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K12 (NYSE:LRN)
Q1 2018 Earnings Conference Call
Jan. 25, 2018 5:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Greetings and welcome to the K12 Second-Quarter Fiscal 2018 Earnings Conference Call. At this time all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press * 0 on your telephone keypad.

As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mike Kraft, VP of finance. Please go ahead.

Mike Kraft -- Vice President of Finance

Thank you and good afternoon. Welcome to K12's second-quarter earnings call for fiscal year 2018. Before we begin, I would like to remind you that in addition to historical information, certain comments made during this conference call may be considered forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and should be considered in conjunction with cautionary statements contained in our earnings release and the company's periodic filings with the SEC. Forward-looking statements involve risks and uncertainties that may cause actual performance or results to differ materially from those expressed or implied by such statements.

In addition, this conference call contains time-sensitive information that reflects management's best analysis only as of the day of this live call. K12 does not undertake any obligation to publicly update or revise any forward-looking statements. For further information concerning risks and uncertainties that could materially affect financial and operational performance and results, please refer to our reports filed with the SEC including, without limitation, cautionary statements made in K12's 2017 annual report on Form 10-K. These filings can be found on the Investor Relations section of our website at www.k12.com.

In addition to disclosing financial results in accordance with generally accepted accounting principles in the U.S., or GAAP, we will discuss certain information that is considered non-GAAP financial information. A reconciliation of this non-GAAP financial information to the most closely comparable GAAP information was included in our earnings release and is also posted on our website. This call is open to the public and is being webcast. The call will be available for replay for 30 days.

With me on today's call is Stuart Udell, chief executive officer, and James Rhyu, chief financial officer. Following our prepared remarks, we will answer any questions you may have. I'd like to now turn the call over to Stuart. Stuart?

Stuart Udell -- Chief Executive Officer

Thanks, Mike. Good afternoon, and thanks for joining us on the call today. Our results for the quarter were solidly in line with the guidance we provided. Revenue for the quarter was $217.2 million, a decrease of 1.8% year over year, and adjusted operating income was $20.9 million, a decrease of 8.7% year over year.

Both the year-over-year decline in revenue and adjusted operating income are largely results of positive performance in our managed public schools, offset by lower performance in our institutional business. Year-over-year managed public school enrollment increased 2.2%, with slightly lower revenue per enrollment. Institutional revenues declined 16.4% year over year as a result of sales execution not being as effective as it needed to be, especially during last summer's selling season. We are now halfway through the year, and as our third-quarter outlook suggests, our expectations remain in line with our original guidance for the year.

Our team continues to focus on increasing long-term shareholder value by executing against our strategic priorities in the areas of academic outcomes, student retention, curriculum innovation, and diversification. We believe that by executing well in these priorities, we will drive revenue and free cash flow growth over the long term. With regard to academic outcomes, after the initial roll-out of the academic excellence framework last school year, in Year 2, our school partners are laser-focused on driving best practices and fidelity of implementation. This comprehensive framework rooted in research and best practices from high-performing schools creates a consistent set of expectations across all of our partner schools in areas such as curriculum, instruction, assessments, and school climate.

In fact, we saw preliminary course-passing rates for the first semester of the school year increase by 500 to 700 basis points for grades 6 through 12 year over year. We believe that the framework helped drive these gains and that will form a solid foundation to support our partner schools in driving further academic improvement over the long term. In terms of student retention, I'm excited to share that, thanks to a companywide effort, including streamlining the student and family on-boarding process and ramping up our strong start in [Inaudible] efforts, we're beginning to see improved retention levels, especially at the beginning of the second semester. Specifically, we've talked about improving student retention back to fiscal '16 levels.

We are currently on a trajectory which we believe will help us return to student retention levels we achieved in fiscal '16, and potentially even better. Continued execution on these retention programs throughout this year may allow us to enter the next school year with a growing student population. We're also leveraging the students' first check-in program to keep our fingers on the pulse of student and family sentiment. And we've launched several pilot programs to better understand key drivers of student engagement and ultimately retention.

While there is obviously lots of work still to do, I'm confident we're on the right path toward delivering improvements in student retention over both the short and long term. Our product teams are hard at work building engaging, highly adaptive curriculum and product offerings that will truly differentiate K12 in the marketplace. This year we are integrating Stride's adaptive practice solutions into our managed public school curriculum, which will allow students more targeted practice time and ultimately drive performance. We are also continuing to upgrade course catalog, focusing development efforts on assessed subject areas of math, English language arts, and science.

And lastly, we're executing on a holistic platform strategy to drive consistency across our technology platforms and reduce overhead costs over the long term. We are still working hard toward diversifying our market presence through the expansion of our career technical education offering. In fiscal '17 we added five new programs to bring the total to seven academies. Thus far, 2018 enrollment in these seven academies has nearly doubled.

While the absolute enrollment numbers are still modest, we are encouraged by the early demand. This quarter we are focusing on expanding the number of destinations career academies for next school year. Importantly, early results from the seven academies in place support the premise that CTE is one of the most effective dropout-prevention strategies known today. For students who take even one CTE course, we're seeing improved withdrawal rates.

Furthermore, students enrolled full-time in one of our Destinations career academies are retaining at an improved rate of several hundred basis points. CTE is just one reason that we are optimistic that our business will be more efficient in the future in retaining students while also attracting more students to programs that are helping solve the skills gap, one of the most talked-about problems in America's job market. Management is also keenly focused on driving improvements in free cash flow by continuing our structured process around investment decisions on both an operating and capital basis. As evidenced by our results this quarter, operating expenses declined year over year by about $3 million, excluding stock-based compensation, and capital outlays were at the bottom of our guidance range.

We will continue to make careful build-versus-buy decisions for business model components to further improve operating leverage in cash flows over the long term. And with a more efficient product-development process, we believe we're actually delivering more for less. Overall, from a financial and operational perspective, we are right where we need to be in midyear to achieve our objectives for fiscal '18 and set us up for fiscal '19 and beyond. Now, before I hand the call over to James, I wanted to mention two things.

First I want to draw your attention to an announcement we made about Bob Knowling joining the K12 board of directors. Bob brings a wealth of CEO-level business and financial acumen to the board along with relevant experience in the field of education and, most of all, the same passion for helping students that motivates all of us here at K12. Bob is a strong believer in the importance of developing bold and innovative leaders, the type who comprise the heart and soul of our business. Bob's passion led him to become the founding chief executive officer of the NYC Leadership Academy, an independent nonprofit corporation created by then–New York City Schools Chancellor Joel Klein and Mayor Michael Bloomberg.

Through his efforts, the NYC Leadership Academy developed groundbreaking recruiting, training, and support systems to empower aspiring school principals with a comprehensive sustainable approach to leadership development and program implementation. We're very excited to have Bob Knowling join the K12 board of directors. Second, as many of you are aware, a very large virtual school in Ohio, ECOT, formally closed on January 16. In the wake of the ECOT closure, the governing board of our largest school partner has said that they want to help as many students, families, and teachers as possible who were displaced mid-school year by this decision.

To date, we have received thousands of phone calls from ECOT families, and we look forward to working with our partner to serve a larger group of students in Ohio this semester and in the year ahead. On another Ohio note, we learned last evening that the current authorizer for the Insight School of Ohio will not be renewing its charter for next year. Insight Ohio enrollments represent only a small portion of the students we serve in Ohio. The governing school board is reviewing options and existing alternatives in the state.

The nonrenewal will have no financial impact this fiscal year. Going forward, and considering the ECOT situation, net-net we believe the overall level of demand for virtual education services we offer through partners in Ohio will be quite strong. I'll now hand the call over to James to review second-quarter results as well as our third-quarter guidance. Thanks very much for your support.

James?

James Rhyu -- Chief Financial Officer

Thanks, Stuart. Good afternoon, everybody. First I want to quickly recap our results. Revenue for the quarter was $217.2 million, down 1.8% from last year.

Adjusted operating income, $20.9 million, declined $2 million from last year, and capital expenditures were $8.2 million, which is $1.6 million lower than last year. In each case, these results met or exceeded the expectations we provided in our guidance last quarter. Revenue of $217.2 million was at the lower end of our guidance, driven by declines in our institutional business, which I'll discuss more in a moment. Overall, however, we feel comfortable with our full-year revenue guidance, and I've already seen some positive signs for enrollments in January that bodes well for the rest of the year.

In managed public school programs, revenue increased 0.5% to $183.4 million compared to the prior year. This performance was the result of a 2.2% increase in student enrollments offset by declining revenue per enrollment due to mix. However, as we begin the second semester in January, we see mix improving in the first few weeks of the third quarter. From an enrollment standpoint, as Stuart mentioned, we are beginning to see some improvement in retention as a result of our practice set of programs we've ramped up over the past couple of years.

We will continue to invest in these programs and believe that over time, retention levels continue to improve. New student enrollment activities during the quarter was somewhat softer, as we've seen more enrollments push into January instead of December, and the backlog of interest working through the enrollment process remained strong through the first weeks of January. Revenue per enrollment decreased 1.6% this quarter. This decline is largely the result of school mix.

That mix stems from indexing a bit more in newer states with below-average revenue per enrollment. Additionally, from a seasonal perspective, we often see second-quarter revenue per enrollment decline and then increase sequentially in the third and fourth quarters. We continue to expect full-year revenue per enrollment to be largely flat on a year-over-year basis. In our institutional business, which includes both non-managed public school programs as well as our institutional software and services, revenue declined 16.4% on a year-over-year basis, which is in line with the expectations we outlined last quarter.

Non-managed public program revenues decreased 20.7% versus last year as a result of enrollments declining 16.7% and revenue per enrollment declining 4.7%. Some of our larger customers have experienced enrollment softness, which is contributing to this decline. Institutional software and services revenues declined 10.4% as a result of software sales at the beginning of the season, as Stuart mentioned and we outlined in last quarter results. We're clearly not satisfied with these results and working to turn this around.

Our sales execution over the past year has been poor. In our private-pay business, revenues increased slightly to $8.4 million versus a year ago, as we highlighted last quarter. While we remain bullish on the long-term prospects for this business, we anticipate revenues to be largely flat in fiscal '18 compared to last year. Gross margins were 35.9%, down 190 basis points due to the lower mix of institutional revenues in the period.

On a full-year basis, we continue to look for margins that are about 200 basis points below last year. Selling, administrative, and other expenses were $62 million, flat from a year ago. However, net of stock-based compensation, expenses declined $3 million, or 5.2%, as a result of strong cost controls across the organization. Management continues to be focused on driving operating leverage over the long term and is being very judicious about incremental investment in the business.

Product development expenses were down 17% to $2.4 million, which is consistent with our overall lower CAPEX as well. EBITDA for the quarter was $32.3 million, compared to $37 million in second quarter of last year. This decline was largely a result of lower operating results in the quarter, including a $2.6 million increase in stock-based compensation. The increase in stock-based compensation was for performance-based stock vesting that we indicated may happen last quarter.

We now expect full-year stock-based compensation of approximately $20 million, give or take 10%, as we still have some additional potential performance-based vesting that may occur. Adjusted EBITDA was $39.5 million, compared to $41.6 million last year. Operating income was $13.7 million, or $4.6 million lower than last year, and adjusted operating income was $20.9 million, or $2 million lower than last year. Turning to some other items, we ended the quarter with cash and equivalents of $189.5 million, and in line with normal seasonal trends, we would expect to see our cash balance increase throughout the rest of the year.

CAPEX, which includes curriculum and software development and infrastructure, was $8.2 million, a decrease of $1.6 million compared to the second quarter of last year. We continue to make meaningful product investments but are doing so at lower unit cost. So while we have lowered our CAPEX over the past couple of years, output is actually increasing, and investments and innovation will continue. Our tax rate for the quarter was 4.1% and was heavily influenced by the new tax legislation.

The impact of the legislation on this year's results as well as our prime outlook for fiscal '19 will be largely beneficial. As you are well aware, the federal tax rate on corporations was reduced to 21%. However, since K12 operated on a junior end, we straddled both the former tax rate and the new rate for six months each. So for fiscal '18, the statutory rate will be 28%.

In addition we will also be able to take a benefit this quarter on remeasuring our deferred tax liability at the lower rates, which was somewhat offset by some taxes we will pay on overseas earnings. So all in, for this year, we will likely have an effective tax rate around 10%, plus or minus a few percent. As we look to next fiscal year, we'll get a full year's benefit of the new legislation, and on a very preliminary basis, excluding the impact of stock-based compensation, next year's rates should fall to around 30% plus or minus 2%. Of course, we'll update this as we provide more guidance in October.

One more item I'd like to update you on for next year, as I'm sure you know, there's a new revenue recognition accounting standard that just went into effect. For K12, we will adopt this beginning in July for our next fiscal year. We're making good progress on evaluating and implementing the new standard. We largely expect full-year revenue to be unaffected by this new accounting standard.

However, we will likely see some revenue shift from the first quarter to the rest of the year, likely a few to several tens of millions of dollars. We'll provide more guidance on this next year, but I wanted to at least let you know that the full year is not going to be impacted, but the phasing throughout the year might be. Let me summarize our guidance for the upcoming third-quarter. Revenue in the range of $224 million to $230 million, adjusted operating income in the range of $25 million to $27 million, and capital expenditures of $9 million to $11 million.

Thank you, and I'll hand the call back over now to Stuart.

Stuart Udell -- Chief Executive Officer

Thanks, James. I appreciate that, and we would be happy to take any questions that you might have.

Questions and Answers:

Operator

Thank you. At this time we will be conducting a question-and-answer session. If you would like to ask a question, please press * 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue.

You may press * 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the * key. One moment, please, while we pull for questions. Our first question comes from Alex Paris from Barrington Research.

Please proceed with your question.

Chris Howe -- Barrington Research -- Analyst

Good afternoon. This is Chris Howe sitting in for Alex Paris.

Stuart Udell -- Chief Executive Officer

Hey, Chris.

Chris Howe -- Barrington Research -- Analyst

I had a question first off in regards to FuelEd. You mentioned the reset to the strategy last quarter. Just an update on this, how it's going, what you're seeing so far in regards to improving the execution going forward.

Stuart Udell -- Chief Executive Officer

Sure, well, you know, as you might imagine, when you're in kind of an institutional sales cycle, it's a reasonably long sales cycle, there are three entry points to the year. You can sell at the beginning of the school year, you can implement new programs in the second semester -- call it January, and there are smaller summer-school opportunities, so you have to kind of back up from those entry points, really on any new program. We started by, you know, revamping our team, putting a new team on the ground back in May when we announced that Shawn Ryan came in as the general manager of that business. We've recently, over the last few weeks, brought in a new vice president, or senior vice president of marketing -- I'm sorry, of sales -- to help reorganize the sales team, so we're still, I would say, getting our footing, but I think we're doing a good job of articulating, you know, how our products align to markets and channels and very targeted opportunities, so there is discipline around what we're doing but we have yet to really see that take hold.

We do certainly expect that by doing the right thing, going into next school year we will have, you know, corrected the situation.

Chris Howe -- Barrington Research -- Analyst

That's very helpful. Thank you. And I have one follow-up, just in regard to what you saw this past quarter. For state- and board-imposed caps, were any caps lifted this quarter, and if so, in which states?

Stuart Udell -- Chief Executive Officer

We really don't have that much in-year lifting of caps. We manage to [Inaudible] cap levels throughout the year. It's, you know, it's complicated in the sense that caps can be of all different varieties. Some are at an overall level, some are at a grade-band level, some are at, you know, high school versus elementary school level, so, but, in general, no major changes.

We do, as we look into next year, we are always looking to -- where we see strong demand -- push for higher caps so we can serve what we think is increasing demand for our programs, but nothing to announce this time.

Chris Howe -- Barrington Research -- Analyst

Thank you so much. I'll hop back in the queue for now.

Stuart Udell -- Chief Executive Officer

Thanks, Chris.

Operator

Our next question comes from Corey Greendale with First Analysis. Please proceed with your question.

Corey Greendale -- First Analysis -- Analyst

Thank you. Good afternoon. I'm in an airport so if there's a lot of background noise, tell me, I don't want to aggravate anyone, I can follow up offline. But, couple questions on Ohio.

So first of all, on ECOT, can you give us some sense, is there like a limit to the number of students you would take just in terms of [Inaudible] how many you can serve well, and just give us a quick primer on how the funding works in Ohio? So if you take students midyear, will they be fully funded for the portion that you're serving them?

Stuart Udell -- Chief Executive Officer

You bet. Thanks, Corey. I'll take the first part of the question and then hand funding over to James. You know, there are no caps in Ohio Virtual Academy.

The governing board there has really stepped forward as, I'd say, the only significant operator in the state, or school in the state, to say they were willing to take on more students, and we think that, you know, based on conversations, the state is very pleased with that, because, you know, it's a very challenging situation, as you might have seen in the press, there were 12,000 students in ECOT. As I mentioned we have already received in 10 days or so thousands of phone calls, so call that a meaningful portion of students who are looking for options. Some will go back to brick-and-mortar schools, some may go to some other virtual, but for the most part, you know, we've been the major player that has stepped up. Since there was so much preview time into the likely closure of ECOT, we had time to prepare and frankly, you know, lots of teachers from ECOT were reaching out to us, so we've been able -- and this gets to your question about quality of services -- we've been able to ramp up teaching staff, support staff, in anticipation of taking students on.

So we think from a quality perspective, we will be able to continue to deliver, you know, the great services that Ohio Virtual Academy is known for. Regarding your funding question, I'll turn that over to James.

James Rhyu -- Chief Financial Officer

Hey, Corey. So obviously the right question around the funding we -- The funding model in Ohio is essentially a pro rata funding model, so we will get, the Ohio school that we manage will get funding for the kids. It depends on engagement and attendance and things like that, so it's not, you know, there's an automatic funding, so you know, the kids that are transferring over midyear, you know, given all the turmoil stuff, you know, they might fund at a slight lower rate just because they are ramping up, and we often see that with kids coming in midyear as a ramp up, so, but the general answer is, you know, the funding will come for the half-year that we serve them.

Corey Greendale -- First Analysis -- Analyst

That's very helpful. And can you give us -- I realize it's a fluid situation, but have you included any contributions from those former ECOT students in your Q3 guidance?

James Rhyu -- Chief Financial Officer

Yeah, you know, I think the Q3 guidance range is not necessarily -- doesn't necessarily contemplate what could happen, because as we were putting this together, as you can imagine, it's been so fluid; we had a big weekend this past weekend of calls that came in, and the reality is that we don't yet know how many will actually enroll with us, so it's very hard to predict for Q3 of the balance of the year what the actual impact would be. You know, so it was too early to really bake it in.

Corey Greendale --  First Analysis -- Analyst

OK. And if I could, just one maybe couple-part question for you, James, I know you're focused on free cash flow and you mentioned the op expenses coming down, the cash flow from ops is also down, it seems like it's working capital moving around? If you just could tell us what's going on there?

James Rhyu -- Chief Financial Officer

Yeah, sure. So [Inaudible] pick up quickly on that, so yes, working capital's got a little bit, say, negative, on us; our DSOs have gotten a little bit behind on us. We have a couple of large customers that are, I think, not a payment issue but funding timing and things like that, and just working through some of those logistics, but largely I'd say a DSO-driven issue, which we expect to work through, and not a long- term structural issue for us.

Corey Greendale -- First Analysis -- Analyst

OK, and I appreciate the guidance on the tax rate impact of tax reform. Can you give us some sense of what the cash flow impact will be?

James Rhyu -- Chief Financial Officer

Yeah, so either it should be directionally positive for both this year and next year with sort of the movement in the effective rate and some other nuances to the tax law -- we've got some depreciation benefits and things like that. It is fairly nuanced and it's still a thousand pages over the past month to digest so you may know that SEC has sort of given a year for everybody to really get their arms around this, but I think from a cash flow perspective, generically positive for this year and likely, I'd say, positive also for next year.

Corey Greendale -- First Analysis -- Analyst

OK, I will turn it over. Thank you.

James Rhyu -- Chief Financial Officer

Thank you.

Operator

As a reminder, if you'd like to ask a question please press * 1 on your telephone keypad. Please stand by for the question. Our next question comes from Jeff Silber with BMO Capital Markets. Please proceed with your question.

Jeff Silber -- BMO Capital Markets

Thank you so much. Just one more question about Ohio. On a revenue-per-student basis, is Ohio higher than your average, lower than your average, you know, from a mix perspective, [Inaudible} you get an influx of students, how that impacts?

James Rhyu -- Chief Financial Officer

It is a little bit higher than average, although like I say just the whole capture element of it might, you know, as students transition on, but statewide average is a little bit higher than average.

Jeff Silber -- BMO Capital Markets

Got it, OK. And then I think, Stuart, I'm not sure if it was you that said this in the prepared remarks, but when we were talking about retention and, you know, hopefully if you continue to improve, I think you said you could potentially enter next school year with a growing population. What does that mean, exactly? Does it mean as of June 30, 2018, you'll be up year over year? If you just could explain that, that'll be helpful.

Stuart Udell -- Chief Executive Officer

Yeah, I think if you look at the year-over-year comps, we hope to essentially -- if you look at the Q2 year-over-year comp versus what we're hoping to see is the Q4 year-over-year comp, we should see that expand, if you will. That and it gives us a larger base of students upon which to try to reregister for next school year.

Jeff Silber -- BMO Capital Markets

Got it. So when you say Q2 and Q4, you're talking about the end-of-quarter population, ending enrollment?

Stuart Udell -- Chief Executive Officer

Correct.

Jeff Silber -- BMO Capital Markets

OK, got it, just wanted to clarify that. Thank you. And then just one follow-up on the institutional side. You know, I know this has been an issue for you for a while, you're bringing in new leadership.

Is it just, you know, sales execution? I mean, what gives you the confidence, one, that the market's not shifting away from you, or maybe you don't have the right products? If you can talk about that, that would be great.

Stuart Udell -- Chief Executive Officer

I think first, sure, first of all, we have outmanaged the product set so we've actually built that out, I'd say, considerably. We had historically what I'd call, you know, lots of core courseware products; we have in the last, you know, year, year and a half or two, brought in Stride, the LTS acquisition, which expands the product bag; we recently did the Big Universe acquisition, also helps expand the product bag. So it allows us to offer some lower-price supplemental products to help round out the bag a little bit. You know, why we're still certainly very bullish about our aggregate product set is that from a breadth perspective we just have what, you know, no one else we believe really has in terms of comprehensiveness, world-class as far as the world-language program, we've got the CTE program, and of course all of the core, English, math, science, social studies from grades K through 12.

So when we think about what the possibilities are, the bundles, and coupled with service, we just don't see our product set as being a significant issue. So we really look toward execution in terms of leadership generally speaking and in terms of sales leadership.

James Rhyu -- Chief Financial Officer

I'll also tell you, Jeff, that, actually what I think is maybe one of the prime indicators for us is that within our sales organization, we had outstanding performance in pockets, so that tells us that we've got product that can be sold, we just haven't done it consistently enough, and we've tried experimentation on inside sales and things like that have worked really well so we have pockets of actually strong performance that point to, if we can do this consistently at greater scale, you know, it should bode well for the business.

Jeff Silber -- BMO Capital Markets

OK, that's good to hear. Thanks so much.

Operator

Ladies and gentlemen, we have reached the end of the question and answer session, and I would like to turn the call back to management for closing remarks.

Stuart Udell -- Chief Executive Officer

Well, I want to thank everyone for your support and attention and questions. And we look forward to doing this again about 90 days from now. Take care.

Duration: 33 minutes

Call Participants:

Mike Kraft -- Vice President of Finance

Stuart Udell -- Chief Executive Officer

James Rhyu -- Chief Financial Officer

Chris Howe -- Barrington Research -- Analyst

Corey Greendale -- First Analysis -- Analyst

Jeff Silber -- BMO Capital Markets

More LRN analysis

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