, a consolidated complaint in a shareholder derivativelawsuit was filed against five of our current and former executive officers,ten of our current and former Directors and PWC, our independent registeredpublic accounting firm, in the Superior Court of Hamilton County, Indiana underthe following caption: *In Re ITT EducationalServices, Inc. Derivative Litigation*.  This action is a result of the court’s March 30,2004 order to consolidate two separate shareholder derivative lawsuits filed onor about February 27, 2004.  On December 1,2004, the court dismissed the consolidated complaint without prejudice and gavethe plaintiffs 30 days to replead their complaint.  On January 3, 2005, the plaintiffs filedan amended consolidated complaint.  Theamended consolidated complaint alleges, among other things, that:

 

•                  certainindividual defendants breached a fiduciary duty by selling our common stock andmisappropriating our information;

•                  all defendants breached theirfiduciary duties to us, abused their ability to control and influence us,grossly mismanaged us, caused us to waste corporate assets and were unjustlyenriched; and

•                  PWC breached a duty of care andprofessional competence to us and breached its contracts with us.

 

The amended consolidatedcomplaint seeks unspecified damages, extraordinary equitable and/or injunctiverelief, disgorgement of profits, benefits and other compensation, costs andattorneys’ fees.  All of the individualdefendants intend to defend themselves vigorously against the allegations inthe complaint.

 

On September 7,2004, a shareholder derivative lawsuit was filed against five of our currentand former executive officers, ten of our current and former Directors and PWC,in the U.S. District Court for the Southern District of Indiana under thefollowing caption: *Alaska Electrical PensionFund Derivatively on Behalf of ITT Educational Services, Inc. v. Rene R.Champagne, et al.*  Thecomplaint alleges, among other things, that the defendants caused us to violatestate and federal education finance laws and regulations by falsifying ourstudent records and federal securities laws by falsifying our accounting,auditing and financial reporting between October 2002 and April 2004.  As a result, the complaint alleges, amongother things, that the individual defendants:

 

•                  breached and/or aided and abetted inthe breach of:

•                  a duty todisseminate accurate information about us;

•                  fiduciaryduties of care, candor and loyalty to us and disclosure to our shareholders;

•                  a duty totest, oversee and monitor our system of internal controls, governanceprocedures and disclosure procedures; and

•                  a duty toensure that our internal controls, governance procedures and disclosureprocedures were functioning in an effective manner and in compliance with Pub.L. 107-204, 116 Stat. 745 (2002);

•                  abused their ability to control and influenceus;

•                  grosslymismanaged us;

•                  committed constructive fraud;

•                  will be and have been unjustlyenriched at our expense; and

•                  violated Section 10(b)of the Exchange Act and Rule 10-5 promulgated thereunder by:

•                  disseminatingor approving false statements that they knew or recklessly disregarded weremisleading;

•                  failing to disclose material factsnecessary in order to make those statements not misleading; and

•                  misappropriating our proprietaryinformation.

 

Inaddition, the complaint alleges, among other things, that PWC:

 

•                  violated Section 10(b) of theExchange Act and Rule 10b-5 promulgated thereunder by:

•                  disseminatingor approving false statements that it knew or recklessly disregarded weremisleading; and

•                  failing to disclose material factsnecessary in order to make those statements not misleading;

•                  was negligent and committedaccounting malpractice by failing to conduct its audits of our 2002 and 2003fiscal year financial statements in accordance with generally acceptedaccounting principles, generally accepted auditing standards and SEC rules;

 

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•                  aided and abetted the individualdefendants’:

•                  breach offiduciary duties to us;

•                  abuse oftheir control of us; and

•                  grossmismanagement of us; and

•                  violated their duty of candor to ourshareholders.

 

The complaint seeksunspecified damages, extraordinary equitable and/or injunctive relief, punitivedamages, costs and expenses, attorneys’ fees, pre-judgment interest, an orderdirecting the defendants to account for all damages caused by them and allprofits, special benefits and unjust enrichment they obtained, and an orderdirecting us to reform and improve our corporate governance and internalcontrol procedures.  On December 8,2004, the parties agreed to stay this action pending the entry of a finaljudgment in the *In Re ITT EducationalServices, Inc. Derivative Litigation* action, except that the staywill be lifted if a subsequently filed shareholder derivative lawsuit is filedin the Southern District of Indiana and the defendants are unable to enter intoa similar stay of that action.  All ofthe individual defendants intend to defend themselves vigorously against theallegations in the complaint.

 

On November 17,2004, a shareholder derivative lawsuit was filed against ten of our current andformer Directors, in the Chancery Court of New Castle County, Delaware underthe following caption: *Albert Reitan,derivatively on behalf of nominal defendant ITT Educational Services, Inc. v.Rand V. Araskog, et al.*  Thecomplaint alleges, among other things, that the defendants abdicated theirfiduciary duty of good faith to us by making no effort to oversee ouroperations and business practices to ensure that we comply with all applicablelaws, rules and regulations.  Thecomplaint seeks unspecified damages, equitable relief, attorneys’ fees,accountants’ fees, experts’ fees, costs and expenses.  All of the defendants intend to defendthemselves vigorously against the allegations in the complaint.

 

Although the derivative actions are brought nominallyon behalf of us, we expect to incur defense costs and other expenses inconnection with the derivative lawsuits, and we cannot assure you that theultimate outcome of these or other actions will not have a material adverseeffect on our financial condition or results of operations.

 

On July 7,2004, we received a derivative demand letter pursuant to Del. Ct. Ch. R. 23.1on behalf of Arthur Stein, a purported shareholder, demanding that our Board ofDirectors commence a civil action against each of our current Directors, oneformer Director and four of our current and former executive officers torecover for our benefit the amount of damages sustained by us as aresult of the misconduct alleged in the letter.  The misconduct alleged inthe letter is similar to the type of misconduct alleged against theindividual defendants in the consolidatedshareholder derivative lawsuit described above.  The demandletter indicates that Mr. Stein will commence a shareholder’s derivativeaction on our behalf, if our Board does not commence an action as demandedtherein within a reasonable period of time.  We have informed Mr. Steinthat our Board has deferredits decision with respect to Mr. Stein’s demand until the conclusion of the DOJinvestigation of us, the inquiry initiated by the SEC into the allegationsbeing investigated by the DOJ and the securities class action lawsuits filedagainst us, or until the receipt of additional information concerning theallegations made in the demand.

 

On October 26,2004, a lawsuit was filed against us in the Chancery Court of New CastleCounty, Delaware under the following caption: *ArthurStein v. ITT Educational Services, Inc.*  The complaint alleges that we violated Section 220of the Delaware General Corporation Law by refusing to allow Mr. Stein toinspect and make copies of our books and records relating to the misconductalleged in his derivative demand letter described above.  The complaint seeks an order compelling us topermit Mr. Stein to inspect and make copies of our books and records, and topay his costs, expenses and attorney’s fees to prosecute this action.  We intend to defend the action vigorously.

 

On December 15,2004, a lawsuit was filed against us, our internal committee that administersour 401(k) retirement savings plan (the “Plan”), the chairperson of thatcommittee and a number of other unnamed entities and individuals, in the UnitedStates District Court for the Southern District of Indiana under the followingcaption: *William Curry, individually and onbehalf of all others similarly situated v. ITT Educational Services, Inc., etal.*  The complaint alleged,among other things, that the defendants breached their fiduciary duties under Section 502of the Employee Retirement Income Security Act (“ERISA”) that are owed to theparticipants and beneficiaries of the Plan by failing to prudently manage thePlan’s assets.  Allegedly, the breacharose from the Plan’s holding and acquisition of our common stock when thedefendants knew or should have known that our common stock was not a suitableand appropriate investment for the Plan. The complaint alleged that our common stock was an inappropriate investment,because we supposedly misrepresented our operational success and the subsequentdisclosure of those misrepresentations caused the price of our common stock todecrease.  As a result of this decreasein the price of our common stock, the complaint alleged that the value of the Planassets suffered losses.  The plaintiffsought to certify this action as a class action to include all participants inthe Plan and their beneficiaries, excluding the defendants and

 

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their immediate familymembers, for whose accounts the Plan fiduciaries made or maintained investmentsin our common stock from October 17, 2002 through March 18, 2004. Theplaintiff also sought, among other things:

 

•                  a declaration that the defendants breachedtheir fiduciary duties under ERISA to the Plan;

•                  to require the defendants to restoreto the Plan all losses resulting from the alleged imprudent investment of thePlan’s assets;

•                  to require the defendants to restoreto the Plan all profits that the defendants made through their use of the Plan’sassets;

•                  to require the defendants to restoreto the Plan all profits that the Plan would have realized had the defendantsfulfilled their fiduciary obligations under ERISA;

•                  other unspecified equitable restitutionand monetary relief;

•                  a constructive trust with respect toany unjust enrichment received by the defendants at the expense of the Plan asa result of the defendants’ alleged breach of their fiduciary duties underERISA;

•                  to enjoin the defendants from furtherviolating their fiduciary duties under ERISA;

•                  the appointment of independentfiduciaries to administer the Plan; and

•                  costs and attorneys’ fees.

 

The plaintiff filed anotice to voluntarily dismiss this action on January 25, 2005, and thecourt dismissed this action without prejudice on the same date.

 

The current andformer executive officers named in one or more of the securities class action,shareholder derivative and Plan class action lawsuits and derivative demandletter described above include: Gene A. Baugh, Rene R. Champagne, Clark D.Elwood, Nina F. Esbin, Eugene W. Feichtner, Martin A. Grossman, Thomas W.Lauer, Kevin M. Modany and Omer E. Waddles.

 

Certain of ourcurrent and former officers and Directors are or may become a party in certainof the actions described above. Our By-Laws and Restated Certificate ofIncorporation obligate us to indemnify our officers and Directors to thefullest extent permitted by Delaware law, provided that their conduct compliedwith certain requirements. We are obligated to advance defense costs to ourofficers and Directors, subject to the individual’s obligation to repay suchamount if it is ultimately determined that the individual was not entitled toindemnification. In addition, our indemnity obligation can, under certaincircumstances, include indemnifiable judgments, penalties, fines and amountspaid in settlement in connection with those actions.

 

As previously disclosed, on March 4, 2004, our Board of Directorsappointed a Special Committee of independent Directors. The Special Committeehas completed its investigation relating to the conduct and integrity of oursenior management. In late June 2004, the Special Committee reported toour Board of Directors that it had found no evidence that our senior managementhad engaged in any violations of our policies and procedures or any wrongful orcriminal conduct related to the matters that are the subject of the DOJ and CAGinvestigations and the securities class action lawsuit described above. TheSpecial Committee also reported that when allegations of possible violationshave been brought to the attention of our senior management, we haveinvestigated those allegations and our senior management has taken appropriateaction when responding to those allegations and any violations found.

 

**Item 4.  SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS.**

 

No matters were submitted to a vote of the holders ofthe common stock during the fourth quarter of 2004.

 

**PART II**

 

**Item 5.  MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES.**

 

Ourcommon stock is listed on the New York Stock Exchange (“NYSE”) under thetrading symbol ‘‘ESI.’’ The prices set forth below are the high and low saleprices of our common stock during the periods indicated, as reported in theNYSE’s consolidated transaction reporting system.

 

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| ** **               | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| **Fiscal Quarter Ended** | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| March 31            |       | $        | 60.75      |     | $          | 27.83 |   | $ | 30.00 |   | $ | 23.19 |   |
| June 30             |       | $        | 43.34      |     | $          | 31.05 |   | $ | 31.55 |   | $ | 26.34 |   |
| September 30        |       | $        | 38.78      |     | $          | 27.98 |   | $ | 49.45 |   | $ | 28.97 |   |
| December 31         |       | $        | 50.60      |     | $          | 34.26 |   | $ | 56.50 |   | $ | 44.19 |   |

 

Therewere 127 holders of record of our common stock on February 15, 2005.

 

We didnot pay a cash dividend in 2003 or 2004. We do not anticipate paying any cashdividends on our common stock in the foreseeable future and we plan to retainour earnings to finance future growth. The declaration and payment of dividendson our common stock are subject to the discretion of our Board of Directors andcompliance with applicable law. Our decision to pay dividends in the futurewill depend on general business conditions, the effect of such payment on ourfinancial condition and other factors our Board of Directors may in the futureconsider to be relevant.

 

Theinformation required by this Item concerning securities authorized for issuanceunder equity compensation plans is set forth in or incorporated herein byreference into Part III, Item 12 of this Annual Report.

 

We did not sell any of our securities during the threemonths ended December 31, 2004 that were not registered under theSecurities Act of 1933, as amended (the “Securities Act”). The followinginformation is furnished as to our securities sold in January 2005 thatwere not registered under the Securities Act:

 

(a)                                  OnJanuary 1, 2005, we issued 420 treasury shares of our common stock to onenon-employee director under the ESI Non-Employee Directors DeferredCompensation Plan (the “Directors Deferred Compensation Plan”) as the stockportion of the semi-annual installment payment of his annual retainer.

 

(b)                                 OnJanuary 1, 2005, we credited 420 treasury shares of our common stock tothe deferred share accounts of each of five non-employee directors under theDirectors Deferred Compensation Plan as the stock portion of the semi-annualinstallment payment of their annual retainer for 2005. These shares of ourcommon stock will be issued upon the termination of the non-employee director’sservice as a non-employee director for any reason, including retirement ordeath.

 

The transactions described in paragraphs (a) and (b)above are exempt from the registration requirements of the Securities Actpursuant to Section 4(2) thereof.

 

The followingtable sets forth information regarding purchases made by us of shares of ourcommon stock on a monthly basis during the fourth quarter of 2004:

 

**Issuer Purchases of Equity Securities**

 
| **Period**                                           | ** ** | **Total Number of  Shares  Purchased** | ** ** | **Average  Price Paid  per Share** | ** ** | **Total Number of Shares  Purchased as Part of  Publicly Announced  Plans or Programs (1)** | ** ** | **Maximum Number of  Shares that May Yet Be  Purchased Under the  Plans or Programs (1)** | ** ** |
|------------------------------------------------------|------------|----------------------------------------|------------|------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| October 1, 2004 through October 31, 2004   |       | —                                 |       | $                                  | —     |                                                                                        | —     |                                                                                      | 4,216,300  |   |
| November 1, 2004 through November 30, 2004 |       | —                                 |       | —                             |       | —                                                                                      |       | 4,216,300                                                                                 |       |
| December 1, 2004 through December 31, 2004 |       | —                                 |       | —                             |       | —                                                                                      |       | 4,216,300                                                                                 |       |
| **Total**                                            |       | —                                 |       | $                                  | —     |                                                                                        | —     |                                                                                      |       |   |

 

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(1)                                  OnOctober 17, 2002, we announced that our Board of Directors on October 15,2002 authorized us to repurchase 5.0 million shares of our common stock (the “2002Repurchase Program”). As of December 31, 2004, 4,216,300 shares remainedto be repurchased under the 2002 Repurchase Program. The terms of the 2002Repurchase Program provide that we may repurchase shares of our common stock,from time to time depending on market conditions and other considerations, inthe open market or through privately negotiated transactions in accordance

 

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withRule 10b-18 of the Exchange Act. Unless earlier terminated by our Board ofDirectors, the 2002 Repurchase Program will expire when we repurchase allshares authorized for repurchase thereunder.

 

**Item 6.  SELECTED FINANCIAL DATA.**

 

The following selectedfinancial data are qualified by reference to and should be read with ourConsolidated Financial Statements and Notes to Consolidated FinancialStatements and other financial data included elsewhere in this report.

 
| ** **                                                                          | ** ** | **Year Ended December 31,**                         | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2004**                                                 | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                          | ** ** | **(In thousands, except per share  and operating data)** | ** ** |
| **Statement of Income Data:**                                                       |       |                                                     |       |   |   |   |   |   |   |   |   |
| Revenue (a)                                                                         |       | $                                                        | 617,834    |   | $ | 522,856 |   | $ | 454,118 |   | $ | 400,063 |   | $ | 336,331 |   |
| Cost of educational services (a)                                                    |       | 298,747                                                  |       | 280,006 |   | 256,675 |   | 237,641 |   | 200,460 |   |
| Student services and administrative expenses                                        |       | 174,396                                                  |       | 148,329 |   | 129,134 |   | 110,816 |   | 94,156 |   |
| Special legal and other investigation costs (b)                                     |       | 25,143                                                   |       | — |   | — |   | — |   | — |   |
| Total costs and expenses                                                            |       | 498,286                                                  |       | 428,335 |   | 385,809 |   | 348,457 |   | 294,616 |   |
| Operating income                                                                    |       | 119,548                                                  |       | 94,521 |   | 68,309 |   | 51,606 |   | 41,715 |   |
| Interest income, net                                                                |       | 3,834                                                    |       | 1,995 |   | 2,684 |   | 2,708 |   | 2,707 |   |
| Income before income taxes and cumulative effect of  change in accounting principle |       | 123,382                                                  |       | 96,516 |   | 70,993 |   | 54,314 |   | 44,422 |   |
| Income taxes                                                                        |       | 48,119                                                   |       | 37,658 |   | 27,139 |   | 20,600 |   | 16,937 |   |
| Income before cumulative effect of change in  accounting principle                  |       | 75,263                                                   |       | 58,858 |   | 43,854 |   | 33,714 |   | 27,485 |   |
| Cumulative effect of change in accounting principle,  net of tax (c)                |       | —                                                   |       | — |   | — |   | — |   | (2,776 | ) |
| Net income                                                                          |       | $                                                        | 75,263     |   | $ | 58,858 |   | $ | 43,854 |   | $ | 33,714 |   | $ | 24,709 |   |
| Earnings per share (d):                                                             |       |                                                     |       |   |   |   |   |   |   |   |   |
| Basic (e)                                                                           |       | $                                                        | 1.64       |   | $ | 1.31 |   | $ | 0.96 |   | $ | 0.71 |   | $ | 0.51 |   |
| Diluted (f)                                                                         |       | $                                                        | 1.61       |   | $ | 1.27 |   | $ | 0.94 |   | $ | 0.70 |   | $ | 0.51 |   |
|                                                                                |       |                                                     |       |   |   |   |   |   |   |   |   |
| **Other Operating Data:**                                                           |       |                                                     |       |   |   |   |   |   |   |   |   |
| Capital expenditures, net                                                           |       | $                                                        | 19,116     |   | $ | 14,391 |   | $ | 14,265 |   | $ | 21,560 |   | $ | 29,393 |   |
| Facility expenditures and land purchases                                            |       | $                                                        | 16,376     |   | $ | 25,718 |   | $ | 19,843 |   | $ | — |   | $ | — |   |
| Number of students at end of period (unaudited)                                     |       | 40,876                                                   |       | 37,076 |   | 32,631 |   | 30,778 |   | 27,640 |   |
| Number of technical institutes at end of period  (unaudited)                        |       | 77                                                       |       | 77 |   | 74 |   | 70 |   | 69 |   |

 
| ** **                                                  | ** ** | **At December 31,** | ** ** |
|-------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                  | ** ** | **2004**                 | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                  | ** ** | **(In thousands)**       | ** ** |
| **Balance Sheet Data:**                                     |       |                     |       |   |   |   |   |   |   |   |   |
| Cash and cash equivalents, restricted cash and  investments |       | $                        | 356,516    |   | $ | 254,174 |   | $ | 156,708 |   | $ | 110,232 |   | $ | 70,618 |   |
| Total current assets                                        |       | $                        | 372,781    |   | $ | 256,646 |   | $ | 173,266 |   | $ | 133,026 |   | $ | 92,570 |   |
| Property and equipment, less accumulated depreciation       |       | $                        | 98,746     |   | $ | 81,503 |   | $ | 62,584 |   | $ | 49,593 |   | $ | 46,560 |   |
| Total assets                                                |       | $                        | 493,389    |   | $ | 363,270 |   | $ | 247,707 |   | $ | 194,215 |   | $ | 150,896 |   |
| Total current liabilities                                   |       | $                        | 233,101    |   | $ | 202,337 |   | $ | 142,495 |   | $ | 105,372 |   | $ | 79,926 |   |
| Total liabilities                                           |       | $                        | 258,315    |   | $ | 217,146 |   | $ | 158,683 |   | $ | 116,027 |   | $ | 86,210 |   |
| Shareholders’ equity                                   |       | $                        | 235,074    |   | $ | 146,124 |   | $ | 89,024 |   | $ | 78,188 |   | $ | 64,686 |   |

 

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(a)                                  Thereclassification of tuition revenue with respect to students who withdrawreduced revenue and cost of educational services by $10,828 in the year ended December 31,2002, $10,488 in the year ended December 31, 2001 and $11,193 in the yearended December 31, 2000. The reclassifications had no impact on our totalconsolidated results reported in any period presented. See Note 1 to our Notesto Consolidated Financial Statements.

 

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(b)                                 Accruedestimated legal and other investigation costs associated with the DOJinvestigation, the inquiry initiated by the SEC into the allegations beinginvestigated by the DOJ, and the securities class action, shareholderderivative and books and records inspection lawsuits filed against us, certainof our current and former executive officers and each of our Directors.

(c)                                  Cumulativeeffect of change in accounting principle, net of tax represents revenuerecognition in accordance with Staff Accounting Bulletin No. 101, “RevenueRecognition in Financial Statements.”

(d)                                 Earningsper share in all prior periods have been restated to reflect the two-for-onestock split declared on May 10, 2002 that became effective June 6, 2002.

(e)                                  Basicearnings per share data are based on historical net income and the number ofshares of our common stock outstanding during each period. Basic earnings pershare for all periods have been calculated in conformity with Statement ofFinancial Accounting Standards No. 128, “Earnings per Share.”

(f)                                    Thedifference in the number of shares used to calculate diluted earnings per sharefrom the number of shares used to calculate basic earnings per share representsthe average number of shares issued under our stock option plans less sharesassumed to be purchased with proceeds from the exercise of those stock options.

 

**Item 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS.**

 

*Thefollowing discussion should be read with the Selected Financial Data and theConsolidated Financial Statements and Notes to Consolidated FinancialStatements included elsewhere in this report.*

 

**General**

 

We operate77 institutes in 30 states, which were providing technology-orientedpostsecondary education to more than 40,000 students as of December 31,2004. We derive our revenue almost entirely from tuition, tool kits, fees andcharges paid by, or on behalf of, our students. Most students at our institutespay a substantial portion of their tuition and other education-related expenseswith funds received under various government-sponsored student financial aidprograms, especially the federal student financial aid programs under Title IV(“Title IV Programs”) of the Higher Education Act of 1965, as amended (the “HEA”).In 2004, we indirectly derived approximately 66% of our revenue, determined ona cash accounting basis as defined by the U.S. Department of Education’s (“ED”)regulations, from Title IV Programs.

 

Ourrevenue varies based on the aggregate student population, which is influencedby the following factors:

 

•                  the number of students attending ourinstitutes at the beginning of a fiscal period;

•                  the number of new first-time studentsentering and former students re-entering our institutes during a fiscal period;

•                  student retention rates; and

•                  general economic conditions.

 

Newstudents generally enter our institutes at the beginning of an academic quarterthat begins for most programs of study in early March, mid-June, early September orlate November. Our establishment of new institutes and the introduction ofadditional program offerings at our existing institutes have been significantfactors in increasing the aggregate student population in recent years.

 

Inorder to participate in Title IV Programs, a new institute must be authorizedby the state in which it will operate, accredited by an accrediting commissionrecognized by the ED, and certified by the ED to participate in Title IVPrograms. The accrediting commission that accredits our institutes grantsaccreditation to a new institute prior to its first class start date. The ED’scertification process cannot commence until the institute receives its stateauthorization and accreditation. In the last two years, we have experiencedminimal delay in obtaining ED certification of our new institutes and learningsites.

 

Weearn tuition revenue on a weekly basis, pro rata over the length of each offour, 12-week academic quarters in each fiscal year. State regulations,accrediting commission criteria and our policies generally require us to refunda portion of the tuition and fee payments received from a student who withdrawsfrom one of our institutes during an academic quarter. Our statement of incomerecognizes immediately the amount of tuition and fees, if any, that we mayretain after payment of any refund.

 

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Priorto 2003, if a student withdrew, the tuition revenue related to the remainder ofthat academic quarter and the fee revenue related to the remainder of thestudent’s program were recorded and the amount of any refund resulting from theapplication of federal, state or accreditation requirements or our refundpolicy was recorded as an expense. For the periods presented, we havereclassified tuition and fee revenue by netting the corresponding revenue andexpense related to the remaining tuition and fees with any related refundrecorded for students who withdrew. As a result, revenue and cost ofeducational services have each been reduced by $10,828 for the year ended December 31,2002. The reclassifications had no impact on our total consolidated resultsreported in any period presented.

 

We incurexpenses throughout a fiscal period in connection with the operation of ourinstitutes. The cost of educational services includes faculty andadministrative salaries, cost of course materials, occupancy costs,depreciation and amortization of equipment costs, facilities and leaseholdimprovements, and certain other administrative costs incurred by ourinstitutes.

 

Studentservices and administrative expenses include direct marketing costs (which aremarketing expenses directly related to new student recruitment), indirectmarketing expenses, an allowance for doubtful accounts and administrativeexpenses incurred at our corporate headquarters. Direct marketing costs includesalaries and employee benefits for recruiting representatives and directsolicitation expenses. We capitalize our direct marketing costs (excludingadvertising expenses) using the successful efforts method and amortize them ona cost-pool-by-cost-pool basis over the period that we expect to receiverevenue streams associated with those assets. We expense as incurred ourmarketing costs that do not relate to the direct solicitation of potentialstudents.

 

In2002, we developed five new residence bachelor degree programs and one newonline bachelor degree program. We began offering one or more of these newbachelor degree programs at 39 of our institutes in 2002. In addition, a totalof 41 of our institutes were approved to offer bachelor degree programs as of December 31,2002 compared to 29 as of December 31, 2001.

 

In2003, we developed:

 

•                  three new residence bachelor degreeprograms;

•                  three new residence associate degreeprograms; and

•                  one new online master degree program.

 

In addition, a total of51 of our institutes were approved to offer bachelor degree programs as of December 31,2003 compared to 41 as of December 31, 2002. We also expanded to severaladditional institutes in 2003 the use of our hybrid education delivery model,pursuant to which certain program courses are taught on campus and others aretaught online over the Internet (the “Hybrid Delivery Model”).

 

In2004, we developed:

 

•                  two new residence bachelor degreeprograms;

•                  two new online bachelor degreeprograms;

•                  three new residence associate degreeprograms; and

•                  three new online associate degreeprograms.

 

In addition, a total of52 of our institutes were approved to offer bachelor degree programs as of December 31,2004 compared to 51 as of December 31, 2003. We also expanded the use ofthe Hybrid Delivery Model to 62 institutes in 2004.

 

Weopened four new institutes in 2002, three new institutes in 2003 and two newinstitutes and one learning site in 2004. We also closed two institutes in2004. We plan to open three or four new institutes and up to four learningsites in the remainder of 2005. Our new institutes have historically incurred aloss during the 24-month period after the first class start date.

 

**CriticalAccounting Policies and Estimates**

 

Thismanagement’s discussion and analysis of financial condition and results ofoperations is based on our consolidated financial statements, which have beenprepared in conformity with generally accepted accounting principles. Thepreparation of these financial statements requires us to make estimates andjudgments that affect the

 

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reported amount of assetsand liabilities, revenue and expenses and contingent assets and liabilities. Actualresults may differ from those estimates and judgments under differentassumptions or conditions.

 

Webelieve the following critical accounting policies affect our more significantestimates and judgments used in the preparation of our consolidated financialstatements. These policies should be read in conjunction with Note 1 of theNotes to Consolidated Financial Statements.

 

*Propertyand Equipment.*We include all property and equipment in thefinancial statements at cost and make provisions for depreciation of propertyand equipment using the straight-line method. Estimated useful lives generallyrange from three to ten years for our furniture and equipment, three to 14years for leasehold improvements, 20 to 40 years for the buildings and three toeight years for capitalized software. Changes in circumstances, such as changesin our curricula and technological advances, may result in the actual usefullives of our property, equipment and capitalized software differing from ourestimates. We regularly review and evaluate the estimated useful lives of ourproperty and equipment and capitalized software. Although we believe ourassumptions and estimates are reasonable, deviations from our assumptions andestimates could produce a materially different result.

 

*Recognitionof Revenue.*Tuition revenue is recorded on a straight-linebasis over the length of the applicable course. If a student withdraws from aninstitute, the standards of most state education authorities that regulate ourinstitutes, the accrediting commission that accredits our institutes and ourown internal policy limit a student’s obligation for tuition and fees to theinstitute depending on when a student withdraws during an academic quarter (“RefundPolicies”). The terms of the Refund Policies vary by state, and the limitationsimposed by the Refund Policies are generally based on the portion of theacademic quarter that has elapsed at the time the student withdraws. Thegreater the portion of the academic quarter that has elapsed at the time thestudent withdraws, the greater the student’s obligation is to the institute forthe tuition and fees related to that academic quarter. We record revenue net ofany refunds paid as a result of any applicable Refund Policy. On an individualstudent basis, tuition earned in excess of cash received is recorded asaccounts receivable, and cash received in excess of tuition earned is recordedas deferred revenue.

 

Thecost of textbooks is included in the tuition and is amortized on astraight-line basis over the applicable course length and the deferral oftextbook costs is recorded in prepaids and other current assets. Tool kit salesand the related cost of the tool kits are recognized at the beginning of eachacademic quarter. Academic fees (which are charged only one time to students ontheir first day of class attendance) and admission processing fees (which,prior to their discontinuance in 2003, were charged only one time to studentsupon being evaluated for admission to their programs of study) are recognizedas revenue on a straight-line basis over the average program length of 24months. Deferred revenue is recorded for fees collected in excess of revenuerecognized. If a student withdraws from an institute, all unrecognized revenuerelating to his or her fees, net of any refunds paid as a result of anyapplicable Refund Policy, is recognized upon the student’s departure.Administrative fees, which are charged to students when they withdraw orgraduate from their programs of study at an institute, are recognized when thestudents withdraw or graduate from their programs of study at the institute.

 

Morethan 95% of our revenue represents tuition charges and less than 5% of ourrevenue represents bookstore sales and student fees. The amount of tuitionearned depends on the cost per credit hour of the courses in the program, thenumber of courses in the program, how long a student remains enrolled in theprogram, how many program courses a student takes during each period ofenrollment in the program, and the total number of students enrolled in eachprogram. Each of these factors is known at the time our tuition revenue iscalculated and is not subject to estimation.

 

*DirectMarketing Costs.*Direct costs incurred relating to theenrollment of new students are capitalized using the successful efforts method.Direct marketing costs include salaries and employee benefits of recruitingrepresentatives and other direct costs less admission processing fees, if any.Successful efforts is the ratio of students enrolled to prospective studentsinterviewed. The higher the rate of interviewed students who enroll, thegreater the percentage of our direct marketing costs that are capitalized. Weamortize our direct marketing costs on a cost-pool-by-cost-pool basis over theperiod that we expect to receive revenue streams associated with those assets. Thedirect costs subject to capitalization are readily quantifiable and are notsubject to estimation. The amortization method is based on historical trends ofstudent enrollment and retention activity and is not subject to significantassumptions. We regularly evaluate the future recoverability of these deferredcosts.

 

*Contingent Liabilities.*We are subject to litigation in the ordinary course of our business. When weare aware of a claim or potential claim, we assess the likelihood of any lossor exposure. If it is probable that a loss will result and the

 

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amount of the loss can be reasonably estimated, werecord a liability for the loss. Theliability recorded includes probable and estimable legal costs associated withthe claim or potential claim. If the loss is not probable or the amountof the loss cannot be reasonably estimated, we disclose the claim if thelikelihood of a potential loss is reasonably possible and the amount involvedis material. Although we believe our estimates are reasonable, deviations fromour estimates could produce a materially different result.

 

**New AccountingPronouncements**

** **

In January andMay 2004, the Financial Accounting Standards Board (“FASB”) issued two staffpositions with respect to the application of Statements of Financial AccountingStandards (“SFAS”) No. 106, “Employers’ Accounting for Postretirement BenefitsOther Than Pensions,” to the accounting and disclosure requirements associatedwith the Medicare Prescription Drug, Improvement and Modernization Act of 2003(“Drug Act”). The Drug Act affects postretirement health care benefits thatcompanies may provide to their employees. We do not provide any postretirementhealth care benefits to our employees, and, therefore, those staff positions donot have an impact on our financial condition or results of operations.

 

In June 2004,the FASB’s Emerging Issues Task Force (“EITF”) issued EITF 03-1, “The Meaningof Other-Than-Temporary Impairment and Its Application to Certain Investments.”EITF 03-1 provides further guidance on the meaning of other-than-temporaryimpairment and its application to debt and equity securities in accordance withAccounting Principles Board (“APB”) Opinion No. 18, “The Equity Method ofAccounting for Investments in Common Stock,” and SFAS No. 115, “Accounting forCertain Investments in Debt and Equity Securities.” In September 2004, theFASB issued FASB Staff Position EITF 03-1-1, which delays the effective dateuntil additional guidance is issued for the application of the recognition andmeasurement provisions of EITF 03-1 to investments in securities that areimpaired. The disclosure requirements of EITF 03-1, however, are effective forannual periods ending after June 15, 2004. Until further guidance isprovided by the FASB, we are unable to determine the effect, if any, that EITF03-1 will have on our financial condition or results of operations. See Note 1for additional disclosures regarding our investments.

 

In December 2004, the FASB issued SFAS No. 123R,“Share-Based Payment” that revises SFAS No. 123, “Accounting for Stock-BasedCompensation” and supercedes APB Opinion No. 25, “Accounting for Stock Issuedto Employees.” Under this revised standard, all share-based payments toemployees, including grants of employee stock options, must be reflected in thefinancial statements using the fair value method with the related expensesrecognized over the service period. SFAS No. 123R will be effective for periodsbeginning after June 15, 2005 and allows for several alternative transitionmethods. We expect to adopt SFAS No. 123R in our third fiscal quarter of 2005on a modified-prospective basis without restating prior interim periods, whichwill require that we recognize compensation expense for all stock option andother equity-based awards that vest or become exercisable after the effectivedate. We are currently evaluating the impact that SFAS No. 123R will have onour financial condition or results of operations.

 

**Variationsin Quarterly Results of Operations**

 

Ourquarterly results of operations have tended to fluctuate within a fiscal yeardue to the timing of student matriculations. Each of our four fiscal quarters have 12 weeks of earned tuitionrevenue.  Revenue in our third and fourthfiscal quarters generally benefits from increased student matriculations.  The number of new students entering ourinstitutes tends to be substantially higher in June (24% of all newstudents in 2004) and September (35% of all new students in 2004) becauseof the significant number of recent high school graduates entering ourinstitutes for the academic quarters beginning in those two months. Theacademic schedule generally does not affect our incurrence of most of ourcosts, however, and costs do not fluctuate significantly on a quarterly basis.

 

Thefollowing table sets forth our revenue in each fiscal quarter of 2004, 2003,and 2002.

 

**QuarterlyRevenue**

 
| ** **             | ** ** | **2004**                   | ** ** | **2003**    | ** ** | **2002**   | ** ** |
|------------------------|------------|----------------------------|------------|-------------|------------|------------|------------|
| ** **             | ** ** | **(Dollars in thousands)** | ** ** |
| **Three Months Ended** | ** ** | **Amount**                 | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| March 31          |       | $                          | 141,730    |        | 23         | %          | $          | 119,000 |   | 23 | % | $ | 105,112 |   | 23 | % |
| June 30           |       | 150,931                    |       | 24          | %          | 124,831    |       | 24 | % | 108,325 |   | 24 | % |
| September 30      |       | 157,945                    |       | 26          | %          | 134,382    |       | 26 | % | 117,746 |   | 26 | % |
| December 31       |       | 167,228                    |       | 27          | %          | 144,643    |       | 27 | % | 122,935 |   | 27 | % |
| Total for Year         |       | $                          | 617,834    |        | 100        | %          | $          | 522,856 |   | 100 | % | $ | 454,118 |   | 100 | % |

 

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**Results of Operations**

** **

Thefollowing table sets forth the percentage relationship of certain statement ofincome data to revenue for the periods indicated.

 

 
| ** **                                   | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|
| ** **                                   | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Revenue                                      |       | 100.0                            | %          | 100.0 | % | 100.0 | % |
| Cost of educational services                 |       | 48.3                             | %          | 53.5 | % | 56.5 | % |
| Student services and administrative expenses |       | 28.2                             | %          | 28.4 | % | 28.5 | % |
| Special legal and other investigation costs  |       | 4.1                              | %          | — | % | — | % |
| Operating income                             |       | 19.4                             | %          | 18.1 | % | 15.0 | % |
| Interest income, net                         |       | 0.6                              | %          | 0.4 | % | 0.6 | % |
| Income before income taxes                   |       | 20.0                             | %          | 18.5 | % | 15.6 | % |

 

The following table sets forth our total studentenrollment as of December 31, 2004, 2003 and 2002:

 
| **As of December 31,** | ** ** | **Total Student  Enrollment** | ** ** | **Increase Over  Prior Year** | ** ** |
|-----------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| 2004                        |       | 40,876                        |       | 10.2                          | %          |
| 2003                        |       | 37,076                        |       | 13.6                          | %          |
| 2002                        |       | 32,631                        |       | 6.0                           | %          |

 

The following table sets forth total new studentenrollment during the years ended December 31, 2004, 2003 and 2002:

 
| **For the Year Ended December 31,** | ** ** | **Total New Student  Enrollment** | ** ** | **Increase Over  Prior Year** | ** ** |
|------------------------------------------|------------|-----------------------------------|------------|-------------------------------|------------|
| 2004                                     |       | 41,959                            |       | 16.9                          | %          |
| 2003                                     |       | 35,880                            |       | 16.6                          | %          |
| 2002                                     |       | 30,761                            |       | 4.4                           | %          |

 

We generally organize the academic schedule forprograms of study offered at our institutes on the basis of four 12-weekacademic quarters in a calendar year that typically begin in early March,mid-June, early September and late November.  To measure the persistence of our students,the number of continuing students in any academic quarter is divided by thetotal student enrollment as of the end of the immediately preceding academicquarter.  A continuing student is anystudent who, in any academic quarter, is enrolled in a program of study at anITT Technical Institute and was enrolled in the same program at any ITTTechnical Institute at the end of the immediately preceding academic quarter.Total student enrollment includes all new and continuing students enrolled atour ITT Technical Institutes at the end of an academic quarter.

 

The following table sets forth the rates of our students’persistence for each quarter in 2004, 2003, and 2002:

 
| ** ** | ** ** | **For the Three Months Ended,** | ** ** |
|------------|------------|---------------------------------|------------|
| ** ** | ** ** | **March 31**               | ** ** | **June 30** | ** ** | **Sept 30** | ** ** | **Dec 31** | ** ** |
| 2004       |       | 78                              | %          | 75 | % | 71 | % | 78 | % |
| 2003       |       | 77                              | %          | 77 | % | 73 | % | 80 | % |
| 2002       |       | 79                              | %          | 77 | % | 73 | % | 80 | % |

 

Beginning in the second quarter of 2004, we beganusing the Hybrid Delivery Model with a larger number of our students, whichincreased the number of courses that we teach online over the Internet to ourstudents. Student retention is typically lower in courses taught online overthe Internet compared to courses taught on campus. As a result of the expandeduse of the Hybrid Delivery Model, our student persistence rate decreased. Webelieve that the student persistence rate will continue to decrease until weexpect it to stabilize in the second quarter of 2005.

 

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**YearEnded December 31, 2004 Compared with Year Ended December 31, 2003**

 

*Revenue.*Revenueincreased $94.9 million, or 18.2%, to $617.8 million for the year ended December 31,2004 from $522.9 million for the year ended December 31, 2003, primarilydue to:

 

•                  a 6.0% increase in tuition rates in March 2004;

•                  a 13.6% increase in the total studentenrollment at December 31, 2003 compared to December 31, 2002; and

•                  a 16.9% increase in new studentenrollment at our institutes in the year ended December 31, 2004 comparedto the same period in 2003, which was primarily the result of:

•                  the opening of new institutes;

•                  an increased number of institutesoffering bachelor degree programs;

•                  an increased number of new programsof study offered by our institutes;

•                  an increased number of responses toour marketing and advertising;

•                  operational changes that increasedthe percentage of new student enrollments arising from those responses;

•                  the availability of private studentloans to supplement federal student financial aid; and

•                  the use of the Hybrid Delivery Modelat more institutes.

 

This increase in revenuewas partially offset by a decrease in our students’ persistence rate for theyear ended December 31, 2004.

 

*Cost ofEducational Services.*Cost of educational services increased$18.7 million, or 6.7%, to $298.7 million in 2004 from $280.0 million in 2003.The principal causes of this increase included:

 

•                  the costs required to service theincreased enrollment;

•                  normal inflationary cost increasesfor wages, rent and other costs of services;

•                  increased costs due to opening newinstitutes (one opened in March 2003, one opened in June 2003, oneopened in December 2003, and two opened in December 2004); and

•                  increased costs associated withimplementing the Hybrid Delivery Model at more institutes.

 

Costof educational services as a percentage of revenue decreased to 48.3% in 2004from 53.5% in 2003.  The primary causesof this decrease include:

 

•                  continued facility and facultyutilization efficiencies;

•                  certain fixed costs at our institutesthat did not increase proportionately with increases in our revenue resultingfrom increased student enrollment and tuition rate increases;

•                  new and renegotiated vendorcontracts; and

•                  a net reduction of occupancy costsresulting from our purchase of six facilities in 2003 and one facility in 2004that we had previously leased.

 

*StudentServices and Administrative Expenses.*Student services andadministrative expenses increased $26.1 million, or 17.6%, to $174.4 million in2004 from $148.3 million in 2003. Student services and administrative expenses decreased to 28.2% ofrevenue in 2004 compared to 28.4% of revenue in 2003, primarily due to anincrease in the amount of marketing costs deferred as a result of discontinuingthe admission processing fee, partially offset by a 19.4% increase in mediaadvertising expenses and an increase in bad debt expense from 1.2% of revenuein 2003 to 1.9% of revenue in 2004.

 

*SpecialLegal and Other Investigation Costs.*Special legal and otherinvestigation costs of $25.1 million were accrued in the year ended December 31,2004 for our estimated legal and other investigation costs associated with theDOJ investigation of us, the inquiry initiated by the SEC into the allegationsbeing investigated by the DOJ, and the securities class action, shareholderderivative and books and records inspection lawsuits filed against us, certainof our current and former executive officers and each of our Directors(collectively, the “Actions”).  Weincurred $20.7 million of this accrual and $4.4 million of other non-legalinvestigation costs associated with the Actions during the year ended December 31,2004. See Note 2 of the Notes to Consolidated Financial Statements set forthelsewhere in this report.

 

*OperatingIncome.*Operating income increased $25.0 million, or 26.5%,to $119.5 million in 2004 from $94.5 million in 2003.  The operating margin increased to 19.4% ofrevenue in 2004 from 18.1% in 2003, primarily due to:

 

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•                  continued facility and facultyutilization efficiencies;

•                  new and renegotiated vendorcontracts;

•                  a net reduction of occupancy costsresulting from our purchase of six facilities in 2003 and one facility in 2004that replaced facilities which we previously leased; and

•                  certain fixed costs at our institutesthat did not increase proportionately with increases in our revenue resultingfrom increased student enrollment and tuition rate increases.

 

The increase in operatingmargin was partially offset by the $25.1 million accrual for special legal andother investigation costs associated with the Actions.

 

*IncomeTaxes.*Our combined effective federal and state income taxrate in both 2004 and 2003 was 39.0%.

 

**YearEnded December 31, 2003 Compared with Year Ended December 31, 2002**

 

*Revenue.*Revenueincreased $68.8 million, or 15.1%, to $522.9 million for the year ended December 31,2003 from $454.1 million for the year ended December 31, 2002, primarilydue to:

 

•                  a 5.0% increase in tuition rates in March 2003;

•                  a 6.0% increase in the total studentenrollment at December 31, 2002 compared to December 31, 2001; and

•                  a 16.6% increase in total new studentenrollment at our institutes in 2003 compared to 2002, which is primarily aresult of opening new institutes, an increased number of responses to ourmarketing and advertising, and operational changes that increased thepercentage of new student enrollments arising from those responses.

 

*Cost ofEducational Services.*Cost of educational services increased$23.3 million, or 9.1%, to $280.0 million in 2003 from $256.7 million in 2002.The principal causes of this increase included:

 

•                  the costs required to service theincreased enrollment;

•                  normal inflationary cost increasesfor wages, rent and other costs of services; and

•                  increased costs due to opening newinstitutes (one opened in June 2002, three opened in September 2002,one opened in March 2003, one opened in June 2003 and one opened in December 2003).

 

Costof educational services as a percentage of revenue decreased to 53.5% in 2003from 56.5% in 2002.  The primary causesof this decrease include:

 

•                  continued facility and facultyutilization efficiencies;

•                  certain fixed costs at our institutesthat did not increase proportionately with increases in our revenue resultingfrom increased student enrollment;

•                  new and renegotiated vendorcontracts;

•                  a net reduction of occupancy costsresulting from our purchase of 12 facilities that replaced facilities which wehad previously leased (six were purchased during the three months ended September 30,2002 and six were purchased during the year ended December 31, 2003); and

•                  changes in Indiana tax law thatcaused the classification of certain Indiana taxes to be changed from cost ofeducational services to income taxes.

 

*StudentServices and Administrative Expenses.*Student services andadministrative expenses increased $19.2 million, or 14.9%, to $148.3 million in2003 from $129.1 million in 2002. Student services and administrative expenses decreased to 28.4% ofrevenue in 2003 compared to 28.5% of revenue in 2002, primarily due to a 17.1%increase in media advertising expenses offset by a reduction in bad debtexpense from 1.5% of revenue for 2002 to 1.2% of revenue for 2003.

 

*OperatingIncome.* Operatingincome increased $26.2 million, or 38.4%, to $94.5 million in 2003 from $68.3million in 2002.  The operating marginincreased to 18.1% of revenue in 2003 from 15.0% in 2002, primarily due to:

 

•                  continued facility and facultyutilization efficiencies;

•                  new and renegotiated vendorcontracts;

 

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•                  a net reduction of occupancy costsresulting from our purchase of 12 facilities that replaced facilities which wehad previously leased (six were purchased during the three months ended September 30,2002 and six were purchased during the year ended December 31, 2003);

•                  a reduction in bad debt expense; and

•                  changes in Indiana tax law that causedthe classification of certain Indiana taxes to be changed from cost ofeducational services to income taxes.

 

*IncomeTaxes.*Our combined effective federal and state income taxrate in 2003 was 39.0% compared to 38.2% in 2002, primarily due to changes inIndiana and other state tax laws.

 

**Liquidityand Capital Resources**

 

In2004, we indirectly derived approximately 66% of our revenue, determined on acash accounting basis as defined by the ED’s regulations, from Title IVPrograms. Federal regulations dictate the timing of disbursements of fundsunder Title IV Programs. Students must apply for a new loan for each academicyear, which consists of three academic quarters. Loan funds are generallyprovided by lenders in three disbursements for each academic year. The firstdisbursement is usually received either 30 days after (in the case of studentscommencing a program of study) or ten days before the start of the firstacademic quarter of a student’s academic year, and the second and thirddisbursements are typically received ten days before the start of eachsubsequent quarter of a student’s academic year. While the timing of loandisbursements to us is subject to a student’s directions to the lender and toexisting regulatory requirements regarding such disbursements, we havetypically received student loan funds upon the lender’s disbursement of thestudent loan funds.

 

On May10, 2002, we declared a two-for-one split of our common stock, effected on June 6,2002 by payment of a stock dividend to all shareholders of record at the closeof business on May 28, 2002 of one share on each one share of our common stockissued and outstanding or held as treasury stock on May 28, 2002 (“Stock Split”).  Our earnings per share amounts and the numberof shares in all prior periods have been restated to reflect the Stock Split.

 

On January 25,2005, our Board of Directors approved an amendment to our Restated Certificateof Incorporation to increase the number of authorized shares of our commonstock from 150 million to 300 million (“Amendment”). If the Amendment isapproved by our shareholders at our 2005 annual meeting of shareholders, itwill become effective upon the filing of a Certificate of Amendment with theDelaware Secretary of State.

 

OurBoard of Directors has authorized us to repurchase outstanding shares of ourcommon stock in the open market or through privately negotiated transactions inaccordance with Rule 10b-18 of the Exchange Act.

 

Thefollowing table sets forth the repurchase of outstanding shares of our commonstock during 2004, 2003 and 2002:

 
| ** **                                     | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|
| ** **                                     | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Number of shares repurchased                   |       | —                           |       | 1,078,000 |   | 2,174,300 |   |
| Total cost of shares repurchased (in millions) |       | $                                | —     |   | $ | 28.7 |   | $ | 44.5 |   |
| Average cost per share                         |       | $                                | —     |   | $ | 26.65 |   | $ | 20.44 |   |

 

All ofthe repurchased shares of our common stock became treasury shares uponrepurchase and most of the repurchased shares continue to be held as treasuryshares.  As of December 31, 2004,our existing repurchase authorization permits us to repurchase an additional4,216,300 shares of our common stock.  Wemay elect to repurchase additional shares of our common stock from time to timein the future, depending on market conditions and other considerations.  The purpose of the stock repurchase programis to help us achieve our long-term goal of enhancing shareholder value.

 

Ourprincipal uses of cash are to pay salaries, occupancy and equipment costs,recruiting and marketing expenses, administrative expenses and taxes, includinginstitute start-up costs for new institutes. We have generated positive cash flows from operations for the past fiveyears. Cash flows from operations in 2004 were $136.2 million, a decrease of$16.0 million from $152.2 million in 2003. This decrease was primarily a result of a large initial increase in cashflows from operations realized in 2003 following the implementation of new cashmanagement strategies, and amounts paid in connection with the Actions. As ofDecember 31, 2004, we had $28.4 million of investments that we plan to holduntil maturity. The maturity dates extend beyond one year for $5.4 million ofthose held-to-maturity investments.  Asof December 31, 2004, we had $310.6 million of investments in auction rate debtsecurities, variable rate demand notes and auction rate preferred equitysecurities that were available for sale. Although the contractual maturity dates for some of our auction rate debtsecurities and variable rate demand notes extend beyond ten years, we have theability to quickly liquidate those investments and we do not intend to holdthose investments until they mature. Cash and cash equivalents, restrictedcash, and investments ranged from a low of $183.7 million in February 2004 to ahigh of $370.3 million in November 2004.

 

Ourinvestments in marketable debt securities with remaining contractual maturitydates of 90 days or less are recorded in cash and cash equivalents at cost,which approximates fair market value.  Wehave investments in marketable debt and auction rate preferred equitysecurities, which are classified as trading, available-for-sale orheld-to-maturity, depending on our investment intentions with regard to thosesecurities.  Marketable debt securitiesclassified as trading or available-for-sale securities that have remainingcontractual maturity dates in excess of 90 days at the time of purchase arerecorded at their market value. Marketable debt securities classified asheld-to-maturity securities are recorded at their amortized cost, because wehave the intent and ability to hold those investments until they mature.  Auction rate preferred equity securitiesclassified as available-for-sale securities are recorded at their marketvalue.  Investments that we intend tohold for more than one year are recorded as non-current investments.

 

Ourinvestments included auction rate debt securities, variable rate demand notesand auction rate preferred equity securities that were classified asavailable-for-sale securities and recorded in short-term investments and investmentson our Consolidated Balance Sheets as of December 31, 2004 and 2003.  Despite the long-term nature of thecontractual maturities of our auction rate debt securities and variable ratedemand notes, we have the ability to quickly liquidate those investments.  We also had no material gross unrealizedholding or realized gains (losses) from our investments in auction rate debt securitiesand variable rate demand notes for the years ending December 31, 2004, 2003 and2002.  All income generated from thoseinvestments was recorded as interest income.

 

Previously,some of our investments in auction rate debt securities and variable ratedemand notes were recorded in cash and cash equivalents instead of short-terminvestments, based on their interest reset dates rather than their remainingcontractual maturity dates.  In addition,we had classified some of our investments in auction rate debt securities,variable rate demand notes and auction rate preferred equity securities asheld-to-maturity securities.  Inconnection with the preparation of this report, we reassessed theclassification and recording of our investments in auction rate debt securities,variable rate demand notes and auction rate preferred equity securities, and wedetermined that it was appropriate to:

 

•      reclassify as available-for-salesecurities all of our auction rate debt securities, variable rate demand notesand auction rate preferred equity securities;

•      record on our Consolidated Balance Sheetsas of December 31, 2004 and 2003 all of our investments in auction rate debt securitiesand variable rate demand notes with remaining contractual maturities of:

•      90 days or less in cash and cashequivalents; and

•      greater than 90 days in either short-terminvestments or investments, based on our intent and ability to hold thoseauction rate debt securities and variable rate demand notes; and

•      record all of our investments in auctionrate preferred equity securities in short-term investments on our ConsolidatedBalance Sheets as of December 31, 2004 and 2003.

 

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The reclassifications hadno impact on our total current assets, cash flows provided by (used for)operating activities, cash flows provided by (used for) financing activities ortotal consolidated results reported in any period presented.

 

On December 31,2004, we had positive working capital of $139.7 million.  Deferred revenue, which represents the cashreceived from students in excess of tuition earned, increased $26.4 million to$156.8 million on December 31, 2004 from $130.4 million on December 31,2003.  This increase was primarily due tothe students’ use of supplemental private loans and increased tuition revenueresulting from higher tuition rates and increased enrollment.

 

During2002, we recorded a $5.0 million minimum pension liability adjustment withrespect to our obligations under the ESI Pension Plan and a corresponding $3.1million reduction in shareholders’ equity, which is net of a $1.9 milliondeferred tax asset.  During 2003, wereduced our minimum pension liability by $1.0 million as a result of obtainingan investment return on plan assets in excess of our original estimates, and werecorded a corresponding $0.6 million increase in shareholders’ equity, whichis net of a $0.4 million deferred tax asset. During 2004, we increased ourminimum pension liability by $2.1 million as a result of:

 

•                  obtaining an investment return onplan assets less than our original estimate;

•                  a decrease in our discount rate; and

•                  refinements made to our futureexpected benefit payment assumptions.

 

We also recorded acorresponding $1.3 million reduction in shareholders’ equity, which was net ofa $0.8 million deferred tax asset.

 

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Underthe HEA, an institution may lose its eligibility to participate in some or allTitle IV Programs, if the rates at which the institution’s students default ontheir federal student loans exceed specified percentages.  An institution whose FFEL/FDL cohort defaultrate is: (a) 25% or greater for three consecutive federal fiscal years loseseligibility to participate in the FFEL, FDL and Pell programs for the remainderof the federal fiscal year in which the ED determines that the institution haslost its eligibility and for the two subsequent federal fiscal years; or (b)greater than 40% for one federal fiscal year loses eligibility to participatein the FFEL and FDL programs for the remainder of the federal fiscal year inwhich the ED determines that the institution has lost its eligibility and forthe two subsequent federal fiscal years. If one of the campus groups lost its eligibility to participate in TitleIV Programs and we could not arrange for alternative financing sources onsimilar terms for the students (and their parents) attending an institute inthat campus group, the students’ ability to finance their education would beadversely affected, our receivables would increase and the number of studentsattending that campus group would probably decrease, which could have amaterial adverse effect on our financial condition, results of operations andcash flows.  Our campus groups’ FFEL/FDLcohort default rates ranged from:

 

•                  4.5% to 17.5% in the 2000 federalfiscal year;

•                  4.9% to 12.7% in the 2001 federalfiscal year; and

•                  2.1% to 12.1% in the 2002 federalfiscal year, the most recent year for which the ED has published FFEL/FDLofficial cohort rates.

 

If an institution’sFFEL/FDL cohort default rate is 25% or greater in any of the three most recentfederal fiscal years, or if its cohort default rate for loans under the Perkinsprogram exceeds 15% for any federal award year, the ED may place thatinstitution on provisional certification status.  The ED may withdraw an institution’sprovisional certification without advance notice, if the ED determines that theinstitution is not fulfilling all material requirements.  The ED may also more closely review aninstitution that is provisionally certified, if it applies for approval to opena new location or makes some other significant change affecting itseligibility.  Provisional certificationdoes not otherwise limit an institution’s access to Title IV Programfunds.  Provisional certification of ourinstitutes has not had a material adverse effect on our financial condition,results of operations or cash flows, and we do not believe that it will in thefuture.

 

Thestandards of most of the state education authorities that regulate ourinstitutes and the Accrediting Council for Independent Colleges and Schoolsthat accredits our institutes limit how much of a student’s tuition and fees aninstitution can retain for a student who withdraws from the institution.  The HEA and its implementing regulationsimpose limits on the amount of Title IV Program funds withdrawing students canuse to pay their education costs (“Return Policy”).  The Return Policy permits a student to useonly a pro rata portion of the Title IV Program funds that the student wouldotherwise be eligible to use, if the student withdraws during the first 60% ofany period of enrollment. The institution must return to the appropriatelenders or the ED any Title IV Program funds that the institution receives onbehalf of a withdrawing student in excess of the amount the student can use forsuch period of enrollment.  Depending onwhen a student withdraws during an academic quarter, the Return Policy canreduce the amount of Title IV Program funds that the withdrawing student canuse to pay his or her education costs owed to the ITT Technical Institute.  In these instances, withdrawing students maybe unable to pay all of their education costs that would have been paid by theTitle IV Program funds that were returned and we may be unable to collect asignificant portion of those costs.  Ourstudents’ use of supplemental private loans has improved our collection of thestudents’ education costs.

 

Undera provision of the HEA commonly referred to as the “90/10” Rule, a for-profitinstitution, such as each of our campus groups, becomes ineligible to participatein Title IV Programs if, on a cash accounting basis, the institution derivesmore than 90% of its applicable revenue for a fiscal year from Title IVPrograms.  For our 2004 fiscal year, therange of our campus groups was from approximately 58% to approximately 75%.

 

In2003, we purchased the facilities of five of our institutes and our corporateheadquarters for a total of $25.7 million. In 2004, we purchased a facility forone of our institutes for $3.8 million. We previously leased these facilities under operating lease agreements.In addition, we purchased four parcels of land in 2004 for $4.9 million onwhich we have commenced construction of facilities. During 2004, we spent $7.7million on the construction of facilities for four of our institutes. We haveagreed to construct four facilities and purchase two existing facilities forour institutes at a cost of $19.5 million, all of which is expected to beincurred in 2005. We may purchase or build additional facilities for ourinstitutes in 2005.

 

Ourcapital assets, other than our facilities discussed above, consist primarily ofclassroom and laboratory equipment (such as computers, electronic equipment androbotic systems), classroom and office furniture, software and leaseholdimprovements.  Capital expenditures,excluding facility and land purchases and facility construction, totaled

 

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$19.1 million in 2004 and$14.4 million during 2003. To date, cash generated from operations has beensufficient to meet our capital expenditures.

 

Weplan to continue to upgrade and expand current facilities and equipment. Weexpect that 2005 capital expenditures, excluding facility and land purchasesand facility construction, will be approximately $20 to $25 million. Thecapital additions are approximately $0.6 million for a new institute and $0.1million for a new learning site.  Weanticipate that our planned capital additions can be funded from cash flowsfrom operations. Cash flows on a long-term basis are highly dependent upon thereceipt of Title IV Program funds and the amount of funds spent on newinstitutes, new learning sites, curricula additions at existing institutes andpossible acquisitions.

 

We donot believe that any reduction in cash and cash equivalents or investments thatmay result from their use to effect any future stock repurchases, facilitypurchases or construction of facilities will have a material adverse effect on:

 

•                  our expansion plans;

•                  planned capital expenditures;

•                  ability to meet any applicableregulatory financial responsibility standards; or

•                  ability to conduct normal operations.

 

**Contractual Obligations**

 

The following table setsforth the specified contractual obligations as of December 31, 2004.

 
| **Contractual Obligations** | ** ** | **Total**                  | ** ** | **Less than  1 Year** | ** ** | **1-3  Years** | ** ** | **4-5  Years** | ** ** | **More than  5 Years** | ** ** |
|-----------------------------|------------|----------------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|------------------------|------------|
| ** **                  | ** ** | **(Dollars in thousands)** | ** ** |
| Operating Lease Obligations |       | $                          | 129,249    |                  | $          | 26,436         |       | $              | 44,102     |                   | $          | 33,822 |   | $ | 24,889 |   |
| Purchase Obligations        |       | 4,709                      |       | 4,709                 | (a)        | —         |       | —         |       | —                 |       |
| Total                       |       | $                          | 133,958    |                  | $          | 31,145         |       | $              | 44,102     |                   | $          | 33,822 |   | $ | 24,889 |   |

 

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(a) Represents the cost to purchase one facility thatwas consummated in January 2005.  Itdoes not include agreements to purchase one existing facility for a cost of$7,500 or to continue constructing buildings for four other facilities at atotal cost not to exceed $7,250. These agreements do not constitute purchaseobligations as defined by SFAS No. 47, “Disclosure of Long Term Obligations.”We expect to incur these costs in 2005.

 

**Off-Balance Sheet Arrangements**

** **

As of December 31,2004, we leased our non-owned facilities under operating lease agreements.  A majority of the operating leases containrenewal options that can be exercised after the initial lease term.  Renewal options are generally for periods ofone to five years.  All operating leaseswill expire over the next 12 years and management expects that:

 

•                  those leases will be renewed orreplaced by other leases in the normal course of business;

•                  we may purchase the facilitiesrepresented by those leases; or

•                  we may purchase or build otherreplacement facilities.

 

There are no materialrestrictions imposed by the lease agreements, and we have not entered into anysignificant guarantees related to the leases. We are required to make additional payments under the operating leaseterms for taxes, insurance and other operating expenses incurred during theoperating lease period.

 

Aspart of our normal course of operations, one of our insurers issues suretybonds for us that are required by various education authorities that regulateus. We are obligated to reimburse our insurer for any of those surety bondsthat are paid by the insurer.  As of December 31,2004, the total face amount of those surety bonds was $9.3 million. We havealso provided a $7.0 million irrevocable standby letter of credit to ourinsurer to secure our obligations under those surety bonds. The letter ofcredit is collateralized by our investments. In addition, we have provided a $2.1 million irrevocable letter ofcredit to our workers’ compensation insurance providers to secure payment ofour workers’ compensation claims.

 

43

----

 

From1994 through 1999, we entered into agreements with unaffiliated, privatefunding sources to provide supplemental loans to students to help pay thestudents’ cost of education that federal and state financial aid sources didnot cover.  Some of these agreementsrequired us to guarantee repayment of the supplemental student loans if thestudents fail to pay. The outstanding loans under these agreements at December 31,2004 aggregated $976,000, for which we have reserved $944,000 for our guaranteeobligation.

 

Certainof our current and former officers and Directors are or may become a party incertain of the Actions. Our By-Laws and Restated Certificate of Incorporationobligate us to indemnify our officers and Directors to the fullest extentpermitted by Delaware law, provided that their conduct complied with certainrequirements. We are obligated to advance defense costs to our officers andDirectors, subject to the individual’s obligation to repay such amount if it isultimately determined that the individual was not entitled to indemnification.In addition, our indemnity obligation can, under certain circumstances, includeindemnifiable judgments, penalties, fines and amounts paid in settlement inconnection with the Actions.

 

Exceptfor the operating lease agreements, the surety bonds, the standby letters ofcredit, the guarantees and the indemnification of our officers and Directorsdisclosed above, we do not have any off-balance sheet arrangements.

 

**Item 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

Our investments in marketabledebt securities with remaining contractual maturity dates of 90 days or lessare recorded in cash and cash equivalents at cost, which approximates marketvalue.  We have investments in marketabledebt and auction rate preferred equity securities, which are classified astrading, available-for-sale or held-to-maturity, depending on our investmentintentions with regard to those securities. Marketable debt securities classified as trading or available-for-salesecurities that have remaining contractual maturity dates in excess of 90 daysat the time of purchase are recorded at their market value.  Marketable debt securities classified asheld-to-maturity securities are recorded at their amortized cost, because wehave the intent and ability to hold those investments until they mature.  Auction rate preferred equity securitiesclassified as available-for-sale securities are recorded at their marketvalue.  Investments that we intend tohold for more than one year are recorded as non-current investments.

 

Weestimate that the market risk associated with our investments in marketabledebt and auction rate preferred equity securities can best be measured by apotential decrease in the fair value of these securities resulting from ahypothetical 10% increase in interest rates. If such a hypothetical increase inrates were to occur, the reduction in the market value of our portfolio of marketabledebt and auction rate preferred equity securities would not be material.

 

**Item 8.  FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA.**

 

The information required by this Item appears on pagesF-1 through F-28 of this Annual Report.

 

**Item 9.  CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.**

 

Not applicable .

 

**Item 9A.  CONTROLS AND PROCEDURES.**

 

**DisclosureControls and Procedures**

 

We areresponsible for establishing and maintaining a set of disclosure controls andprocedures (“DCP”) that are designed to ensure that information required to bedisclosed by us in the reports filed or submitted by us under the Exchange Actis: (a) recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms; and (b) accumulated and communicated toour management, including our principal executive and principal financialofficers, to allow timely decisions regarding required disclosures.  As of December 31, 2004, we conducted anevaluation of the effectiveness of the design and operation of our DCP pursuantto Rule 13a-15 of the Exchange Act. Based on that evaluation, our management concluded that our DCP wereeffective as of December 31, 2004.

 

44

----

 

**InternalControl Over Financial Reporting**

 

Ourmanagement’s report on internal control over financial reporting appears onpage F-1 of this Annual Report and is incorporated herein by reference.

 

Ourmanagement’s assessment of the effectiveness of our internal control over ourfinancial reporting, as defined in Rules 13a-15(f) and 15d-15(f) of theExchange Act, (“ICFR”) as of December 31, 2004 has been audited byPricewaterhouseCoopers LLP, our independent registered public accounting firm,as stated in its report dated March 14, 2005, which appears beginning on pageF-2 of this Annual Report and is incorporated herein by reference.

 

Therewere no changes in our ICFR during our fourth fiscal quarter of 2004 thatmaterially affected or are reasonably likely to materially affect our ICFR.

 

**Item 9B.  OTHER INFORMATION.**

 

Not applicable.

 

**PART III**

** **

**Item 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT.**

 

Theinformation required by this Item concerning our directors, nominees fordirector, executive officers, audit committee members and financial expert,code of ethics and disclosure of delinquent filers is incorporated herein byreference to our definitive Proxy Statement for our 2005 Annual Meeting ofShareholders, to be filed with the SEC pursuant to Regulation 14A within 120days after the end of our last fiscal year.

 

**Item 11.  EXECUTIVE COMPENSATION.**

 

The information required by this Item concerningremuneration of our officers and directors and information concerning materialtransactions involving such officers and directors is incorporated herein byreference to our definitive Proxy Statement for our 2005 Annual Meeting ofShareholders which will be filed with the SEC pursuant to Regulation 14A within120 days after the end of our last fiscal year.

 

##### **Item12.  SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS.**

##### ** **

The information required by this Item concerning thestock ownership of management, five percent beneficial owners and securitiesauthorized for issuance under equity compensation plans is incorporated hereinby reference to our definitive Proxy Statement for our 2005 Annual Meeting ofShareholders which will be filed with the SEC pursuant to Regulation 14A within120 days after the end of our last fiscal year.

 

**Item 13.  CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS.**

 

The information required by this Item concerningcertain relationships and related transactions is incorporated herein by referenceto our definitive Proxy Statement for our 2005 Annual Meeting of Shareholderswhich will be filed with the SEC pursuant to Regulation 14A within 120 daysafter the end of our last fiscal year.

 

**Item14.  PRINCIPAL ACCOUNTANT FEES ANDSERVICES.**

 

The informationrequired by this Item concerning the fees and services of our independentregistered public accounting firm and our Audit Committee actions with respectthereto is incorporated herein by reference to our definitive Proxy Statementfor our 2005 Annual Meeting of Shareholders which will be filed with the SECpursuant to Regulation 14A within 120 days after the end of our last fiscalyear.

 

45

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**PART IV**

 

**Item 15.  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.**

 
| (a) | 1. | Financial Statements: |
|-----|----|-----------------------|

 
| Management’s  Report on Internal Control Over Financial Reporting                                                                         |   |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Report  of Independent Registered Public Accounting Firm                                                                                       |   |
| Consolidated Balance Sheets  as of December 31, 2004 and December 31, 2003                                                           |   |
| Consolidated  Statements of Income for the years ended December 31, 2004, December 31,  2003 and December 31, 2002              |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004, December 31,  2003 and December 31, 2002          |   |
| Consolidated  Statements of Shareholders’ Equity for the years ended December31, 2004, December 31,  2003 and December 31, 2002 |   |
| Notes to  Consolidated Financial Statements                                                                                                    |   |

 
|   | 2.                                                                                                                         | Financial Statement Schedules:                                                                                           |
|--------|----------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                       |                                                                                                                     |
|   |                                                                                                                       | Schedule II – Valuation and Qualifying Accounts of the Company  for the years ended December 31, 2004,    |
|   | December 31, 2003 and December 31, 2002 appear on page F-27  of this Annual Report.                              |
|   |                                                                                                                       |
|   | 3.                                                                                                                         | Quarterly Results for 2004 and 2003 (unaudited) appear on page F-28  of this Annual Report.                              |
|   |                                                                                                                       |                                                                                                                     |
|   | 4.                                                                                                                         | Exhibits:                                                                                                                |
|   |                                                                                                                       |                                                                                                                     |
|   |                                                                                                                       | A list of exhibits required to be filed as part of this report is set  forth in the Index to Exhibits appearing on pages |
|   | S-2 through S-5 of this Annual Report, which immediately precedes  such exhibits, and is incorporated herein by reference. |

 

46

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**Management’sReport on Internal Control****OverFinancial Reporting**

 

We areresponsible for establishing and maintaining adequate internal control over ourfinancial reporting, as defined in Rules 13a-15(f) and 15d-15(f) of theExchange Act (“ICFR”).  Our ICFR is aprocess designed to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles andincludes those policies and procedures that:

 

•                  pertain to the maintenance of ourrecords that in reasonable detail accurately and fairly reflect ourtransactions and asset dispositions;

•                  provide reasonable assurance that ourtransactions are recorded as necessary to permit the preparation of ourfinancial statements in accordance with generally accepted accountingprinciples;

•                  provide reasonable assurance that ourreceipts and expenditures are being made only in accordance with authorizationsof our management and Board of Directors (as appropriate); and

•                  provide reasonable assuranceregarding the prevention or timely detection of any unauthorized acquisition,use or disposition of our assets that could have a material effect on ourfinancial statements.

 

Due to its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements.  In addition,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

 

Underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we assessed theeffectiveness of our ICFR as of December 31, 2004.  In making this assessment, our managementused the criteria for *InternalControl-Integrated Framework* set forth by The Committee ofSponsoring Organizations of the Treadway Commission.  Based on our assessment using these criteria,our management concluded that we maintained effective ICFR as of December 31,2004.

 

Ourmanagement’s assessment of the effectiveness of our ICFR as of December 31,2004 has been audited by PricewaterhouseCoopers LLP, our independent registeredpublic accounting firm, as stated in its accompanying report.

 

#### **ITTEducational Services, Inc.**

Carmel, Indiana

##### **March 14, 2005**

 

F-1

----

 

**Report ofIndependent Registered Public****AccountingFirm**

 

To the Board of Directorsand Shareholders

of ITT EducationalServices, Inc.:

 

We have completed an integrated audit of ITTEducational Services, Inc.’s 2004 consolidated financial statements and of itsinternal control over financial reporting as of December 31, 2004and audits of its 2003 and 2002 consolidatedfinancial statements in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Our opinions, based on ouraudits, are presented below.

 

Consolidated financial statements and financialstatement schedule

 

In our opinion, the consolidated financial statements listed in theindex appearing in Item 15(a)(1) present fairly, in all material respects, thefinancial position of ITT Educational Services, Inc. and its subsidiaries (theCompany) at December 31, 2004 and 2003, and the results of their operations andtheir cash flows for each of the three years in the period ended December 31,2004 in conformity with accounting principles generally accepted in the UnitedStates of America.  In addition, in ouropinion, the financial statement schedule listed in the index appearing inItem15(a)(2) presents fairly, in all material respects, the information setforth therein when read in conjunction with the related consolidated financialstatements.  These financial statementsand financial statement schedule are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these financial statements and financial statementschedule based on our audits.  Weconducted our audits of these statements in accordance with the standards ofthe Public Company Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit of financial statements includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements,assessing the accounting principles used and significant estimates made bymanagement, and evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

Internal control over financial reporting

 

Also, in our opinion, management’sassessment, included in Management’s Report on Internal Control Over FinancialReporting appearing under Item 9A, that the Company maintained effectiveinternal control over financial reporting as of December 31, 2004based on criteria established in *Internal Control - Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO), isfairly stated, in all material respects, based on those criteria. Furthermore,in our opinion, the Company maintained, in all material respects, effectiveinternal control over financial reporting as of December 31, 2004, basedon criteria established in *Internal Control -Integrated Framework* issued by the COSO.  The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financialreporting.  Our responsibility is toexpress opinions on management’s assessment and on the effectiveness ofthe Company’s internal control over financial reporting based on our audit. Weconducted our audit of internal control over financial reporting in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects.  An audit of internalcontrol over financial reporting includes obtaining an understanding ofinternal control over financial reporting, evaluating management’s assessment,testing and evaluating the design and operating effectiveness of internalcontrol, and performing such other procedures as we consider necessary in thecircumstances.  We believe that our auditprovides a reasonable basis for our opinions.

 

Acompany’s internal control over financial reporting is a process designed toprovide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordancewith generally accepted accounting principles. A company’s internal control over financial reporting includes thosepolicies and procedures that (i) pertain to the maintenance of recordsthat, in reasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that

 

F-2

----

 

transactionsare recorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and(iii) provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use, or disposition of the company’sassets that could have a material effect on the financial statements.

 

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements.  Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

 

 
| /s/ PricewaterhouseCoopers LLP  |   |
|---------------------------------|--------|
| **PricewaterhouseCoopers  LLP** |
| Indianapolis, Indiana           |
| **March 14, 2005**         |

 

F-3

----

 

**ITTEDUCATIONAL SERVICES, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(Inthousands, except per share data)**

 
| ** **                                                                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                      | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Assets**                                                                                      |       |                  |       |   |   |
| Current assets                                                                                  |       |                  |       |   |   |
| Cash and cash equivalents                                                                       |       | $                     | 9,389      |   | $ | 43,042 |   |
| Restricted cash                                                                                 |       | 8,194                 |       | 8,496 |   |
| Short-term investments                                                                          |       | 332,570               |       | 189,169 |   |
| Accounts receivable, less allowance for doubtful  accounts of $1,518 and $1,644                 |       | 10,430                |       | 9,398 |   |
| Deferred and prepaid income tax                                                                 |       | 6,587                 |       | 2,906 |   |
| Prepaids and other current assets                                                               |       | 5,611                 |       | 3,635 |   |
| Total current assets                                                                            |       | 372,781               |       | 256,646 |   |
| Property and equipment, net                                                                     |       | 98,746                |       | 81,503 |   |
| Direct marketing costs                                                                          |       | 14,713                |       | 10,844 |   |
| Investments                                                                                     |       | 6,363                 |       | 13,467 |   |
| Other assets                                                                                    |       | 786                   |       | 810 |   |
| Total assets                                                                                    |       | $                     | 493,389    |   | $ | 363,270 |   |
|                                                                                            |       |                  |       |   |   |
| **Liabilities and Shareholders’ Equity**                                                   |       |                  |       |   |   |
| Current liabilities                                                                             |       |                  |       |   |   |
| Accounts payable                                                                                |       | $                     | 33,769     |   | $ | 36,543 |   |
| Accrued compensation and benefits                                                               |       | 16,122                |       | 16,986 |   |
| Other accrued liabilities                                                                       |       | 26,418                |       | 18,444 |   |
| Deferred revenue                                                                                |       | 156,792               |       | 130,364 |   |
| Total current liabilities                                                                       |       | 233,101               |       | 202,337 |   |
| Deferred income tax                                                                             |       | 12,842                |       | 4,691 |   |
| Minimum pension liability                                                                       |       | 9,101                 |       | 7,012 |   |
| Other liabilities                                                                               |       | 3,271                 |       | 3,106 |   |
| Total liabilities                                                                               |       | 258,315               |       | 217,146 |   |
|                                                                                            |       |                  |       |   |   |
| Commitments and contingent liabilities (Note 10)                                                |       |                  |       |   |   |
|                                                                                            |       |                  |       |   |   |
| Shareholders’ equity                                                                       |       |                  |       |   |   |
| Preferred stock, $.01 par value, 5,000,000 shares  authorized, none issued or outstanding       |       | —                |       | — |   |
| Common stock, $.01 par value, 150,000,000 shares  authorized, 54,068,904 issued and outstanding |       | 540                   |       | 540 |   |
| Capital surplus                                                                                 |       | 59,657                |       | 52,688 |   |
| Retained earnings                                                                               |       | 293,910               |       | 221,400 |   |
| Accumulated other comprehensive income (loss)                                                   |       | (5,532                | )          | (4,263 | ) |
| Treasury stock, 8,074,919 and 8,638,535 shares, at  cost                                        |       | (113,501              | )          | (124,241 | ) |
| Total shareholders’ equity                                                                 |       | 235,074               |       | 146,124 |   |
| Total liabilities and shareholders’ equity                                                 |       | $                     | 493,389    |   | $ | 363,270 |   |

 

The accompanying notesare an integral part of these financial statements.

 

F-4

----

 

**ITTEDUCATIONAL SERVICES, INC.**

**CONSOLIDATEDSTATEMENTS OF INCOME**

**(Inthousands, except per share data)**

 
| ** **                                   | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|
| ** **                                   | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                         |       |                             |       |   |   |   |   |
| **Revenue**                                  |       | $                                | 617,834    |   | $ | 522,856 |   | $ | 454,118 |   |
|                                         |       |                             |       |   |   |   |   |
| **Costs and Expenses**                       |       |                             |       |   |   |   |   |
| Cost of educational services                 |       | 298,747                          |       | 280,006 |   | 256,675 |   |
| Student services and administrative expenses |       | 174,396                          |       | 148,329 |   | 129,134 |   |
| Special legal and other investigation costs  |       | 25,143                           |       | — |   | — |   |
| Total costs and expenses                     |       | 498,286                          |       | 428,335 |   | 385,809 |   |
|                                         |       |                             |       |   |   |   |   |
| Operating income                             |       | 119,548                          |       | 94,521 |   | 68,309 |   |
|                                         |       |                             |       |   |   |   |   |
| Interest income, net                         |       | 3,834                            |       | 1,995 |   | 2,684 |   |
|                                         |       |                             |       |   |   |   |   |
| Income before income taxes                   |       | 123,382                          |       | 96,516 |   | 70,993 |   |
|                                         |       |                             |       |   |   |   |   |
| Income taxes                                 |       | 48,119                           |       | 37,658 |   | 27,139 |   |
|                                         |       |                             |       |   |   |   |   |
| Net income                                   |       | $                                | 75,263     |   | $ | 58,858 |   | $ | 43,854 |   |
|                                         |       |                             |       |   |   |   |   |
| Earnings per common share (basic)            |       | $                                | 1.64       |   | $ | 1.31 |   | $ | 0.96 |   |
|                                         |       |                             |       |   |   |   |   |
| Earnings per common share (diluted)          |       | $                                | 1.61       |   | $ | 1.27 |   | $ | 0.94 |   |

 

The accompanying notes are an integral part of thesefinancial statements.

 

F-5

----

 

**ITTEDUCATIONAL SERVICES, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Inthousands)**

 
| ** **                                                                                     | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                     | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Cash flows provided by (used for) operating  activities:                                       |       |                             |       |   |   |   |   |
| Net income                                                                                     |       | $                                | 75,263     |   | $ | 58,858 |   | $ | 43,854 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:             |       |                             |       |   |   |   |   |
| Depreciation and amortization                                                                  |       | 18,249                           |       | 21,190 |   | 21,117 |   |
| Provision for doubtful accounts                                                                |       | 11,996                           |       | 6,134 |   | 6,872 |   |
| Deferred taxes                                                                                 |       | 5,290                            |       | (2,835 | ) | 2,156 |   |
| Increase/decrease in operating assets and  liabilities:                                        |       |                             |       |   |   |   |   |
| Short-term investments                                                                         |       | 13,347                           |       | 12,197 |   | 15,397 |   |
| Accounts receivable                                                                            |       | (13,028                          | )          | (6,559 | ) | (3,166 | ) |
| Direct marketing costs                                                                         |       | (3,869                           | )          | (235 | ) | (89 | ) |
| Accounts payable and accrued liabilities                                                       |       | 4,501                            |       | 33,647 |   | 13,304 |   |
| Prepaids and other assets                                                                      |       | (1,952                           | )          | 2,400 |   | 1,541 |   |
| Deferred revenue                                                                               |       | 26,428                           |       | 27,367 |   | 25,845 |   |
| Net cash provided by (used for) operating activities                                           |       | 136,225                          |       | 152,164 |   | 126,831 |   |
|                                                                                           |       |                             |       |   |   |   |   |
| Cash flows provided by (used for) investing  activities:                                       |       |                             |       |   |   |   |   |
| Facility expenditures and land purchases                                                       |       | (16,376                          | )          | (25,718 | ) | (19,843 | ) |
| Capital expenditures, net                                                                      |       | (19,116                          | )          | (14,391 | ) | (14,265 | ) |
| Proceeds from sales and maturities of investments                                              |       | 1,128,172                        |       | 179,230 |   | — |   |
| Purchase of investments                                                                        |       | (1,277,816                       | )          | (368,392 | ) | — |   |
| Net cash provided by (used for) investing activities                                           |       | (185,136                         | )          | (229,271 | ) | (34,108 | ) |
|                                                                                           |       |                             |       |   |   |   |   |
| Cash flows provided by (used for) financing  activities:                                       |       |                             |       |   |   |   |   |
| Purchase of treasury stock                                                                     |       | —                           |       | (28,726 | ) | (44,451 | ) |
| Exercise of stock options                                                                      |       | 14,956                           |       | 26,334 |   | 13,601 |   |
| Net cash flow provided by (used for) financing  activities                                     |       | 14,956                           |       | (2,392 | ) | (30,850 | ) |
|                                                                                           |       |                             |       |   |   |   |   |
| Net increase (decrease) in cash, cash equivalents  and restricted cash                         |       | (33,955                          | )          | (79,499 | ) | 61,873 |   |
|                                                                                           |       |                             |       |   |   |   |   |
| Cash, cash equivalents and restricted cash at  beginning of period                             |       | 51,538                           |       | 131,037 |   | 69,164 |   |
|                                                                                           |       |                             |       |   |   |   |   |
| Cash, cash equivalents and restricted cash at end of  period                                   |       | $                                | 17,583     |   | $ | 51,538 |   | $ | 131,037 |   |
|                                                                                           |       |                             |       |   |   |   |   |
| Supplemental disclosures of cash flow information:                                             |       |                             |       |   |   |   |   |
| Cash paid during the period for:                                                               |       |                             |       |   |   |   |   |
| Income taxes                                                                                   |       | $                                | 34,965     |   | $ | 24,240 |   | $ | 17,328 |   |
| Non-cash financing activities:                                                                 |       |                             |       |   |   |   |   |
| Issuance of treasury stock for 2002 Bonus Parameters  and Directors Deferred Compensation Plan |       | $                                | —     |   | $ | 9 |   | $ | 883 |   |

 

The accompanying notesare an integral part of these financial statements.

 

F-6

----

 

**ITTEDUCATIONAL SERVICES, INC.**

**CONSOLIDATEDSTATEMENTS OF SHAREHOLDERS’****EQUITY**

**(Inthousands)**

 
| ** **                                                     | ** **       | ** ** | ** ** | **Capital  Surplus** | ** ** | **Retained  Earnings** | ** **         | **Compre-  hensive  Income** | ** **     | **Accumulated  Other  Compre-  hensive  Income (Loss)** | ** ** | ** ** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------|------------------|------------|------------|----------------------|------------|------------------------|--------------------|------------------------------|----------------|---------------------------------------------------------|------------|------------|------------|-----------|------------|
| ** **                                                     | ** **       | ** ** | ** ** | ** **           | ** ** | ** **             | ** **         | ** **                   | ** **     | ** **                                              | ** ** | ** ** | ** ** |
| ** **                                                     | **Common Stock** | ** ** | ** ** | ** **           | ** ** | ** **             | **Treasury Stock** | ** **                   | ** **     |
| ** **                                                     | **Shares (a)**   | ** ** | **Amount** | ** **           | ** ** | ** **             | ** **         | ** **                   | **Shares (a)** | ** **                                              | **Amount** | ** ** | ** ** |
| Balance as of December 31, 2001                           |             | 54,069     |       | $                    | 270        |                   | $                  | 37,355                       |           | $                                                       | 148,602    |       |       |      | $          | (1,837 | ) | (7,748 | ) | $ | (106,202 | ) | $ | 78,188 |   |
| Exercise of stock options                                      |             |       |       |                 |       |                   |               | (7,925                       | )              |                                                    |       |       |       | 885       |       | 18,218 |   | 10,293 |   |
| Tax benefit from exercise of stock options                     |             |       |       |                 |       | 3,308                  |               |                         |           |                                                    |       |       |       |      |       |   |   | 3,308 |   |
| Purchase of treasury stock                                     |             |       |       |                 |       |                   |               |                         |           |                                                    |       |       |       | (2,174    | )          | (44,451 | ) | (44,451 | ) |
| Issue treasury stock for 2002 Bonus Parameters                 |             |       |       |                 |       |                   |               | (122                         | )              |                                                    |       |       |       | 48        |       | 968 |   | 846 |   |
| Issue treasury stock for Directors Deferred  Compensation Plan |             |       |       |                 |       |                   |               |                         |           |                                                    |       |       |       | 3         |       | 37 |   | 37 |   |
| 2-for-1 stock split                                            |             |       |       | 270                  |       | (270                   | )                  |                         |           |                                                    |       |       |       |      |       |   |   | — |   |
| Comprehensive income:                                          |             |       |       |                 |       |                   |               |                         |           |                                                    |       |       |       |      |       |   |   |   |   |
| Net income for 2002                                            |             |       |       |                 |       |                   |               | 43,854                       |           | $                                                       | 43,854     |       |       |      |       |   |   |   | 43,854 |   |
| Other comprehensive income (loss), net of tax:                 |             |       |       |                 |       |                   |               |                         |           |                                                    |       |       |       |      |       |   |   |   |   |
| Minimum pension liability adjustment                           |             |       |       |                 |       |                   |               |                         |           | (3,051                                                  | )          | (3,051     | )          |      |       |   |   | (3,051 | ) |
| Other comprehensive income (loss)                              |             |       |       |                 |       |                   |               |                         |           | (3,051                                                  | )          |       |       |      |       |   |   |   |   |
| Comprehensive income                                           |             |       |       |                 |       |                   |               |                         |           | $                                                       | 40,803     |       |       |      |       |   |   |   |   |   |
| Balance as of December 31, 2002                           |             | 54,069     |       | 540                  |       | 40,393                 |               | $                            | 184,409        |                                                    |       |       | (4,888     | )         | (8,986     | ) | (131,430 | ) | 89,024 |   |
| Exercise of stock options                                      |             |       |       |                 |       |                   |               | (21,867                      | )              |                                                    |       |       |       | 1,425     |       | 35,906 |   | 14,039 |   |
| Tax benefit from exercise of stock options                     |             |       |       |                 |       | 12,295                 |               |                         |           |                                                    |       |       |       |      |       |   |   | 12,295 |   |
| Purchase of treasury stock                                     |             |       |       |                 |       |                   |               |                         |           |                                                    |       |       |       | (1,078    | )          | (28,726 | ) | (28,726 | ) |
| Issue treasury stock for Directors Deferred Compensation  Plan |             |       |       |                 |       |                   |               |                         |           |                                                    |       |       |       | 1         |       | 9 |   | 9 |   |
| Comprehensive income:                                          |             |       |       |                 |       |                   |               |                         |           |                                                    |       |       |       |      |       |   |   |   |   |
| Net income for 2003                                            |             |       |       |                 |       |                   |               |                         | 58,858         |                                                    | $          | 58,858     |       |      |       |   |   |   |   | 58,858 |   |
| Other comprehensive income, net of tax:                        |             |       |       |                 |       |                   |               |                         |           |                                                    |       |       |       |      |       |   |   |   |   |
| Minimum pension liability adjustment                           |             |       |       |                 |       |                   |               |                         |           | 625                                                     |       | 625        |       |      |       |   |   | 625 |   |
| Other comprehensive income                                     |             |       |       |                 |       |                   |               |                         |           | 625                                                     |       |       |       |      |       |   |   |   |   |
| Comprehensive income                                           |             |       |       |                 |       |                   |               |                         |           | $                                                       | 59,483     |       |       |      |       |   |   |   |   |   |
| Balance as of December 31, 2003                           |             | 54,069     |       | 540                  |       | 52,688                 |               | 221,400                      |           |                                                    |       | (4,263     | )          | (8,638    | )          | (124,241 | ) | 146,124 |   |
| Exercise of stock options                                      |             |       |       |                 |       | 614                    |               | (2,753                       | )              |                                                    |       |       |       | 563       |       | 10,740 |   | 8,601 |   |
| Tax benefit from exercise of stock options                     |             |       |       |                 |       | 6,355                  |               |                         |           |                                                    |       |       |       |      |       |   |   | 6,355 |   |
| Comprehensive income:                                          |             |       |       |                 |       |                   |               |                         |           |                                                    |       |       |       |      |       |   |   |   |   |
| Net income for 2004                                            |             |       |       |                 |       |                   |               |                         | 75,263         |                                                    | $          | 75,263     |       |      |       |   |   |   |   | 75,263 |   |
| Other comprehensive income, net of tax:                        |             |       |       |                 |       |                   |               |                         |           |                                                    |       |       |       |      |       |   |   |   |   |
| Minimum pension liability adjustment                           |             |       |       |                 |       |                   |               |                         |           | (1,269                                                  | )          | (1,269     | )          |      |       |   |   | (1,269 | ) |
| Other comprehensive income                                     |             |       |       |                 |       |                   |               |                         |           | (1,269                                                  | )          |       |       |      |       |   |   |   |   |
| Comprehensive income                                           |             |       |       |                 |       |                   |               |                         |           | $                                                       | 73,994     |       |       |      |       |   |   |   |   |   |
| Balance as of December 31, 2004                           |             | 54,069     |       | $                    | 540        |                   | $                  | 59,657                       |           | $                                                       | 293,910    |       |       |      | $          | (5,532 | ) | (8,075 | ) | $ | (113,501 | ) | $ | 235,074 |   |

 

----

(a)The number of shares in all prior periods have been restated to reflect thetwo-for-one stock split declared on May 10, 2002 that became effective June 6,2002.

 

Theaccompanying notes are an integral part of these financial statements.

 

F-7

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**ITT EDUCATIONAL SERVICES, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMEN****TS**

**December 31, 2004, 2003 and 2002**

**(Dollar amounts in thousands, except per sharedata and unless otherwise stated)**

 

**1.****                                      Summaryof Accounting Principles and Policies**

 

*BusinessActivities.* We are aleading proprietary postsecondary education system in the United States, and weprimarily offer career-focused, technical degree programs of study. At December 31,2004, we operated 77 technical institutes throughout the United States. Wemaintain our corporate headquarters in Carmel, Indiana.

 

*Principlesof Consolidation*.  Theconsolidated financial statements include both our and our wholly-ownedsubsidiaries’ accounts.  All significantintercompany balances and transactions are eliminated in consolidation.

 

*Use ofEstimates.*The preparation of these financial statements, inconformity with generally accepted accounting principles, includes estimatesthat are determined by our management. Actual results may differ from estimates used.

 

*Reclassifications*.  Certain reclassifications have been made toconform to the 2004 presentation.

 

*Revisionin the Classification of Certain Cash Equivalents and Investments*.  Certain cash equivalents and investmentsreclassifications have been made to the 2003 and 2002 financial statements toconform to the 2004 presentation. Previously, some of our investments in auction rate debt securities andvariable rate demand notes were recorded in cash and cash equivalents insteadof short-term investments, based on their interest reset dates rather thantheir remaining contractual maturity dates. In addition, we had classified some of our investments in auction rate debtsecurities, variable rate demand notes and auction rate preferred equitysecurities as held-to-maturity securities. In connection with the preparation of this report and in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting forCertain Investments in Debt and Equity Securities” and Accounting ResearchBulletin No. 43, “Restatement and Revision of Accounting Research Bulletins,”we reassessed the classification and recording of our investments in auctionrate debt securities, variable rate demand notes and auction rate preferredequity securities, and we determined that it was appropriate to:

 

•      reclassify as available-for-salesecurities all of our auction rate debt securities, variable rate demand notesand auction rate preferred equity securities;

•      record on our Consolidated Balance Sheetsas of December 31, 2004 and 2003 all of our investments in auction rate debt securitiesand variable rate demand notes with remaining contractual maturities of:

•      90days or less in cash and cash equivalents; and

•      greaterthan 90 days in either short-term investments or investments, based on ourintent and ability to hold those auction rate debt securities and variable ratedemand notes; and

•      record all of our investments in auctionrate preferred equity securities in short-term investments on our ConsolidatedBalance Sheets as of December 31, 2004 and 2003.

 

As a result, our Consolidated Balance Sheets were affected as follows:

 

•    cashand cash equivalents decreased and short-term investments increased by $121,960as of December 31, 2004 and $125,231 as of December 31, 2003; and

•    investmentsas of December 31, 2004 and 2003 did not change.

 

We also made corresponding adjustments to our ConsolidatedStatements of Cash Flows for the years ended December 31, 2004, 2003 and 2002in accordance with SFAS No. 95, “Statement of Cash Flows,” to reflect (a) thereclassification as available-for-sale securities of all of our auction rate debtsecurities, variable rate demand notes and auction rate preferred equitysecurities, and (b) the gross purchases and sales of our auction rate debt securities,variable rate demand notes and auction rate preferred equity securities asinvesting activities, rather than as a component of cash and cash equivalents,as follows:

 

•      netcash provided by proceeds from sales and maturities of investments increased$909,990 for the year ended December 31, 2004, $102,230 for the year endedDecember 31, 2003 and $0 for the year ended December 31, 2002;

•      netcash used for purchase of investments increased $906,719 for the year endedDecember 31, 2004, $227,461 for the year ended December 31, 2003 and $0 for theyear ended December 31, 2002; and

•      netincrease (decrease) in cash, cash equivalents and restricted cash increased$3,271 for the year ended December 31, 2004, decreased $125,231 for the yearended December 31, 2003 and did not change for the year ended December 31,2002.

 

The reclassifications had no impact on our total current assets, cashflows provided by (used for) operating activities, cash flows provided by (usedfor) financing activities or total consolidated results reported in any periodpresented.

 

*CashEquivalents*.  Ourinvestments in marketable debt securities with remaining contractual maturitydates of 90 days or less are recorded in cash and cash equivalents at cost,which approximates fair market value.

 

*Investments.*  We have investments in marketable debt and auctionrate preferred equity securities, which are classified as trading,available-for-sale or held-to-maturity, depending on our investment intentionswith regard to those securities.  Marketabledebt securities classified as trading or available-for-sale securities thathave remaining contractual maturity dates in 

 

F-8

----

 

excess of 90 days at the time of purchaseare recorded at their market value. Marketable debt securities classified asheld-to-maturity securities are recorded at their amortized cost, because wehave the intent and ability to hold those investments until they mature.  Auction rate preferred equity securitiesclassified as available-for-sale securities are recorded at their marketvalue.  Investments that we intend tohold for more than one year are recorded as non-current investments.

 

Our investments includedauction rate debt securities, variable rate demand notes and auction rate preferredequity securities that were classified as available-for-sale securities andrecorded in short-term investments and investments on our Consolidated BalanceSheets as of December 31, 2004 and 2003. Despite the long-term nature of the contractual maturities of ourauction rate debt securities and variable rate demand notes, we have theability to quickly liquidate those investments. We also had no material gross unrealized holding or realized gains(losses) from our investments in auction rate debt securities and variable ratedemand notes for the years ending December 31, 2004, 2003 and 2002.  All income generated from those investmentswas recorded as interest income.

 

The cost of securities soldis based on the first-in, first-out method. All of our investments are in marketable debt and auction rate preferredequity securities.

 
| ** **               | ** ** | **As of  December 31, 2004** | ** ** | **As of  December 31, 2003** | ** ** | ** **   | ** ** |
|--------------------------|------------|------------------------------|------------|------------------------------|------------|--------------|------------|
| ** **               | ** ** | **Trading**                  | ** ** | **Available-**               | ** ** | **Held-to-** | ** ** | ** ** | ** ** | **Trading** | ** ** | **Available-** | ** ** | **Held-to-** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Securities**               | ** ** | **For-Sale**                 | ** ** | **Maturity** | ** ** | **Total** | ** ** | **Securities** | ** ** | **For-Sale** | ** ** | **Maturity** | ** ** | **Total** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Short-term  investments  |       | $                            | —     |                         | $          | 309,567      |       | $ | 23,003 |   | $ | 332,570 |   | $ | 13,347 |   | $ | 160,233 |   | $ | 15,589 |   | $ | 189,169 |   |   |   |   |   |   |   |   |   |
| Non-current  investments |       | —                       |       | 1,000                        |       | 5,363        |       | 6,363 |   | — |   | 7,895 |   | 5,572 |   | 13,467 |   |   |   |   |   |   |   |   |   |
|                     |       | $                            | —     |                         | $          | 310,567      |       | $ | 28,366 |   | $ | 338,933 |   | $ | 13,347 |   | $ | 168,128 |   | $ | 21,161 |   | $ | 202,636 |   |   |   |   |   |   |   |   |   |

 

Investment income for the years ended December 31,2004, 2003 and 2002 consists of:

 

| ** **                                              | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                              | ** ** | **2004**                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net realized  gains (losses) on the sale of investments |       | $                           | 19         |   | $ | (27 | ) | $ | (48 | ) |
| Interest income,  net                                   |       | 3,844                       |       | 2,292 |   | 2,463 |   |
| Change in net  unrealized holding gain (loss)           |       | (29                         | )          | (270 | ) | 269 |   |
|                                                    |       | $                           | 3,834      |   | $ | 1,995 |   | $ | 2,684 |   |

 

The contractualmaturities of our marketable debt securities classified as available-for-saleas of December 31, 2004 were as follows:

 
| **Available-For-Sale**                  | ** ** | **Fair Value** | ** ** |
|-----------------------------------------|------------|----------------|------------|
| Due after five  years through ten years |       | $              | 8,636      |   |
| Due after ten  years                    |       | 167,897        |       |
|                                    |       | $              | 176,533    |   |

 

The above table excludes $134,034 of auctionrate preferred equity securities that were classified as available-for-salesecurities as of December 31, 2004.  Ournon-current investments that were classified as held-to-maturity securities asof December 31, 2004 had remaining contractual maturities between one and twoyears.

 

F-9

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*Propertyand Equipment.*We include all property and equipment in ourfinancial statements at cost.  We applythe American Institute of Certified Public Accountants Statements of PositionNo. 98-1, “Accounting for the Costs of Computer Software Developed or Obtainedfor Internal Use.”  Facility constructioncosts are capitalized as incurred, and depreciation commences upon completionof the construction.  We havehistorically paid for all real estate projects without any external financingand, therefore, we do not have any capitalized interest.  Provisions for depreciation of property andequipment have generally been made using the straight-line method for financialreporting purposes and accelerated methods for tax purposes.  Estimated useful lives generally range fromthree to ten years for furniture and equipment, three to 14 years for leaseholdimprovements, 20 to 40 years for buildings and three to eight years forcapitalized software.  Maintenance,repairs and renewals not of a capital nature are expensed as incurred. Fullydepreciated assets no longer in use are removed from both the asset andaccumulated depreciation accounts in the year of their retirement. Any gains orlosses on dispositions are credited or charged to income, as appropriate.

 

Weapply SFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets.”  We regularly review ourlong-lived assets for impairment whenever events or changes in circumstancesindicate that their carrying amounts may not be recoverable.  If we determine that the carrying amount of along-lived asset exceeds the total amount of the estimated undiscounted futurecash flows from that asset, we recognize a loss to the extent the carryingamount exceeds the fair value of that asset. We base our impairment analyses of long-lived assets on our currentbusiness strategy, expected growth rates and estimates of future economic andregulatory conditions.

 

*FairValue of Financial Instruments.*The carrying amounts reportedon the balance sheets for cash and cash equivalents, restricted cash, accountsreceivable, accounts payable, other accrued liabilities and deferred revenueapproximate fair value because of the immediate or short-term maturity of thesefinancial instruments.  Investments classifiedas trading securities are recorded at their market value.

 

*Revisionin the Classification of Certain Revenue.*Certain revenue reclassifications have beenmade to the 2002 financial statements to conform to the 2003 presentation.  Prior to 2003, if a student withdrew,the tuition revenue related to the remainder of that academic quarter and thefee revenue related to the remainder of the student’s program were recorded andthe amount of any refund resulting from the application of federal, state oraccreditation requirements or our refund policy was recorded as an expense. In2003, we began classifying tuition and fee revenue by netting the correspondingrevenue and expense related to the remaining tuition and fees with any relatedrefund recorded for students who withdrew. As a result, revenue and cost ofeducational services have each been reduced by $10,828 for the year ended December 31,2002. The reclassifications had no impact on our total consolidated resultsreported in any period presented.

 

*Recognitionof Revenue.*Tuition revenue is recorded on a straight-linebasis over the length of the applicable course. If a student withdraws from an institute, the standards of most stateeducation authorities that regulate our institutes, the accrediting commissionthat accredits our institutes and our own internal policy limit a student’sobligation for tuition and fees to the institute depending on when the studentwithdraws during an academic quarter (“Refund Policies”).  The terms of the Refund Policies vary bystate, and the limitations imposed by the Refund Policies are generally basedon the portion of the academic quarter that has elapsed at the time the studentwithdraws.  The greater the portion ofthe academic quarter that has elapsed at the time the student withdraws, thegreater the student’s obligation is to the institute for the tuition and feesrelated to that academic quarter.  Werecord revenue net of any refunds paid as a result of any applicable RefundPolicy.  On an individual student basis,tuition earned in excess of cash received is recorded as accounts receivable,and cash received in excess of tuition earned is recorded as deferred revenue.

 

Thecost of textbooks is included in the tuition and is amortized on astraight-line basis over the applicable course length and the deferral oftextbook costs is recorded in prepaids and other current assets. Tool kit salesand the related cost of the tool kits are recognized at the beginning of theacademic quarter. Academic fees (which are charged only one time to students ontheir first day of class attendance) and admission processing fees (which,prior to their discontinuance in 2003, were charged only one time to studentsupon being evaluated for admission to their programs of study) are recognizedas revenue on a straight-line basis over the average program length of 24months. Deferred

 

F-10

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revenue is recorded forfees collected in excess of revenue recognized. If a student withdraws from an institute, all unrecognized revenuerelating to his or her fees, net of any refunds paid as a result of anyapplicable Refund Policy, is recognized upon the student’s departure.  Administrative fees, which are charged tostudents when they withdraw or graduate from their programs of study at aninstitute, are recognized when the students withdraw or graduate from theirprograms of study at the institute.

 

Wereport 12 weeks of tuition revenue in each of our four fiscal quarters.  We standardized the number of weeks ofrevenue reported in each fiscal quarter, because the timing of student breaksin a calendar quarter can fluctuate from quarter to quarter each year.  The total number of weeks of school duringeach year is 48.

 

*AdvertisingCosts.*We expense all advertising costs as incurred.

 

*DirectMarketing Costs.*Direct costs incurred relating to theenrollment of new students are capitalized using the successful efforts method.Direct marketing costs include salaries and employee benefits of recruitingrepresentatives and other direct costs less admission processing fees, if any.Successful efforts is the ratio of students enrolled to prospective studentsinterviewed.  We amortize our directmarketing costs on a cost-pool-by-cost-pool basis over the period that weexpect to receive revenue streams associated with those assets.  We define a cost pool as the group ofstudents that begin each academic quarter (“Class”).  The direct marketing costs that arecapitalized with respect to a particular Class are amortized using a methodthat corresponds to the amount of tuition revenue that will be recognized ineach academic quarter for that Class. Since we recognize tuition revenue for a Class on a straight-line basisover the program length, we also recognize the amortization of the capitalizeddirect marketing costs with respect to that Class on a straight-line basis overthe same period.  If a student withdraws,however, any remaining amount of the capitalized direct marketing costs relatedto that student is expensed immediately, because the realizability of theremaining capitalized direct marketing costs related to that student isimpaired.

 

Wereview the carrying amount of the capitalized direct marketing costs on aregular basis in order to compare the recorded amounts with the estimatedremaining future revenue streams associated with those assets.  If we determine that the value of thecapitalized direct marketing costs recorded exceeds the remaining futurerevenue estimated to be generated from those assets, the excess amount iswritten off and recorded as an advertising expense for the related period.

 

Directmarketing costs on the balance sheet totaled $14,713 at December 31, 2004and $10,844 at December 31, 2003, net of accumulated amortization of$14,949 at December 31, 2004 and $11,211 at December 31, 2003.

 

*IncomeTaxes. *In accordancewith SFAS No. 109, “Accounting for Income Taxes,” we account for income taxesusing the asset and liability method, which requires the recognition ofdeferred tax assets and liabilities for expected future tax consequences oftemporary differences that currently exist between the tax bases and financialreporting bases of our assets and liabilities.

 

*Contingent Liabilities.*  We are subject to litigation in the ordinarycourse of our business. When we are aware of a claim or potential claim, weassess the likelihood of any loss or exposure. If it is probable that a loss will result and the amount of the loss canbe reasonably estimated, we record a liability for the loss.  Theliability recorded includes probable and estimable legal costs associated withthe claim or potential claim.  Ifthe loss is not probable or the amount of the loss cannot be reasonablyestimated, we disclose the claim if the likelihood of a potential loss isreasonably possible and the amount involved is material.

 

*TreasuryStock. *Our Board ofDirectors has authorized us to repurchase outstanding shares of our commonstock in the open market or through privately negotiated transactions inaccordance with Rule 10b-18 of the Securities Exchange Act of 1934, asamended.  The purpose of the stockrepurchase program is to help us achieve our long-term goal of enhancingshareholder value.  Treasury stock isaccounted for under the last in, first out method.

 

F-11

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*EarningsPer Common Share. *On May 10, 2002, we declared a two-for-onesplit of our common stock, effected on June 6, 2002 by payment of a stockdivided to all shareholders of record at the close of business on May 28, 2002of one share on each one share of our common stock issued and outstanding orheld as treasury stock on May 28, 2002. Our earnings per share amounts and thenumber of shares in all prior periods have been restated to reflect this stocksplit.

 

Earningsper common share for all periods have been calculated in conformity with SFASNo. 128, “Earnings Per Share.”  This datais based on historical net income and the average number of shares of ourcommon stock outstanding during each period.

 
| ** ** | ** ** | **Average shares outstanding  for the year ended December 31,** | ** ** |
|------------|------------|----------------------------------------------------------------------|------------|
| ** ** | ** ** | **2004**                                                             | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** ** | ** ** | **(in thousands)**                                                   | ** ** |
| Basic      |       | 45,791                                                               |       | 45,086 |   | 45,736 |   |
| Diluted    |       | 46,808                                                               |       | 46,280 |   | 46,793 |   |

 

Thedifference in the number of shares used to calculate basic and diluted earningsper share represents the average number of shares issued under our stock optionplans less shares assumed to be purchased with proceeds from the exercise ofthose stock options.  Shares underlyingoutstanding stock options with exercise prices greater than the average marketprice of our common stock (613,000 shares at December 31, 2004, 1,000shares at December 31, 2003 and 97,000 shares at December 31, 2002)have been excluded from the calculation of our earnings per common share,because the effect would be anti-dilutive.

 

*Authorized Shares*.  On January 25, 2005, our Board ofDirectors approved an amendment to our Restated Certificate of Incorporation toincrease the number of authorized shares of our common stock from 150 millionto 300 million (“Amendment”).  If theAmendment is approved by our shareholders at our 2005 annual meeting ofshareholders, it will become effective upon the filing of a Certificate ofAmendment with the Delaware Secretary of State.

 

*Stock Options. *Weadopted and our stockholders approved the ITT Educational Services, Inc. 1994Stock Option Plan (‘‘1994 Stock Plan’’) and the 1997 ITT Educational Services,Inc. Incentive Stock Plan (‘‘1997 Stock Plan’’).  We also established the 1999 OutsideDirectors Stock Option Plan (“1999 Directors Stock Plan”), which provides forawards of non-qualified stock options to non-employee directors. We haveadopted the disclosure only provisions of SFAS No. 123, ‘‘Accounting forStock-Based Compensation.’’ Accordingly, no compensation cost has beenrecognized in the financial statements for the Plans. We have elected, aspermitted by the standard, to continue following the intrinsic value basedmethod of accounting for stock options consistent with Accounting PrinciplesBoard (“APB”) Opinion No. 25, ‘‘Accounting for Stock Issued to Employees.’’Under the intrinsic method, compensation cost for stock options is measured asthe excess, if any, of the quoted market price of our common stock at themeasurement date over the exercise price.

 

Ifcompensation costs for the plans had been determined based on the fair value ofthe stock options at grant date consistent with SFAS No. 123, our compensationcosts would have increased and our net income and earnings per share for theyears ended December 31, 2004, 2003 and 2002 would have been reduced tothe proforma amounts indicated below:

 

F-12

----

 
| ** **                                                                                                                                                                           | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                                                           | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net income as reported                                                                                                                                                               |       | $                                | 75,263     |   | $ | 58,858 |   | $ | 43,854 |   |
| Deduct:         Total stock-based employee compensation  expense determined under the fair value based method for stock options, net  of tax |       | (7,457                           | )          | (5,099 | ) | (3,601 | ) |
|                                                                                                                                                                                 |       |                             |       |   |   |   |   |
| Proforma net income                                                                                                                                                                  |       | $                                | 67,806     |   | $ | 53,759 |   | $ | 40,253 |   |
|                                                                                                                                                                                 |       |                             |       |   |   |   |   |
| Earnings per share:                                                                                                                                                                  |       |                             |       |   |   |   |   |
| Basic as reported                                                                                                                                                                    |       | $                                | 1.64       |   | $ | 1.31 |   | $ | 0.96 |   |
| Basic proforma                                                                                                                                                                       |       | $                                | 1.48       |   | $ | 1.19 |   | $ | 0.88 |   |
| Impact of stock options                                                                                                                                                              |       | $                                | (0.16      | ) | $ | (0.12 | ) | $ | (0.08 | ) |
|                                                                                                                                                                                 |       |                             |       |   |   |   |   |
| Diluted as reported                                                                                                                                                                  |       | $                                | 1.61       |   | $ | 1.27 |   | $ | 0.94 |   |
| Diluted proforma                                                                                                                                                                     |       | $                                | 1.45       |   | $ | 1.16 |   | $ | 0.86 |   |
| Impact of stock options                                                                                                                                                              |       | $                                | (0.16      | ) | $ | (0.11 | ) | $ | (0.08 | ) |

 

Thefair value of each option grant was estimated on the date of grant using theBlack-Scholes option-pricing model with the following assumptions for the threeyears ended December 31:

 
| ** **                | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Risk free interest rates  |       | 3.3                              | %          | 2.7 | % | 4.4 | % |
| Expected lives (in years) |       | 5                                |       | 5 |   | 5 |   |
| Volatility                |       | 58                               | %          | 57 | % | 56 | % |
| Dividend yield            |       | None                             |       | None |   | None |   |

 

*New Accounting Pronouncements.*

 

In January andMay 2004, the Financial Accounting Standards Board (“FASB”) issued two staffpositions with respect to the application of SFAS No. 106, “Employers’Accounting for Postretirement Benefits Other Than Pensions,” to the accountingand disclosure requirements associated with the Medicare Prescription Drug,Improvement and Modernization Act of 2003 (“Drug Act”).  The Drug Act affects postretirement healthcare benefits that companies may provide to their employees.  We do not provide any postretirement healthcare benefits to our employees, and, therefore, those staff positions do nothave an impact on our financial condition or results of operations.

 

In June 2004,the FASB’s Emerging Issues Task Force (“EITF”) issued EITF 03-1, “The Meaningof Other-Than-Temporary Impairment and Its Application to Certain Investments.”  EITF 03-1 provides further guidance on themeaning of other-than-temporary impairment and its application to debt andequity securities in accordance with APB Opinion No. 18, “The Equity Method ofAccounting for Investments in Common Stock,” and SFAS No. 115, “Accounting forCertain Investments in Debt and Equity Securities.”  In September 2004, the FASB issued FASBStaff Position EITF 03-1-1, which delays the effective date until additionalguidance is issued for the application of the recognition and measurementprovisions of EITF 03-1 to investments in securities that are impaired. Thedisclosure requirements of EITF 03-1, however, are effective for annual periodsending after June 15, 2004.  Untilfurther guidance is provided by the FASB, we are unable to determine theeffect, if any, that EITF 03-1 will have on our financial condition or resultsof operations.  See Note 1 for additionaldisclosures regarding our investments.

 

In December 2004, the FASB issued SFAS No. 123R,“Share-Based Payment” that revises SFAS No. 123, “Accounting for Stock-BasedCompensation” and supercedes APB Opinion No. 25, “Accounting for Stock Issuedto Employees.”  Under this revisedstandard, all share-based payments to employees, including grants of employeestock

 

F-13

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options,must be reflected in the financial statements using the fair value method withthe related expenses recognized over the service period. SFAS No. 123R will beeffective for periods beginning after June 15, 2005 and allows for severalalternative transition methods. We expect to adopt SFAS No. 123R in our thirdfiscal quarter of 2005 on a modified-prospective basis without restating priorinterim periods, which will require that we recognize compensation expense forall stock option and other equity-based awards that vest or become exercisableafter the effective date. We are currently evaluating the impact that SFAS No.123R will have on our financial condition or results of operations.

 

**2.****                                      SpecialLegal and Other Investigation Costs**

 

Consistentwith our accounting policy for contingent liabilities (pursuant to which weaccrue probable legal costs associated with a claim or a potential claim), werecorded a charge of $20,705 in the year ended December 31, 2004 forestimated legal costs associated with the investigation of us being conductedby the U.S. Department of Justice (“DOJ”), the inquiry initiated by the SECinto the allegations being investigated by the DOJ, and the securities classaction, shareholder derivative and books and records inspection lawsuits filedagainst us, certain of our current and former executive officers and each ofour Directors (collectively, the “Actions”), as described below in Note 10.During the year ended December 31, 2004, we were billed $15,950 of thoselegal costs. We regularly evaluate the reasonableness of our estimate of theprobable legal costs associated with the Actions and make any adjustmentsconsidered necessary. We believe that it is probable that we will incur atleast $20,705 in legal costs related to these matters. Due to the uncertaintyregarding the outcomes of these matters, however, we cannot estimate themaximum amount of costs that we could potentially incur with respect to thesematters. In accordance with the financial accounting standards for losscontingencies, we have accrued what we believe to be a reasonable estimate ofcosts that it is probable we will incur. If our estimate proves to beinadequate, however, it is possible that we could subsequently be required torecord a charge to earnings which could have a material adverse effect on ourresults of operations.

 

Weincurred non-legal costs related to the Actions in the amount of $4,438 duringthe year ended December 31, 2004. Those costs were expensed as incurredand primarily included fees charged by our independent registered publicaccounting firm for the performance of extended audit procedures as a result ofthe Actions, costs to create an electronic database of all documents seized inconnection with the DOJ investigation and other non-legal costs related to theActions.

 

**3.****                                      FinancialAid Programs**

 

Weparticipate in various federal student financial aid programs under Title IV (“TitleIV Programs”) of the Higher Education Act of 1965, as amended (“HEA”). Approximately66% of our 2004 revenue, determined on a cash accounting basis as defined bythe U.S. Department of Education’s (“ED”) regulations, was indirectly derivedfrom funds distributed under these programs.

 

As of December 31,2004, we no longer participate in the Federal Perkins Loan (‘‘Perkins’’)program. We administered on behalf of the federal government a pool of Perkinsstudent loans which aggregated $0 at December 31, 2004 and $107 at December 31,2003. We have recorded in our financial statements only our aggregate mandatorycontributions to this program, which aggregated $0 at December 31, 2004and $32 at December 31, 2003. In order to cover potential losses relatedto funds committed by us under the Perkins program, we provided $32 at December 31,2003.

 

Weadminister the Title IV Programs in separate accounts as required by governmentregulation. We are required to administer the funds in accordance with therequirements of the HEA and the ED’s regulations and must use due diligence inapproving and disbursing funds and servicing loans. In the event we do notcomply with federal requirements, or if student loan default rates rise to alevel considered excessive by the federal government, we could lose oureligibility to participate in Title IV Programs or could be required to repayfunds determined to have been improperly disbursed. Our management believesthat we are in substantial compliance with the federal requirements.

 

F-14

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**4.****                                      RestrictedCash**

 

Weparticipate in the Electronic Funds Transfer (‘‘EFT’’) program through the ED. Allmonies transferred to us via the EFT program are subject to certain holdingperiod restrictions, generally from three to seven days, before they can bedrawn into our cash account. These amounts are classified as restricted cashuntil they are applied to the students’ accounts.

 

**5.****                                      Propertyand Equipment**

 

Fixedassets include the following:

 
| ** **                    | ** ** | **As of December 31,** | ** ** |
|-------------------------------|------------|-----------------------------|------------|
| ** **                    | ** ** | **2004**                    | ** ** | **2003** | ** ** |
| Furniture and equipment       |       | $                           | 111,550    |   | $ | 124,899 |   |
| Buildings                     |       | 37,691                      |       | 34,491 |   |
| Leasehold improvements        |       | 7,679                       |       | 8,954 |   |
| Capitalized software          |       | 13,088                      |       | 12,904 |   |
| Construction in progress      |       | 8,545                       |       | 40 |   |
| Land and land improvements    |       | 17,249                      |       | 11,452 |   |
|                          |       | 195,802                     |       | 192,740 |   |
| Less accumulated depreciation |       | (97,056                     | )          | (111,237 | ) |
|                          |       | $                           | 98,746     |   | $ | 81,503 |   |

 

Accumulateddepreciation includes accumulated amortization of capitalized software of$5,318 at December 31, 2004 and $6,454 at December 31, 2003. Depreciationand amortization expense includes software amortization of $2,380 for the yearended December 31, 2004, $3,326 for the year ended December 31, 2003,and $2,491 for the year ended December 31, 2002.

 

**6.****                                      Taxes**

 

Theprovision (benefit) for income taxes attributable to income before income taxesincludes the following:

 
| ** ** | ** ** | **Year Ended December 31,** | ** ** |
|------------|------------|----------------------------------|------------|
| ** ** | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Current    |       |                             |       |   |   |   |   |
| Federal    |       | $                                | 36,471     |   | $ | 34,765 |   | $ | 22,263 |   |
| State      |       | 6,359                            |       | 5,728 |   | 2,720 |   |
|       |       | 42,830                           |       | 40,493 |   | 24,983 |   |
| Deferred   |       |                             |       |   |   |   |   |
| Federal    |       | 4,413                            |       | (2,365 | ) | 1,800 |   |
| State      |       | 876                              |       | (470 | ) | 356 |   |
|       |       | 5,289                            |       | (2,835 | ) | 2,156 |   |
|       |       | $                                | 48,119     |   | $ | 37,658 |   | $ | 27,139 |   |

 

F-15

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Deferredtax assets (liabilities) include the following:

 
| ** **                            | ** ** | **As of December 31,** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|
| ** **                            | ** ** | **2004**                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Direct marketing costs                |       | $                           | (5,771     | ) | $ | (4,253 | ) | $ | (4,161 | ) |
| Capitalized software                  |       | (3,047                      | )          | (2,530 | ) | (3,903 | ) |
| Deferral of book costs                |       | (1,985                      | )          | (1,425 | ) | (1,665 | ) |
| Depreciation                          |       | (4,161                      | )          | — |   | — |   |
| Prepaid pension                       |       | (4,154                      | )          | (1,734 | ) | (1,849 | ) |
| Total deferred tax liabilities        |       | (19,118                     | )          | (9,942 | ) | (11,578 | ) |
|                                  |       |                        |       |   |   |   |   |
| Deferred revenue                      |       | 1,719                       |       | 2,102 |   | 1,987 |   |
| Depreciation                          |       | —                      |       | — |   | 250 |   |
| Minimum pension liability             |       | 3,569                       |       | 2,750 |   | 3,153 |   |
| Legal reserve                         |       | 2,692                       |       | 741 |   | 635 |   |
| Accrued compensation plans            |       | 1,020                       |       | — |   | — |   |
| Accrued medical claims                |       | 1,507                       |       | — |   | — |   |
| Other                                 |       | 2,357                       |       | 2,564 |   | 1,337 |   |
| Total deferred tax assets             |       | 12,864                      |       | 8,157 |   | 7,362 |   |
|                                  |       |                        |       |   |   |   |   |
| Net deferred tax assets (liabilities) |       | $                           | (6,254     | ) | $ | (1,785 | ) | $ | (4,216 | ) |

 

Differencesbetween effective income tax rates and the statutory U.S. federal income taxrates are as follows:

 
| ** **                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|
| ** **                                 | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Statutory U.S. federal income tax rate     |       | 35.0                             | %          | 35.0 | % | 35.0 | % |
| State income taxes, net of federal benefit |       | 3.9                              | %          | 3.8 | % | 2.8 | % |
| Permanent differences and other            |       | 0.1                              | %          | 0.2 | % | 0.4 | % |
| Effective income tax rate                  |       | 39.0                             | %          | 39.0 | % | 38.2 | % |

 

Other accrued liabilities includes: income taxespayable of $10,230 as of December 31, 2004 and $8,722 as of December 31,2003; and other taxes payable of $3,508 as of December 31, 2004 and $3,761as of December 31, 2003.

 

**7.****                                      RetirementPlans**

 

*EmployeePension Benefits*. Our ESI Pension Plan, a non-contributorydefined benefit pension plan, commonly referred to as a cash balance plan,covers substantially all of our employees who began their employment with usprior to June 2, 2003. This plan provides benefits based on an employee’sannual earnings times an established percentage of pay determined by theemployee’s age and years of benefit service. Effective June 2, 2003, weclosed participation in the ESI Pension Plan to all new employees. Employeeswho begin their employment with us on or after June 2, 2003 do notparticipate in the ESI Pension Plan. The ESI Pension Plan participants willcontinue to receive annual allocations and accrue benefit and vesting serviceaccording to the terms of the ESI Pension Plan.

 

OurESI Excess Pension Plan, a non-qualified, unfunded retirement plan, covers aselect group of our management. This plan provides for payment of thosebenefits at retirement that cannot be paid from the ESI Pension

 

F-16

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Plan due to federalstatutory limits on the amount of benefits that can be paid and compensationthat can be recognized under a tax-qualified retirement plan. The practicaleffect of the ESI Excess Pension Plan is to provide retirement benefits to allof our employees who participate in the ESI Pension Plan on a uniform basis.

 

Thefollowing tables are based on an actuarial valuation date as of September 30and amounts recognized in our consolidated financial statements as of December 31:

 

Net periodic benefit cost for the plans:

 
| ** **                           | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Service cost                         |       | $                                | 6,539      |   | $ | 5,880 |   | $ | 5,209 |   |
| Interest cost                        |       | 2,261                            |       | 1,779 |   | 1,309 |   |
| Expected return on assets            |       | (2,238                           | )          | (1,569 | ) | (1,464 | ) |
| Recognized net actuarial loss/(gain) |       | 1,150                            |       | 993 |   | 354 |   |
| Amortization of prior service cost   |       | (88                              | )          | (88 | ) | (88 | ) |
| Net periodic pension cost            |       | $                                | 7,624      |   | $ | 6,995 |   | $ | 5,320 |   |

 

Changein benefit obligation:

 
| ** **                                          | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|
| ** **                                          | ** ** | **2004**                         | ** ** | **2003** | ** ** |
|                                                |       |                             |       |   |   |
| Accumulated benefit obligation                      |       | $                                | 42,421     |   | $ | 32,396 |   |
|                                                |       |                             |       |   |   |
| Projected benefit obligation at beginning of period |       | $                                | 36,737     |   | $ | 27,614 |   |
| Service cost                                        |       | 6,539                            |       | 5,880 |   |
| Actuarial loss                                      |       | 4,115                            |       | 2,165 |   |
| Interest cost                                       |       | 2,261                            |       | 1,779 |   |
| Benefits paid                                       |       | (1,273                           | )          | (701 | ) |
| Projected benefit obligation at end of period       |       | 48,379                           |       | 36,737 |   |
| Fair value of plan assets                           |       | 32,340                           |       | 23,103 |   |
| Funded status                                       |       | (16,039                          | )          | (13,634 | ) |
| Unrecognized net actuarial loss                     |       | 15,366                           |       | 11,972 |   |
| Unrecognized prior service cost                     |       | (531                             | )          | (618 | ) |
| Minimum pension liability adjustment                |       | (9,101                           | )          | (7,012 | ) |
| Accrued benefit cost                                |       | $                                | (10,305    | ) | $ | (9,292 | ) |

 

F-17

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Changein plan assets:

 
| ** **                                     | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|
| ** **                                     | ** ** | **2004**                         | ** ** | **2003** | ** ** |
| Fair value of plan assets at beginning of year |       | $                                | 23,103     |   | $ | 15,399 |   |
| Actual return on plan assets                   |       | 1,810                            |       | 2,205 |   |
| Employer contributions                         |       | 8,700                            |       | 6,200 |   |
| Benefits paid                                  |       | (1,273                           | )          | (701 | ) |
| Fair value of plan assets at end of year       |       | $                                | 32,340     |   | $ | 23,103 |   |

 

Fairvalue of total plan assets by major asset category:

 
| ** **                | ** ** | **As of December 31,** | ** ** |
|---------------------------|------------|-----------------------------|------------|
| ** **                | ** ** | **2004**                    | ** ** | **2003** | ** ** |
| Cash and cash equivalents |       | $                           | 335        |   | 1 | % | $ | 382 |   | 2 | % |
| Mutual funds              |       | 21,341                      |       | 66 | % | 16,583 |   | 72 | % |
| Common stocks             |       | 9,582                       |       | 30 | % | 5,988 |   | 26 | % |
| Foreign equities          |       | 1,082                       |       | 3 | % | 150 |   | 0 | % |
| Total                     |       | $                           | 32,340     |   | 100 | % | $ | 23,103 |   | 100 | % |
|                           |            |                             |            |  |  |  |  |  |  |  |  |  |

 

Weighted-averageassumptions used to determine benefit obligations as of September 30,2004, 2003 and 2002:

 
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Discount rate                 |       | 5.75     | %          | 6.00     | %          | 6.50     | %          |
| Rate of compensation increase |       | 4.50     | %          | 4.50     | %          | 4.50     | %          |

 

Weighted-averageassumptions used to determine net periodic pension cost for years ended September 30,2004, 2003 and 2002:

 
| ** **                               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Discount rate                            |       | 6.00     | %          | 6.50     | %          | 7.25     | %          |
| Expected long-term return on plan assets |       | 8.00     | %          | 8.00     | %          | 9.00     | %          |
| Rate of compensation increase            |       | 4.50     | %          | 4.50     | %          | 4.50     | %          |

 

Theamortization of any prior service cost is determined using a straight-lineamortization of the cost over the average remaining service period foremployees expected to receive benefits under the pension plans, as permittedunder Paragraph 26 of SFAS No. 87, “Employers’ Accounting for Pensions.”

 

F-18

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Thefollowing benefit payments are expected to be paid from the pension plans:

 
| **Year**           | ** ** | **Amount** | ** ** |
|--------------------|------------|------------|------------|
| Fiscal 2005        |       | $          | 2,400      |   |
| Fiscal 2006        |       | $          | 3,200      |   |
| Fiscal 2007        |       | $          | 3,500      |   |
| Fiscal 2008        |       | $          | 4,600      |   |
| Fiscal 2009        |       | $          | 5,600      |   |
| Fiscal 2010 - 2014 |       | $          | 34,300     |   |

 

Weinvest plan assets based on a total return on investment approach, pursuant to whichthe plan assets include a diversified blend of equity and fixed incomeinvestments toward a goal of maximizing the long-term rate of return withoutassuming an unreasonable level of investment risk. We determine the level ofrisk based on an analysis of plan liabilities, the extent to which the value ofthe plan assets satisfies the plan liabilities and our financial condition. Ourinvestment policy includes target allocations ranging from 30% to 70% forequity investments, 20% to 60% for fixed income investments and 0% to 50% forcash equivalents. The equity portion of the plan assets represents growth andvalue stocks of small, medium and large companies. We measure and monitor theinvestment risk of the plan assets both on a quarterly basis and annually whenwe assess plan liabilities.

 

We usea building block approach to estimate the long-term rate of return on planassets. This approach is based on the capital market principle that the greaterthe volatility, the greater the return over the long term. An analysis of thehistorical performance of equity and fixed income investments, together withcurrent market factors such as the inflation and interest rates, are used tohelp us make the assumptions necessary to estimate a long-term rate of return onplan assets. Once this estimate is made, we review the portfolio of plan assetsand make adjustments thereto that we believe are necessary to reflect adiversified blend of equity and fixed income investments that is capable ofachieving the estimated long-term rate of return without assuming anunreasonable level of investment risk. We also compare the portfolio of planassets to those of other pension plans to help us assess the suitability andappropriateness of the plan investments.

 

In January 2005,we contributed $11,795 to the ESI Pension Plan. This amount represents thetotal amount we intend to contribute to the ESI Pension Plan in 2005.

 

During 2002, we increased our minimum pensionliability with respect to our obligations under the ESI Pension Plan by $5,020,and we recorded a corresponding $3,051 reduction in shareholders’ equity, whichwas net of a $1,969 deferred tax asset. During 2003, we reduced our minimumpension liability by $1,029 as a result of obtaining an investment return onplan assets in excess of our original estimates, and we recorded acorresponding $625 increase in shareholders’ equity, which was net of a $404deferred tax asset. During 2004, we increased our minimum pension liability by$2,089 as a result of obtaining an investment return on plan assets less thanour original estimates, and we recorded a corresponding $1,269 reduction inshareholders’ equity, which was net of a $820 deferred tax asset.

 

*RetirementSavings Plan.* Our ESI 401(k) Plan, a defined contributionplan, covers substantially all of our employees. Prior to March 19, 2004,our contributions under the ESI 401(k) plan were made in cash to a fund thatinvested in our common stock, which a plan participant could not redirect toother plan investment options until the participant reached age 55. All of ourcontributions under the ESI 401(k) plan that we have made on and after March 19,2004 have been in the form of cash to plan investment options directed by theparticipant.

 

OurESI Excess Savings Plan, a non-qualified, unfunded deferred compensation plan,covers a select group of our management. The plan provides for salary deferralof contributions that the participants are unable to make under the ESI 401(k)Plan and our contributions that cannot be paid under the ESI 401(k) Plan due tofederal statutory limits on the amount that an employee can contribute under adefined contribution plan. The practical effect of the ESI Excess Savings Planis to provide a savings plan to all of our employees on a uniform basis.

 

F-19

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Thecosts of providing the benefits under the ESI 401(k) Plan and ESI ExcessSavings Plan (including certain administrative costs of the plans) were $3,246for December 31, 2004, $2,856 for the year ended December 31, 2003,and $2,734 for the year ended December 31, 2002.

 

**8.****                                      StockOption and Key Employee Incentive Plans**

 

Underthe 1994 Stock Plan, a maximum of 810,000 shares of our common stock may beissued upon exercise of options. Under the 1997 Stock Plan, a maximum of 1.5%of our outstanding shares of common stock may be issued each year commencing in1997, with any unissued shares issuable in later years. Under the 1997 StockPlan, a maximum of 8,100,000 shares of our common stock may be issued uponexercise of options and pursuant to other forms of awards. Under the 1999Directors Stock Plan, a maximum of 500,000 shares of our common stock may beissued upon exercise of options. Under all Plans, the option price may not beless than 100% of the fair market value of our common stock on the date ofgrant. Under the 1994 Stock Plan and 1997 Stock Plan, the options vest andbecome exercisable in three equal annual installments commencing with the firstanniversary of the grant. Under the 1999 Directors Stock Plan, the options vestand become exercisable on the first anniversary of the grant. The maximum termof options granted under the 1994 Stock Plan and 1997 Stock Plan is 10 yearsand 2 days from the date of grant. The maximum term of options granted underthe 1999 Directors Stock Plan: (a) prior to January 25, 2005, was 10 yearsfrom the date of grant; and (b) on or after January 25, 2005, is sevenyears from the date of grant. The options outstanding, granted, forfeited andexercised for the three years ended December 31, 2004 are as follows:

 
| ** **                       | ** ** | **2004**         | ** ** | **2003**                             | ** ** | **2002**         | ** ** |
|----------------------------------|------------|------------------|------------|--------------------------------------|------------|------------------|------------|
| ** **                       | ** ** | **# of  Shares** | ** ** | **Weighted  Average  Option  Price** | ** ** | **# of  Shares** | ** ** | **Weighted  Average  Option  Price** | ** ** | **# of  Shares** | ** ** | **Weighted  Average  Option  Price** | ** ** |
| Outstanding at beginning of year |       | 3,232,068        |       | $                                    | 16.37      |             | 3,791,415  |   | $ | 11.95 |   | 3,765,446 |   | $ | 10.38 |   |
| Granted                          |       | 777,500          |       | 49.42                                |       | 927,000          |       | 24.63 |   | 938,000 |   | 17.98 |   |
| Forfeited                        |       | (176,010         | )          | 34.73                                |       | (61,674          | )          | 19.57 |   | (26,670 | ) | 13.08 |   |
| Exercised                        |       | (563,616         | )          | 15.26                                |       | (1,424,673       | )          | 9.84 |   | (885,361 | ) | 11.63 |   |
| Outstanding at end of year       |       | 3,269,942        |       | $                                    | 23.43      |             | 3,232,068  |   | $ | 16.37 |   | 3,791,415 |   | $ | 11.95 |   |

 
| ** **                                                          | ** ** | **Exercise Price Range** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                          | ** ** | **$ 5.97-$8.03**    | ** ** | **$ 9.72-$12.13** | ** ** | **$ 14.75-$21.78** | ** ** | **$ 22.48-$31.45** | ** ** | **$ 34.30-$51.20** | ** ** | **Total** | ** ** |
| Options outstanding at end of year                                  |       | 311,118                  |       | 731,920 |   | 727,713 |   | 775,691 |   | 723,500 |   | 3,269,942 |   |
| Weighted average exercise price on options  outstanding             |       | $                        | 6.66       |   | $ | 10.51 |   | $ | 17.22 |   | $ | 24.12 |   | $ | 49.21 |   | $ | 23.43 |   |
| Weighted average remaining contractual life                         |       | 4.2 years                |       | 4.4 years |   | 6.1 years |   | 8.0 years |   | 9.1 years |   | 6.7 years |   |
| Options exercisable at end of year                                  |       | 311,118                  |       | 731,920 |   | 534,656 |   | 327,299 |   | 36,999 |   | 1,941,992 |   |
| Weighted average exercise price on exercisable  options outstanding |       | $                        | 6.66       |   | $ | 10.51 |   | $ | 17.20 |   | $ | 24.50 |   | $ | 50.09 |   | $ | 14.85 |   |

 

In January 2005,the Compensation Committee of our Board of Directors awarded additional stockoptions for 486,400 shares of our common stock. The effective date of thisaward was February 2, 2005 and the exercise price is $49.74 per share.

 

**9.****                                      Lettersof Credit**

 

Duringthe year ended December 31, 2004, we provided a $7,000 irrevocable standbyletter of credit to one of our insurers to secure the surety bonds issued bythat insurer which are required as part of our normal course of operations byvarious education authorities that regulate us. The letter of credit iscollateralized by our investments. As of

 

F-20

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December 31, 2004,the total face value of those surety bonds was $9,290. In addition, we haveprovided a $2,143 irrevocable letter of credit to our workers’ compensationinsurance providers to secure the payment of our workers’ compensation claims.

 

**10.****                               Commitmentsand Contingent Liabilities**

 

*LeaseCommitments.*We lease most of our facilities under operatinglease agreements. A majority of the operating leases contain renewal optionsthat can be exercised after the initial lease term. Renewal options aregenerally for periods of one to five years. All operating leases will expireover the next 12 years and we expect that:

 

•                  those leases will be renewed orreplaced by other leases in the normal course of business;

•                  we may purchase the facilitiesrepresented by those leases; or

•                  we may purchase or build otherreplacement facilities.

 

There are no materialrestrictions imposed by the lease agreements, and we have not entered into anysignificant guarantees related to the leases. We are required to makeadditional payments under the operating lease terms for taxes, insurance andother operating expenses incurred during the operating lease period.

 

Rentexpense was $26,546 for the year ended December 31, 2004, $26,748 for theyear ended December 31, 2003, and $29,421 for the year ended December 31,2002.

 

Futureminimum rental payments required under our operating leases that have initialor remaining non-cancelable lease terms in excess of one year as of December 31,2004 are as follows:

 
| 2005        |   | $      | 26,436  |   |
|-------------|--------|--------|---------|--------|
| 2006        |   | 23,554 |    |
| 2007        |   | 20,548 |    |
| 2008        |   | 19,798 |    |
| 2009        |   | 14,024 |    |
| Later Years |   | 24,889 |    |
|        |   | $      | 129,249 |   |

 

Future minimum rentalpayments related to equipment leases are not significant.

 

Wepurchased one of our facilities for $4,709 in January 2005 and paid thepurchase price with cash from operations.

 

*ContingentLiabilities.*From 1994 through 1999, we entered intoagreements with unaffiliated, private funding sources to provide supplementalloans to students to help pay the students’ cost of education that federal andstate financial aid sources did not cover. Some of these agreements required usto guarantee repayment of the supplemental student loans if the students failto pay. The outstanding loans under these agreements at December 31, 2004aggregated $976, for which we have reserved $944 for our guarantee obligation.

 

On November 5, 1999, a qui tam action was filedin the United States District Court for the Southern District of Texas by twoformer employees (“relators”) on behalf of themselves and the federalgovernment under the following caption: *United States ex rel. DanGraves and Susan Newman v. ITT Educational Services, Inc., et al.*(the“Graves Action”). The Graves Action alleges, among other things, violations ofthe False Claims Act, 31 U.S.C. § 3730, by us, one of our employees andour registered public accounting firm in connection with how we compensated oursales representatives. The relators seek various forms of recovery on behalf ofthemselves and the federal government, including: (a) treble the amount ofunspecified damages sustained by the federal government; (b) a civil penalty ofup to $10,000 for each violation of the False Claims Act; (c) double back payfor Susan Newman; and (d) attorney’s fees, costs and interest.

 

F-21

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A qui tam action is a civil lawsuit brought by one ormore individuals (a qui tam “relator”) on behalf of the federal or stategovernment for an alleged submission to the government of a false claim forpayment. A qui tam action is always filed under seal and remains under sealuntil the government decides whether to intervene in the litigation. Whenever arelator files a qui tam action, the government typically initiates aninvestigation in order to determine whether to intervene in the litigation. Ifthe government intervenes, it has primary control over the litigation. If thegovernment declines to intervene, the relator may pursue the litigation onbehalf of the federal or state government and, if successful, receives aportion of the government’s recovery.

 

On May 25, 2001, the DOJ declined to intervene in the GravesAction. On March 31, 2002, the court dismissed all of the claims againstall of the defendants for failure to allege facts sufficient to support theclaims and gave the relators 20 days to file an amended complaint. The relatorsfiled an amended complaint on April 22, 2002 against all of thedefendants. On March 31, 2003, the court issued a final judgment in the GravesAction dismissing with prejudice all of the relators’ claims against us and allof the other defendants for failure to state a claim. On April 28, 2003,the relators filed a notice of appeal to the United States Court of Appeals forthe Fifth Judicial Circuit (“5th Circuit”). On October 20,2004, the 5th Circuit affirmed the district court’s judgment thatdismissed with prejudice all of the relators’ claims against us and the otherdefendants in the Graves Action. On November 3, 2004, the relators filed apetition with the 5th Circuit requesting a rehearing *en banc* of the relators’ appeal. On November 18,2004, the 5th Circuit denied the relators’ request for a rehearing. Onor about February 17, 2005, the relators filed a petition with the U.S.Supreme Court requesting that the Court hear the relators’ appeal of the 5thCircuit’s affirmation of the district court’s judgment dismissing the Graves action.

 

                OnMarch 4, 2005, we were served with a qui tam action that was filed on April 8,2004 in the United States District Court for the Southern District of Indianaby a former employee ("relator") on behalf of himself and the federalgovernment under the following caption: *United States of Americaex rel. Robert Olson v. ITT Educational Services, Inc. d/b/a ITT TechnicalInstitute* (the "Olson Action"). The relator alleges thatwe violated the False Claims Act, 31 U.S.C. § 3729, *et seq.*,by knowingly making and using false records and statements relating to, amongother things, student recruitment, admission, enrollment, attendance andgrading, graduate placement and course materials in order to fraudulentlyparticipate in the federal student financial aid programs. The complaint seeksan unspecified judgment and attorney's fees and costs. We were served with theOlson Action after the DOJ declined to intervene in the litigation. We intendto defend ourselves vigorously against the allegations made in the complaint.

 

On February 25,2004, federal agents executed search warrants at our corporate headquarters andat ten of our 77 ITT Technical Institutes nationwide. On that same date, ourDirectors and executive officers and some of our other employees each receiveda federal grand jury subpoena that was issued, along with the search warrants,by the U.S. District Court, Southern District of Texas, located in Houston,Texas. The search warrants and subpoenas seek broad categories of documents,including documents containing information relating to our figures and ratesfor placement, retention, graduation and attendance, recruitment and admissionsmaterials, student grades, graduate salaries, transferability of credits toother institutions, and personnel records. Although no formal charges have beenfiled, we believe that the DOJ is investigating claims alleging, among othermatters, falsification of records relating to student attendance, grades andacademic progress and graduate job placement statistics, and fraudulentmisrepresentations regarding the transferability of credits, graduation ratesand graduates’ salaries. We, our Directors and our executive officers arecontinuing to work with the DOJ to resolve its investigation. The costs that wehave incurred in connection with the DOJ investigation have had a materialadverse effect on our financial condition and results of operations, and wecannot assure you that the ultimate outcome of the DOJ investigation will nothave a further material adverse effect on our financial condition and resultsof operations.

 

On March 4,2004, we were notified by the Fort Worth, Texas regional office of the SEC thatit had initiated an inquiry into the allegations being investigated by the DOJas described in the preceding paragraph. We are cooperating with the SEC in itsinquiry. We cannot assure you, however, that the ultimate outcome of the SECinquiry will not have a material adverse effect on our financial condition orresults of operations.

 

In October 2002,the Office of the Attorney General for the State of California (“CAG”) informedus that it had initiated an investigation of our ITT Technical Institutes inCalifornia. We believe that the CAG’s investigation is in response to one ormore qui tam actions filed against us under the state and/or federal FalseClaims Acts. The CAG has not asserted any claims against us. Based on theinformation that the CAG has requested, however, we believe that the CAG isinvestigating, among other matters, whether one or more of our California ITTTechnical Institutes:

 

•                  falsified records relating to studentattendance, grades and academic progress;

•                  falsified student grade point averagecalculations used to qualify students for financial aid under the State’s CalGrant Program; and

•                  retaliated against employees who mayhave complained about those alleged acts.

 

F-22

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We are cooperating withthe CAG in its investigation, and we have been conducting our own investigationof the same matters. While we cannot assure you of the ultimate outcome of theCAG investigation, based on the results of our investigation to date, we do notbelieve that the CAG investigation and any qui tam actions that may beassociated with the investigation will have a material adverse effect on ourfinancial condition, results of operations or cash flows.

 

On August 19,2004, a consolidated complaint in a securities class action lawsuit was filedagainst us and ten of our current and former Directors and executive officersin the U.S. District Court for the Southern District of Indiana under thefollowing caption: *City of Austin PoliceRetirement System, Individually And On Behalf Of All Others Similarly Situatedv. ITT Educational Services, Inc., et al.* This action is a result ofthe court’s June 18, 2004 order to consolidate 13 separate securitiesclass action lawsuits filed from February 26, 2004 through April 23,2004. The consolidated complaint alleges, among other things, that thedefendants violated Sections 10(b) and 20(a) of the Exchange Act, and Rule10b-5 promulgated thereunder, by engaging in an unlawful course of conduct,pursuant to which the defendants knowingly or recklessly engaged in acts,transactions, practices and courses of business to conceal adverse materialinformation about our financial condition, and that this conduct operated as afraud and deceit upon the plaintiffs. The complaint also alleges that thedefendants made various deceptive and untrue statements of material facts andomitted to state material facts necessary in order to make the statements made,in light of the circumstances under which they were made, not misleading to theplaintiffs, causing the plaintiffs to purchase our securities at artificiallyinflated prices. The putative class period in this action is from October 17,2002 through March 8, 2004. The plaintiffs seek, among other things, anaward of unspecified compensatory damages, interest, costs, expenses andattorney’s fees. All of the defendants intend to defend themselves vigorouslyagainst the allegations made in the complaint. We cannot assure you, however,that the ultimate outcome of this or other actions (including other actionsunder federal or state securities laws) will not have a material adverse effecton our financial condition or results of operations.

 

On orabout April 29, 2004, a consolidated complaint in a shareholder derivativelawsuit was filed against five of our current and former executive officers,ten of our current and former Directors and PricewaterhouseCoopers LLP (“PWC”),our independent registered public accounting firm, in the Superior Court ofHamilton County, Indiana under the following caption: *In Re ITT Educational Services, Inc. DerivativeLitigation*. This action is a result of the court’s March 30,2004 order to consolidate two separate shareholder derivative lawsuits filed onor about February 27, 2004. On December 1, 2004, the court dismissedthe consolidated complaint without prejudice and gave the plaintiffs 30 days toreplead their complaint. On January 3, 2005, the plaintiffs filed anamended consolidated complaint. The amended consolidated complaint alleges,among other things, that:

 

•                  certain individual defendantsbreached a fiduciary duty by selling our common stock and misappropriating ourinformation;

•                  all defendants breached theirfiduciary duties to us, abused their ability to control and influence us,grossly mismanaged us, caused us to waste corporate assets and were unjustlyenriched; and

•                  PWC breached a duty of care andprofessional competence to us and breached its contracts with us.

 

The amended consolidatedcomplaint seeks unspecified damages, extraordinary equitable and/or injunctiverelief, disgorgement of profits, benefits and other compensation, costs and attorneys’fees. All of the individual defendants intend to defend themselves vigorouslyagainst the allegations in the complaint.

 

On September 7,2004, a shareholder derivative lawsuit was filed against five of our currentand former executive officers, ten of our current and former Directors and PWC,in the U.S. District Court for the Southern District of Indiana under thefollowing caption: *Alaska Electrical PensionFund Derivatively on Behalf of ITT Educational Services, Inc. v. Rene R.Champagne, et al.* The complaint alleges, among other things, thatthe defendants caused us to violate state and federal education finance lawsand regulations by falsifying our student records and federal securities lawsby falsifying our accounting, auditing and financial reporting between October 2002and April 2004. As a result, the complaint alleges, among other things,that the individual defendants:

 

F-23

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•                  breached and/or aided and abetted inthe breach of:

•                  a duty to disseminate accurateinformation about us;

•                  fiduciary duties of care, candor andloyalty to us and disclosure to our shareholders;

•                  a duty to test, oversee and monitorour system of internal controls, governance procedures and disclosureprocedures; and

•                  a duty to ensure that our internalcontrols, governance procedures and disclosure procedures were functioning inan effective manner and in compliance with Pub. L. 107-204, 116 Stat. 745(2002);

•                  abused their ability to control and influenceus;

•                  grossly mismanaged us;

•                  committed constructive fraud;

•                  will be and have been unjustlyenriched at our expense; and

•                  violated Section 10(b) of theExchange Act and Rule 10-5 promulgated thereunder by:

•                  disseminating or approving falsestatements that they knew or recklessly disregarded were misleading;

•                  failing to disclose material factsnecessary in order to make those statements not misleading; and

•                  misappropriating our proprietaryinformation.

 

Inaddition, the complaint alleges, among other things, that PWC:

 

•                  violated Section 10(b) of theExchange Act and Rule 10b-5 promulgated thereunder by:

•                  disseminating or approving falsestatements that it knew or recklessly disregarded were misleading; and

•                  failing to disclose material factsnecessary in order to make those statements not misleading;

•                  was negligent and committedaccounting malpractice by failing to conduct its audits of our 2002 and 2003fiscal year financial statements in accordance with generally acceptedaccounting principles, generally accepted auditing standards and SEC rules;

•                  aided and abetted the individualdefendants’:

•                  breach of fiduciary duties to us;

•                  abuse of their control of us; and

•                  gross mismanagement of us; and

•                  violated their duty of candor to ourshareholders.

 

The complaint seeksunspecified damages, extraordinary equitable and/or injunctive relief, punitivedamages, costs and expenses, attorneys’ fees, pre-judgment interest, an orderdirecting the defendants to account for all damages caused by them and allprofits, special benefits and unjust enrichment they obtained, and an orderdirecting us to reform and improve our corporate governance and internalcontrol procedures. On December 8, 2004, the parties agreed to stay thisaction pending the entry of a final judgment in the *In Re ITT Educational Services, Inc. Derivative Litigation*action, except that the stay will be lifted if a subsequently filed shareholderderivative lawsuit is filed in the Southern District of Indiana and thedefendants are unable to enter into a similar stay of that action. All of theindividual defendants intend to defend themselves vigorously against theallegations in the complaint.

 

On November 17,2004, a shareholder derivative lawsuit was filed against ten of our current andformer Directors, in the Chancery Court of New Castle County, Delaware underthe following caption: *Albert Reitan,derivatively on behalf of nominal defendant ITT Educational Services, Inc. v.Rand V. Araskog, et al.* The complaint alleges, among other things,that the defendants abdicated their fiduciary duty of good faith to us bymaking no effort to oversee our operations and business practices to ensurethat we comply with all applicable laws, rules and regulations. The complaintseeks unspecified damages, equitable relief, attorneys’ fees, accountants’fees, experts’ fees, costs and expenses. All of the defendants intend to defendthemselves vigorously against the allegations in the complaint.

 

Although the derivative actions are brought nominallyon behalf of us, we expect to incur defense costs and other expenses inconnection with the derivative lawsuits, and we cannot assure you that theultimate outcome of these or other actions will not have a material adverseeffect on our financial condition or results of operations.

 

F-24

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On July 7,2004, we received a derivative demand letter pursuant to Del. Ct. Ch. R. 23.1on behalf of Mr. Stein, a purported shareholder, demanding that our Board ofDirectors commence a civil action against each of our current Directors, oneformer Director and four of our current and former executive officers torecover for our benefit the amount of damages sustained by us as aresult of the misconduct alleged in the letter.  The misconduct alleged inthe letter is similar to the type of misconduct alleged against theindividual defendants in the consolidated shareholderderivative lawsuit described above.  The demand letter indicates thatMr. Stein will commence a shareholder’s derivative action on ourbehalf, if our Board does not commence an action as demanded therein within areasonable period of time.  We have informed Mr. Stein that our Board has deferred its decision with respectto Mr. Stein’s demand until the conclusion of the DOJ investigation of us, theinquiry initiated by the SEC into the allegations being investigated by the DOJand the securities class action lawsuits filed against us, or until the receiptof additional information concerning the allegations made in the demand.

 

On October 26,2004, a lawsuit was filed against us in the Chancery Court of New CastleCounty, Delaware under the following caption: *ArthurStein v. ITT Educational Services, Inc.* The complaint alleges thatwe violated Section 220 of the Delaware General Corporation Law byrefusing to allow Mr. Stein to inspect and make copies of our books and recordsrelating to the misconduct alleged in his derivative demand letter describedabove. The complaint seeks an order compelling us to permit Mr. Stein toinspect and make copies of our books and records, and to pay his costs,expenses and attorney’s fees to prosecute this action. We intend to defend theaction vigorously.

 

On December 15, 2004, a lawsuit was filed againstus, our internal committee that administers our 401(k) retirement savings plan(the “Plan”), the chairperson of that committee and a number of other unnamedentities and individuals, in the United States District Court for the SouthernDistrict of Indiana under the following caption: *William Curry, individually and on behalf of all others similarlysituated v. ITT Educational Services, Inc., et al.* The complaintalleged, among other things, that the defendants breached their fiduciaryduties under Section 502 of the Employee Retirement Income Security Act (“ERISA”)that are owed to the participants and beneficiaries of the Plan by failing toprudently manage the Plan’s assets. Allegedly, the breach arose from the Plan’sholding and acquisition of our common stock when the defendants knew or shouldhave known that our common stock was not a suitable and appropriate investmentfor the Plan. The complaint alleged that our common stock was an inappropriateinvestment, because we supposedly misrepresented our operational success andthe subsequent disclosure of those misrepresentations caused the price of ourcommon stock to decrease. As a result of this decrease in the price of ourcommon stock, the complaint alleged that the value of the Plan assets sufferedlosses. The plaintiff sought to certify this action as a class action toinclude all participants in the Plan and their beneficiaries, excluding thedefendants and their immediate family members, for whose accounts the Planfiduciaries made or maintained investments in our common stock from October 17,2002 through March 18, 2004. The plaintiff also sought, among otherthings:

 

•                  a declaration that the defendantsbreached their fiduciary duties under ERISA to the Plan;

•                  to require the defendants to restoreto the Plan all losses resulting from the alleged imprudent investment of thePlan’s assets;

•                  to require the defendants to restoreto the Plan all profits that the defendants made through their use of the Plan’sassets;

•                  to require the defendants to restoreto the Plan all profits that the Plan would have realized had the defendantsfulfilled their fiduciary obligations under ERISA;

•                  other unspecified equitablerestitution and monetary relief;

•                  a constructive trust with respect toany unjust enrichment received by the defendants at the expense of the Plan asa result of the defendants’ alleged breach of their fiduciary duties underERISA;

•                  to enjoin the defendants from furtherviolating their fiduciary duties under ERISA;

•                  the appointment of independentfiduciaries to administer the Plan; and

•                  costs and attorneys’ fees.

 

The plaintiff filed anotice to voluntarily dismiss this action on January 25, 2005, and thecourt dismissed this action without prejudice on the same date.

 

F-25

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The current andformer executive officers named in one or more of the securities class action,shareholder derivative and Plan class action lawsuits and derivative demandletter described above include: Gene A. Baugh, Rene R. Champagne, Clark D.Elwood, Nina F. Esbin, Eugene W. Feichtner, Martin A. Grossman, Thomas W.Lauer, Kevin M. Modany and Omer E. Waddles.

 

Certain of ourcurrent and former officers and Directors are or may become a party in certainof the actions described above. Our By-Laws and Restated Certificate of Incorporationobligate us to indemnify our officers and Directors to the fullest extentpermitted by Delaware law, provided that their conduct complied with certainrequirements. We are obligated to advance defense costs to our officers andDirectors, subject to the individual’s obligation to repay such amount if it isultimately determined that the individual was not entitled to indemnification.In addition, our indemnity obligation can, under certain circumstances, includeindemnifiable judgments, penalties, fines and amounts paid in settlement inconnection with those actions.

 

As previouslydisclosed, on March 4, 2004, our Board of Directors appointed a SpecialCommittee of independent Directors. The Special Committee has completed itsinvestigation relating to the conduct and integrity of our senior management. Inlate June 2004, the Special Committee reported to our Board of Directorsthat it had found no evidence that our senior management had engaged in anyviolations of our policies and procedures or any wrongful or criminal conductrelated to the matters that are the subject of the DOJ and CAG investigationsand the securities class action lawsuit described above. The Special Committeealso reported that when allegations of possible violations have been brought tothe attention of our senior management, we have investigated those allegationsand our senior management has taken appropriate action when responding to thoseallegations and any violations found.

 

F-26

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**SCHEDULE II**

 

**ITTEDUCATIONAL SERVICES, INC.**

**VALUATIONAND QUALIFYING ACCOUNTS**

**FORTHE THREE YEARS ENDED DECEMBER 31, 2004**

**(Inthousands)**

 
| **Description**                   | ** ** | **Balance at  Beginning  of Period** | ** ** | **Charged  to  Expenses** | ** ** | **Write-offs** | ** ** | **Balance  at End of  Period** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|---------------------------|------------|----------------|------------|--------------------------------|------------|
| Allowance for Doubtful Accounts:  |       |                                 |       |                      |       |           |       |                           |       |
| Year Ended December 31, 2004 |       | $                                    | 1,644      |                      | $          | 11,996         |       | $                              | (12,122    | ) | $ | 1,518 |   |
| Year Ended December 31, 2003 |       | $                                    | 1,810      |                      | $          | 6,134          |       | $                              | (6,300     | ) | $ | 1,644 |   |
| Year Ended December 31, 2002 |       | $                                    | 2,216      |                      | $          | 6,872          |       | $                              | (7,278     | ) | $ | 1,810 |   |
|                              |       |                                 |       |                      |       |           |       |                           |       |
| FFEL Reserve(1):                  |       |                                 |       |                      |       |           |       |                           |       |
| Year Ended December 31, 2004 |       | $                                    | 32         |                      | $          | (32            | )          | $                              | —     |   | $ | — |   |
| Year Ended December 31, 2003 |       | $                                    | 165        |                      | $          | (133           | )          | $                              | —     |   | $ | 32 |   |
| Year Ended December 31, 2002 |       | $                                    | 85         |                      | $          | 80             |       | $                              | —     |   | $ | 165 |   |
|                                   |            |                                      |            |                           |            |                |            |                                |            |  |  |  |  |  |  |  |  |

 

----

(1) Represents FederalFamily Education Loan/Perkins Loan programs.

 

F-27

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**ITTEDUCATIONAL SERVICES, INC.**

**QUARTERLYRESULTS**

**FOR2004 AND 2003**

**(In thousands, except per share data)**

**(unaudited)**

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** | ** **       | ** ** |
|-------------------------------------------------|------------|------------------------|------------|------------------|------------|
| ** **                                      | ** ** | **March 31**      | ** ** | **June 30** | ** ** | **Sept. 30** | ** ** | **Dec. 31** | ** ** | **Year** | ** ** |
| **2003**                                        | ** ** | ** **             | ** ** | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                         |       | $                      | 119,000    |             | $          | 124,831 |   | $ | 134,382 |   | $ | 144,643 |   | $ | 522,856 |   |
| Cost of educational services                    |       | $                      | 68,333     |             | $          | 72,449 |   | $ | 69,681 |   | $ | 69,543 | (a) | $ | 280,006 |   |
| Student services and administrative expenses    |       | $                      | 36,998     |             | $          | 36,924 |   | $ | 39,495 |   | $ | 34,912 |   | $ | 148,329 |   |
| Operating income                                |       | $                      | 13,669     |             | $          | 15,458 |   | $ | 25,206 |   | $ | 40,188 | (a) | $ | 94,521 |   |
| Interest income, net                            |       | $                      | 448        |             | $          | 550 |   | $ | 551 |   | $ | 446 |   | $ | 1,995 |   |
| Net income                                      |       | $                      | 8,682      |             | $          | 9,845 |   | $ | 15,841 |   | $ | 24,490 |   | $ | 58,858 |   |
| Earnings per share                              |       |                   |       |             |       |   |   |   |   |   |   |
| Basic                                           |       | $                      | 0.19       |             | $          | 0.22 |   | $ | 0.35 |   | $ | 0.54 |   | $ | 1.31 |   |
| Diluted                                         |       | $                      | 0.19       |             | $          | 0.21 |   | $ | 0.34 |   | $ | 0.52 |   | $ | 1.27 |   |
|                                            |       |                   |       |             |       |   |   |   |   |   |   |
| **2004**                                        |       |                   |       |             |       |   |   |   |   |   |   |
| Revenue                                         |       | $                      | 141,730    |             | $          | 150,931 |   | $ | 157,945 |   | $ | 167,228 |   | $ | 617,834 |   |
| Cost of educational services                    |       | $                      | 76,493     |             | $          | 78,010 |   | $ | 75,033 |   | $ | 69,211 | (a) | $ | 298,747 |   |
| Student services and administrative expenses    |       | $                      | 41,449     |             | $          | 45,045 |   | $ | 43,771 |   | $ | 44,131 |   | $ | 174,396 |   |
| Special legal and other investigation costs (b) |       | $                      | 9,700      |             | $          | 5,606 |   | $ | 9,837 |   | $ | — |   | $ | 25,143 |   |
| Operating income                                |       | $                      | 14,088     |             | $          | 22,270 |   | $ | 29,304 |   | $ | 53,886 | (a) | $ | 119,548 |   |
| Interest income, net                            |       | $                      | 709        |             | $          | 648 |   | $ | 959 |   | $ | 1,518 |   | $ | 3,834 |   |
| Net income                                      |       | $                      | 9,026      |             | $          | 13,980 |   | $ | 18,460 |   | $ | 33,797 |   | $ | 75,263 |   |
| Earnings per share                              |       |                   |       |             |       |   |   |   |   |   |   |
| Basic                                           |       | $                      | 0.20       |             | $          | 0.31 |   | $ | 0.40 |   | $ | 0.74 |   | $ | 1.64 |   |
| Diluted                                         |       | $                      | 0.19       |             | $          | 0.30 |   | $ | 0.39 |   | $ | 0.72 |   | $ | 1.61 |   |

 

----

(a) Includes $1,902 inthe three months ended December 31, 2003 and $3,550 in the three monthsended December 31, 2004 related to year-end inventory adjustments.

(b) Accrued estimatedlegal and other investigation costs associated with the DOJ investigation, theinquiry initiated by the SEC into the allegations being investigated by theDOJ, and the securities class action, shareholder derivative and books andrecords inspection lawsuits filed against us, certain of our current and formerexecutive officers and each of our Directors.

 

F-28

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**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Actof 1934, the registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.

 
|                        | ITT Educational  Services, Inc. |
|-----------------------------|---------------------------------|
|                        |                            |   |   |
|                        | By:                             | /s/ Rene R. Champagne |   |
| Dated: March 15,  2005 |                            | Rene R. Champagne |   |
| * *                    | * *                        | *Chairman and Chief Executive Officer* |   |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **Signature**             | ** ** | **Title**                        | ** ** | **Date**             |
|---------------------------|------------|----------------------------------|------------|----------------------|
| ** **                | ** ** | ** **                       | ** ** | ** **           |
| /s/ Rene R.  Champagne    |       | Chairman, Chief  Executive       |       | March 15,  2005 |
| Rene R.  Champagne        |       | Officer and  Director (Principal |       |                 |
|                      |       | Executive  Officer)              |       |                 |
|                      |       |                             |       |                 |
| /s/ Kevin M.  Modany      |       | Senior Vice  President and Chief |       | March 15,  2005 |
| Kevin M. Modany           |       | Financial  Officer (Principal    |       |                 |
|                      |       | Financial  Officer)              |       |                 |
|                      |       |                             |       |                 |
| /s/ Julie A.  Shedd       |       | Vice President,  Controller and  |       | March 15,  2005 |
| Julie A. Shedd            |       | Treasurer  (Principal Accounting |       |                 |
|                      |       | Officer)                         |       |                 |
|                      |       |                             |       |                 |
| /s/ Rand V.  Araskog      |       | Director                         |       | March 15,  2005 |
| Rand V. Araskog           |       |                             |       |                 |
|                      |       |                             |       |                 |
| /s/ John F.  Cozzi        |       | Director                         |       | March 15,  2005 |
| John F. Cozzi             |       |                             |       |                 |
|                      |       |                             |       |                 |
| /s/ John E. Dean          |       | Director                         |       | March 15,  2005 |
| John E. Dean              |       |                             |       |                 |
|                      |       |                             |       |                 |
| /s/ James D.  Fowler, Jr. |       | Director                         |       | March 15,  2005 |
| James D. Fowler,  Jr.     |       |                             |       |                 |
|                      |       |                             |       |                 |
| /s/ Joanna T.  Lau        |       | Director                         |       | March 15,  2005 |
| Joanna T. Lau             |       |                             |       |                 |
|                      |       |                             |       |                 |
| /s/ Harris N.  Miller     |       | Director                         |       | March 15,  2005 |
| Harris N. Miller          |       |                             |       |                 |
|                      |       |                             |       |                 |
| /s/ Daniel P.  Weadock    |       | Director                         |       | March 15,  2005 |
| Daniel P.  Weadock        |       |                             |       |                 |
|                      |       |                             |       |                 |
| /s/ Vin Weber             |       | Director                         |       | March 15,  2005 |
| Vin Weber                 |       |                             |       |                 |

 

S-1

----

 

**INDEX TO EXHIBITS**

 

 
| **Exhibit  No** | ** ** | **Description**                                                                                                     | ** ** |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|
| ** **      | ** ** | ** **                                                                                                          | ** ** |
| 3.1             |       | (1) Restated Certificate of Incorporation, as  Amended to Date                                                      |       |
|            |       |                                                                                                                |       |
| 3.2             |       | (2) Restated By-laws, as Amended to Date                                                                            |       |
|            |       |                                                                                                                |       |
| 10.1            |       | (3) Registration Rights Agreement between ITT/ESI  and ITT                                                          |       |
|            |       |                                                                                                                |       |
| 10.2            |       | (3) Tax Sharing Agreement between ITT/ESI and ITT                                                                   |       |
|            |       |                                                                                                                |       |
| 10.3            |       | (3) Intercompany Agreement between ITT/ESI and ITT                                                                  |       |
|            |       |                                                                                                                |       |
| 10.4            |       | (3) Trade Name and Service Mark License Agreement  between ITT/ESI and ITT                                          |       |
|            |       |                                                                                                                |       |
| 10.5            |       | (3) Employee Benefits and Administrative Services  Agreement between ITT/ESI and ITT                                |       |
|            |       |                                                                                                                |       |
| 10.6            |       | (3) Treasury Services and Credit Facilities  Agreement between ITT/ESI and ITT                                      |       |
|            |       |                                                                                                                |       |
| 10.7            |       | *(4) ITT Educational Services, Inc. 1994 Stock  Option Plan                                                         |       |
|            |       |                                                                                                                |       |
| 10.8            |       | *(5) 1997 ITT Educational Services, Inc. Incentive  Stock Plan                                                      |       |
|            |       |                                                                                                                |       |
| 10.9            |       | (6) Employee Benefits Agreement between ITT/ESI and  ITT                                                            |       |
|            |       |                                                                                                                |       |
| 10.10           |       | (6) Income Tax Sharing Agreement between ITT/ESI,  ITT and Starwood Hotels & Resorts Worldwide, Inc.            |       |
|            |       |                                                                                                                |       |
| 10.11           |       | (6) Trade Name and Service Mark License Agreement  between ITT/ESI and ITT Sheraton Corporation                     |       |
|            |       |                                                                                                                |       |
| 10.12           |       | (7) Amended and Restated Registration Rights  Agreement between ITT/ESI and ITT                                     |       |
|            |       |                                                                                                                |       |
| 10.13           |       | (8) Stockholder Agreement between ITT/ESI and ITT                                                                   |       |
|            |       |                                                                                                                |       |
| 10.14           |       | *(9) ESI 401(k) Plan                                                                                                |       |
|            |       |                                                                                                                |       |
| 10.15           |       | *(6) ESI Excess Savings Plan                                                                                        |       |
|            |       |                                                                                                                |       |
| 10.16           |       | *(10) ESI Pension Plan                                                                                              |       |
|            |       |                                                                                                                |       |
| 10.17           |       | (11) Stock Repurchase Agreement between ITT/ESI and  ITT                                                            |       |
|            |       |                                                                                                                |       |
| 10.18           |       | (12) First Amendment to Trade Name and Service Mark  License Agreement between ITT/ESI and ITT Sheraton Corporation |       |
|            |       |                                                                                                                |       |
| 10.19           |       | *(1) ESI Excess Pension Plan                                                                                        |       |
|            |       |                                                                                                                |       |
| 10.20           |       | *(13) 1999 Outside Directors Stock Option Plan                                                                      |       |

 

S-2

----

 
| 10.21  |   | *(14) ESI Non-Employee Directors Deferred  Compensation Plan                                                                                                            |   |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |   |                                                                                                                                                                    |   |
| 10.22  |   | *(15) ESI Executive Deferred Bonus Compensation Plan                                                                                                                    |   |
|   |   |                                                                                                                                                                    |   |
| 10.23  |   | *(16) First Amendment of ESI Pension Plan                                                                                                                               |   |
|   |   |                                                                                                                                                                    |   |
| 10.24  |   | (16) Second Amendment to Trade Name and Service Mark  License Agreement between ITT/ESI and ITT Manufacturing Enterprises, Inc.  (assignee of ITT Sheraton Corporation) |   |
|   |   |                                                                                                                                                                    |   |
| 10.25  |   | *(16) First  Amendment to ESI Excess Savings Plan                                                                                                                       |   |
|   |   |                                                                                                                                                                    |   |
| 10.26  |   | *(17) Second Amendment of ESI Pension Plan                                                                                                                              |   |
|   |   |                                                                                                                                                                    |   |
| 10.27  |   | *(18) ESI Senior Executive Severance Pay Plan                                                                                                                           |   |
|   |   |                                                                                                                                                                    |   |
| 10.28  |   | *(18) ESI Special Senior Executive Severance Pay  Plan                                                                                                                  |   |
|   |   |                                                                                                                                                                    |   |
| 10.29  |   | * (19) Third Amendment of ESI Pension Plan                                                                                                                              |   |
|   |   |                                                                                                                                                                    |   |
| 10.30  |   | * (19) Restated ESI 401(k) Plan, as Amended to Date                                                                                                                     |   |
|   |   |                                                                                                                                                                    |   |
| 10.31  |   | * (20) First Amendment of ESI 401(k) Plan                                                                                                                               |   |
|   |   |                                                                                                                                                                    |   |
| 10.32  |   | * (21) Second Amendment to ESI Excess Savings Plan                                                                                                                      |   |
|   |   |                                                                                                                                                                    |   |
| 10.33  |   | * (22) Fourth Amendment of ESI Pension Plan                                                                                                                             |   |
|   |   |                                                                                                                                                                    |   |
| 10.34  |   | * (23) Third Amendment to ESI Excess Savings Plan                                                                                                                       |   |
|   |   |                                                                                                                                                                    |   |
| 10.35  |   | * (23) First Amendment to ESI Excess Pension Plan                                                                                                                       |   |
|   |   |                                                                                                                                                                    |   |
| 10.36  |   | * (23) Fifth Amendment to ESI Pension Plan                                                                                                                              |   |
|   |   |                                                                                                                                                                    |   |
| 10.37  |   | * (23) First Amendment to the 1999 Outside Directors  Stock Option Plan                                                                                                 |   |
|   |   |                                                                                                                                                                    |   |
| 10.38  |   | * (23) First Amendment to the 1997 ITT Educational  Services, Inc. Incentive Stock Plan                                                                                 |   |
|   |   |                                                                                                                                                                    |   |
| 10.39  |   | * (24) Second Amendment of ESI 401(k) Plan                                                                                                                              |   |
|   |   |                                                                                                                                                                    |   |
| 10.40  |   | * (25) Sixth Amendment to ESI Pension Plan                                                                                                                              |   |
|   |   |                                                                                                                                                                    |   |
| 10.41  |   | * (26) Third Amendment to ESI 401(k) Plan                                                                                                                               |   |
|   |   |                                                                                                                                                                    |   |
| 10.42  |   | * (27) Second Amendment to the 1999 Outside  Directors Stock Option Plan                                                                                                |   |
|   |   |                                                                                                                                                                    |   |
| 10.43  |   | * (28) Separation and General Release Agreement                                                                                                                         |   |
|   |   |                                                                                                                                                                    |   |
| 10.44  |   | * (29) 1999 Outside Directors Stock Option Plan-Form  of Non-Qualified Stock Option Agreement                                                                           |   |
|   |   |                                                                                                                                                                    |   |
| 10.45  |   | * (29) 1997 ITT Educational Services, Inc. Incentive  Stock Plan-Form of Nonqualified Stock Option Award Agreement                                                      |   |
|   |   |                                                                                                                                                                    |   |
| 10.46  |   | * (29) Seventh Amendment of ESI Pension Plan                                                                                                                            |   |
|   |   |                                                                                                                                                                    |   |
| 10.47  |   | * (30) Third Amendment to the 1999 Outside Directors  Stock Option Plan                                                                                                 |   |
|   |   |                                                                                                                                                                    |   |
| 10.48  |   | * Summary of Certain Director and Executive  Compensation                                                                                                               |   |
|   |   |                                                                                                                                                                    |   |
| 11     |   | Statement re Computation of Per Share Earnings                                                                                                                          |   |

 

S-3

----

 
| 21     |   | Subsidiaries                                                                                                               |   |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------|--------|
|   |   |                                                                                                                       |   |
| 23     |   | Consent of  Independent Registered Public Accounting Firm                                                                  |   |
|   |   |                                                                                                                       |   |
| 31.1   |   | Chief Executive  Officer’s Certification Pursuant to Rule 13a-14(a)/15d-14(a) of the  Securities Exchange Act of 1934 |   |
|   |   |                                                                                                                       |   |
| 31.2   |   | Chief Financial  Officer’s Certification Pursuant to Rule 13a-14(a)/15d-14(a) of the  Securities Exchange Act of 1934 |   |
|   |   |                                                                                                                       |   |
| 32.1   |   | Chief Executive  Officer’s Certification Pursuant to 18 U.S.C. Section 1350                                      |   |
|   |   |                                                                                                                       |   |
| 32.2   |   | Chief Financial  Officer’s Certification Pursuant to 18 U.S.C. Section 1350                                      |   |

 

----

*The indicated exhibit is a management contract, compensatory plan orarrangement required to be filed by Item 601 of RegulationS-K.

 
| (1)  |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 1999 second fiscal  quarter report on Form 10-Q is incorporated herein by reference.                                                           |
|------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2)  |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2002 third fiscal  quarter report on Form 10-Q is incorporated herein by reference.                                                            |
| (3)  |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 1994 Annual Report on  Form 10-K is incorporated herein by reference.                                                                          |
| (4)  |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s Registration Statement  on Form S-1 (Registration No. 33-78272) is incorporated herein by reference.                                           |
| (5)  |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 1997 second fiscal  quarter report on Form 10-Q is incorporated herein by reference.                                                           |
| (6)  |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 1998 second fiscal  quarter report on Form 10-Q is incorporated herein by reference.                                                           |
| (7)  |   | The copy of this  exhibit filed as Exhibit 99.2 to Starwood Hotels & Resorts Worldwide,  Inc.’s and ITT’s Amendment No. 1 to Schedule 13D dated June 29,  1998 is incorporated herein by reference. |
| (8)  |   | The copy of this  exhibit filed as Exhibit 99.1 to Starwood Hotels & Resorts Worldwide,  Inc.’s and ITT’s Amendment No. 1 to Schedule 13D dated June 29,  1998 is incorporated herein by reference. |
| (9)  |   | The copy of this  exhibit filed as Exhibit 4.3 to ITT/ESI’s Registration Statement on Form S-8  (Registration No. 333-55903) is incorporated herein by reference.                                                      |
| (10) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 1998 third fiscal  quarter report on Form 10-Q is incorporated herein by reference.                                                            |
| (11) |   | The copy of this  exhibit filed as Exhibit 99.1 to ITT/ESI’s current report on Form 8-K dated  December 21, 1998 is incorporated herein by reference.                                                             |
| (12) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 1998 Annual Report on  Form 10-K is incorporated herein by reference.                                                                          |
| (13) |   | The copy of this  exhibit filed as Exhibit 4.3 to ITT/ESI’s Registration Statement on Form S-8  (Registration No. 333-84871) is incorporated herein by reference.                                                      |
| (14) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 1999 third fiscal  quarter report on Form 10-Q is incorporated herein by reference.                                                            |
| (15) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2000 first fiscal  quarter report on Form 10-Q is incorporated herein by reference.                                                            |
| (16) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2000 third fiscal  quarter report on Form 10-Q is incorporated herein by reference.                                                            |
| (17) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2001 second fiscal  quarter report on Form 10-Q is incorporated herein by reference.                                                           |
| (18) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2001 third fiscal  quarter report on Form 10-Q is incorporated herein by reference.                                                            |

 

S-4

----

 

 
| (19) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2001 Annual Report on  Form 10-K is incorporated herein by reference.                        |
|------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (20) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2002 second fiscal  quarter report on Form 10-Q is incorporated herein by reference.         |
| (21) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2002 third fiscal  quarter report on Form 10-Q is incorporated herein by reference.          |
| (22) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2002 Annual Report on  Form 10-K is incorporated herein by reference.                        |
| (23) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2003 second fiscal  quarter report on Form 10-Q is incorporated herein by reference.         |
| (24) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2003 Annual Report on  Form 10-K is incorporated herein by reference.                        |
| (25) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2004 first fiscal  quarter report on Form 10-Q is incorporated herein by reference.          |
| (26) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2004 first fiscal  quarter report on Form 10-Q is incorporated herein by reference.          |
| (27) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2004 first fiscal  quarter report on Form 10-Q is incorporated herein by reference.          |
| (28) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2004 second fiscal  quarter report on Form 10-Q is incorporated herein by reference.         |
| (29) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s 2004 third fiscal  quarter report on Form 10-Q is incorporated herein by reference.          |
| (30) |   | The copy of this  exhibit filed as the same exhibit number to ITT/ESI’s current report on Form  8-K dated January 25, 2005 is incorporated herein by reference. |

 

S-5

----