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Strategic Education, Inc (NASDAQ:STRA)
Q2 2019 Earnings Call
Jul 31, 2019, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Welcome to the Strategic Education's Second Quarter 2019 Earnings Call. I'll now like to turn the call over to Terese Wilke, Manager of Investor Relations for Strategic Education. Ms. Wilke, please go ahead.

Terese Wilke -- Manager, Investor Relations

Thank you, Sarah. Good morning, everyone, and welcome to Strategic Education's conference call, in which we will discuss second quarter 2019 results. With us today to discuss results are Robert Silberman, Executive Chairman; Karl McDonnell, President and Chief Executive Officer; and Daniel Jackson, Executive Vice President and Chief Financial Officer. Following remarks, we will open the call for questions. Please note that this call may include forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The statements are based on current expectations and are subject to a number of assumptions, uncertainties and risks that Strategic Education have identified in today's press release that could cause actual results to differ materially.

Further information about these and other relevant uncertainties may be found in Strategic Education's most recent annual report on Form 10-K, the 10-Q to be filed today, and other filings with the Securities and Exchange Commission as well as Strategic Education's future 8-Ks, 10-Qs and 10-Ks. Copies of these filings and the full press release are available for viewing on the website at strategiceducation.com. And now, I'd like to turn the call over to Rob. Rob, please go ahead.

Robert Silberman -- Executive Chairman

Thank you, Terese, and good morning, ladies and gentlemen. We are delighted to be here today on the 1-year anniversary of the founding of Strategic Education. The company's strong second quarter results reflect both the logic of the Strayer Capella merger as well as the tremendous effort that Karl and his team have put forward in successfully integrating the 2 companies. This morning, I will ask Karl to provide details on our operating and academic results for the second quarter. Dan will provide our detailed financial results for the second quarter. And then, of course, we will stay for as long as you have questions. Karl?

Karl McDonnell -- President and Chief Executive Officer

Thanks, Rob, and good morning, everyone. Our second quarter operating and financial results were once again very solid, and our merger integration work with Capella Education Company is nearing its completion. On an adjusted pro forma basis, SEI's net income increased 58%, resulting in $0.57 of additional earnings per share. That performance was the product of 8% revenue growth, combined with operating expense growth of just 1%. Our $199 million of operating expense was net of $9 million of realized merger synergies in the second quarter, and year-to-date realized merger synergies are $17 million.

Our pre-tax income increased 60% versus the prior year and our operating margin grew 590 basis points, of which 380 basis points were from synergies and 210 basis points were from organic productivity gains. Within our University segments, Strayer's operating margin increased 650 basis points to 19.1%, and Capella's operating margin increased 220 basis points to 18.8%. Enrollment results remained strong at both universities. Strayer's new and total enrollment increased 9% and 12%, respectively. Capella's new enrollment increased 8% and their total enrollment increased 2% from the prior year. New FlexPath enrollments at Capella increased 21% and total FlexPath enrollments increased 37%. FlexPath now comprises 31% of Capella non-doctoral students, up from 23% in the prior year.

During the second quarter, Strayer opened a new campus in Killeen, Texas, and Capella University opens its first -- opened its first ever physical location in Atlanta, Georgia. Strayer remains on track to open 2 to 3 additional new campuses in the second half of 2019, while Capella remains on track to open its second location in Orlando, Florida in the third quarter. SEI's Non-Degree segment generated a slight operating profit in the second quarter, its first, compared to a loss of $1 million in the prior year. We expect this segment to remain operating income positive through the balance of 2019 and into 2020. And finally, the merger integration with Capella Education Company is nearing completion. As of the end of the second quarter, the company has implemented run rate savings of $43 million out of our $50 million target.

Many of the company's most complex technology integration projects were successfully completed during the second quarter without any meaningful service interruptions or outages. Strayer's AI-enabled services have been deployed inside of Capella's various student-facing platforms with initial results in line with Strayer's initial experiences. All remaining integration-related activities remain on track to be completed by the end of 2019. And once again, I just like to thank all of my colleagues across SEI whose continued dedication and professionalism have enabled these results. And with that, I'll turn it over to Dan.

Daniel W. Jackson -- Executive Vice President and Chief Financial Officer

Thank you, Karl, and good morning, everyone. Today, we're reporting consolidated results for Strategic Education, Inc., which includes 3 segments, the Strayer University segment, the Capella University segment and the Non-Degree Programs segment, which includes our coding boot camp businesses and Sophia. Note that our consolidated results exclude the financial results at Capella Education Company that occurred prior to August 1, 2018. For a pro forma view of our second quarter 2019 segment level results, please see the second quarter earnings release slide deck posted to the Investor Relations section of our website.

I also want to remind everyone that our earnings release references as reported are GAAP results, as well as adjusted results, which are non-GAAP. This format is intended to illustrate the financial performance of the core business as reflected in the adjusted numbers in addition to our GAAP results. Our adjusted results exclude amortization expense related to Capella assets acquired in the merger, impairment of goodwill and intangible assets associated with The New York Code + Design Academy, transaction and integration costs associated with the merger, income from investments in partnership interests and other investments and certain discrete tax adjustments.

Please refer to the non-GAAP financial information included in the second quarter earnings release we issued this morning for additional information. Now for a few comments on our Q2 results. SEI's revenue for the second quarter of 2019 was $245.1 million compared to $114.7 million in 2018. Our adjusted income from operations for the quarter was $46 million compared to $13.2 million for the same period in 2018. Our adjusted operating margin for the quarter was 18.8% compared to 11.5% in 2018. Approximately 74% of Q2 general and administration costs were related to marketing investment compared to about 66% in Q2 2018 and 75% in Q1 of 2019.

Second quarter 2019 adjusted operating income excludes $15.4 million of amortization expense related to intangible assets acquired in the merger, and $3 million in merger-related costs. Second quarter 2018 adjusted operating income excludes $6.2 million for impairment of goodwill and intangible assets associated with The New York Code + Design Academy and $2.8 million in merger-related costs. Second quarter 2019 adjusted net income was $35.2 million compared to adjusted net income of $9.9 million for the same period in 2018. Adjusted diluted earnings per share was $1.59 compared to $0.87 in 2018. The adjusted effective tax rate for the second quarter of 2019 was 27.5%, which excludes the impact of amortization of intangible assets, merger costs, income from partnership interests and other investments and certain discrete tax adjustments.

We expect our adjusted effective tax rate for the third quarter and full year 2019 to be approximately 27.5%. Moving to our second quarter segment results. Strayer University segment revenue for the quarter increased 13.2% to $128.9 million from $113.9 million in 2018, driven by higher second quarter enrollment and higher revenue per student. Revenue per student improvement during the second quarter reflected an increase in classes per student and a lower drop rate. We expect revenue per student for the Strayer segment to be flat to slightly down for the full year 2019 due to higher scholarships and the continued mixed shift to lower paying corporate-sponsored students.

Strayer University segment income from operations for the second quarter increased to $24.6 million from $14.3 million last year and the operating margin improved to 19.1% for the quarter from 12.6% in 2018. Capella University segment revenue for the quarter was $112.2 million, reflecting higher enrollment and higher revenue per learner. For the full year 2019, we expect slightly higher revenue per learner at Capella University driven by tuition increases that have commenced in July 2019, offset by higher enrollment from lower paying corporate-sponsored students and continued mixed shift to our lower cost FlexPath programs.

Income from operations for the Capella segment was $21.1 million for the quarter and the operating margin was 18.8%. Q2 2019 revenue for the Non-Degree Programs segment increased to $4 million from $800,000 last year, mainly due to the inclusion of revenue from DevMountain, Hackbright Academy, and Sophia. Income from operations was $300,000 compared to a loss of $1.1 million in the same period in 2018. Moving to the balance sheet and cash flow. We generated $103.1 million in cash from operations in the first 6 months of 2019 compared to $30 million during the same period in 2018.

And ended the quarter with $440.5 million of cash, cash equivalents and marketable securities and no debt. Our bad debt expense for the second quarter was 4.7% of revenue compared to 5.8% for the same period in 2018. Capital expenditures for the first half of 2019 were $18.9 million compared to $8.6 million in the same period last year. And for the full year 2019, we continue to expect capital expenditures to be between $40 million and $45 million. And finally, we continue to maintain $250 million in available credit on our revolver. Rob?

Robert Silberman -- Executive Chairman

Thank you, Dan. Before I open it up for questions, I just wanted to remind everyone that we will hold an Investor Day on November 7 in Washington, DC, which will serve as our third quarter earnings call. The details and logistics of that Investor Day will be available on our website. And with that operator, we'll be pleased to answer any questions.

Questions and Answers:

Operator

[Operator Instructions] Our first question comes from the line of Jeff Silber with BMO Capital Markets. Your line is now open.

Jeff Silber -- BMO Capital Markets -- Analyst

Thanks so much. You had mentioned in terms of the synergies from the merger to be on track. I'm just curious, you know, now that we're -- you're into this. Do you think there's potentially either more synergies may be not only on the expense side, but more importantly, on the revenue side going forward?

Karl McDonnell -- President and Chief Executive Officer

Sure. Jeff, I think, it's slightly too early to think about 2020 in the way of cost savings. Other than to say, we continue to have a disciplined approach to managing our operating expenses. And some of the technologies that we've deployed certainly on the Strayer side pre-merger have generated some significant productivity gains. So whether or not, we have synergies, I do think, we'll continue to focus on productivity moving into 2020.

And I think the potential largest identified revenue synergy opportunity is the opening of physical locations for Capella. It's very early for the Atlanta Capella location. But some of the early data that we're seeing is quite positive. We'll be looking to see, if we get similar data, when we open the Orlando Capella student center later in the quarter. But I think that's likely to be the largest revenue opportunity over the next year or 2.

Jeff Silber -- BMO Capital Markets -- Analyst

Okay, great. I think that's helpful. I believe in the past, your team has thought that your business was a little bit more cyclical or may be not as countercyclical as some of the other companies, I think, their business might be because of your exposure on the corporate partnership side. I know the economy is still going strong, but we're seeing signs of potential weakness here and there. Are you seeing or feeling any of that at all?

Karl McDonnell -- President and Chief Executive Officer

No. Not -- I wouldn't say that we've seen any slowing down of sort of macro demand. We've seen growth across all of our degree levels. So that's not something that we've seen so far, Jeff.

Jeff Silber -- BMO Capital Markets -- Analyst

Okay. That's helpful.

Robert Silberman -- Executive Chairman

Jeff, this is Rob. I would definitely agree with your assertion. Our view is that, both because of our working adult-focused university level degrees and the strong corporate relationships we have, we've always felt that we were not acyclical or countercyclical. The biggest, I think, macro impact is overall employment confidence. And as long as that stays relatively high, I think, the actual business cycle is may be less impactful, but if you get a real shock to the system that destroys employment confidence like we had after '09, that definitely has a negative impact on us.

Jeff Silber -- BMO Capital Markets -- Analyst

Okay. Good. Great. Appreciate that. There is a lot of noise in the market today about some of these potential rules impacting California residents that are attending online non-for-profit school. I just want to double check and see the schools that you run are for-profit or proprietary. This is not an issue for you. Is that correct?

Robert Silberman -- Executive Chairman

Correct. It's not an issue whatsoever.

Jeff Silber -- BMO Capital Markets -- Analyst

Okay. Great. Just wanted to double check on that. And then just one more and I'll jump back in the queue. Can you give us any gauge of what you're expecting for operating expenses in the back half of the year?

Karl McDonnell -- President and Chief Executive Officer

Jeff, we're still on track for what, I think, we originally talked about was. Pro forma operating expenses in 2018, we're going to be flat to slightly above that.

Jeff Silber -- BMO Capital Markets -- Analyst

Okay, great, that's helpful, thanks so much.

Karl McDonnell -- President and Chief Executive Officer

Thank you, Jeff.

Operator

Our next question comes from the line of Corey Greendale with First Analysis. Your line is now open.

Corey Greendale -- First Analysis -- Analyst

Hey, good morning

Karl McDonnell -- President and Chief Executive Officer

Good morning, Corey.

Corey Greendale -- First Analysis -- Analyst

So a couple of quick questions. First, Karl, when you said that student-facing AI has been deployed at Capella. You were talking about sort of the outside the classroom uses or is there some in classroom use that's been deployed?

Karl McDonnell -- President and Chief Executive Officer

It's both. It's -- the virtual assistant technology has been deployed on the chat function for student support function and inside Capella. And then some of the technologies that Strayer has used to scale its online classroom around student engagement, video feedback, various other faculty tools. Those have also been deployed inside Capella's online course room.

Corey Greendale -- First Analysis -- Analyst

Could you may be elaborate just a little bit? I know you said that the early returns have been good, but just the in-classroom part, how that's working relative to outlook at Strayer? And also just I think conceptionally it's going to be tougher to get the same kind of leverage because there's so many more classes at Capella than at Strayer. But just what's your kind of thinking? And how widely that could be deployed?

Karl McDonnell -- President and Chief Executive Officer

Well, I think, it could be deployed across all of Strayer and Capella's online course room, the tools that I'm describing. You're correct in asserting that it's likely to not yield the same kind of productivity that we've seen on the Strayer side just because they have a more disparate course catalog. But we do expect to see similar gains in increases in student engagement, perhaps better drop rates, slightly higher course completion rates, things like that. In the early data on that, that I'm describing is more on improved drops.

Corey Greendale -- First Analysis -- Analyst

Okay. And in terms of the dynamic that helped the revenue per student at Strayer, it sounds like, you don't think that's sustained, but is there anything you would point to that drove that dynamic of more classes per student other than random walk?

Robert Silberman -- Executive Chairman

Yes. Corey, the classes per student is a bit volatile, not volatile, but variable from quarter-to-quarter. So that that's not anything that we necessarily model in on a forward-looking basis. The drop rate improvement though is real. And as Karl mentioned, we expect that to continue. But again, it's offset by scholarships and again mixed shift to lower paying corporate students, as I mentioned earlier.

Corey Greendale -- First Analysis -- Analyst

Yes. And what was the magnitude of the average tuition increase at Capella?

Robert Silberman -- Executive Chairman

It's about 2%.

Corey Greendale -- First Analysis -- Analyst

Okay. And sort of going from that, I don't know, given you're reporting to a few of them at times, you look at any other company, but 2U's stock is down pretty big on for a number of reasons, but they commented that, the competitive environment is getting tougher. And realized you're at a totally different part of the market since they are, but certainly the competitive environment has shifted. So just pegging the question, have you seen anything over the last year changes from any of the -- non-profit competitors particularly that's driving differences in your -- the economics around attracting students or anything like that?

Robert Silberman -- Executive Chairman

I am not sure, Corey, that I would say that we're in a different part of the market. I mean we're running 2 first-rate universities, which we think compete very well with a number of the state schools and private universities that and use like 2U supports. And we've said for years that there is a large supply of educational product. But there's an even larger demand. And our view has always been that if you do a good job in the classroom over time, the reputation of your institution and the commitment of your students and alumni drives the health of the university.

And that tends to swamp any sort of competitive impact. And it has for almost the 20 years that we've run these institutions. So we don't ever comment on other companies, but based on the results that we've reported this morning and the sort of confident view that Karl and the team have about the future of both universities and the efficiencies that we're garnering by the combination of the 2 companies, we feel like, we're in a pretty good position.

Corey Greendale -- First Analysis -- Analyst

Very helpful. Thanks, Rob.

Robert Silberman -- Executive Chairman

Yeah, you better, Corey.

Operator

Our next question comes from the line of Alex Paris with Barrington Research. Your line is now open.

Chris Howe -- Barrington Research -- Analyst

Good morning. This is Chris Howe sitting in for Alex. I have some quick questions here for you. Just on FlexPath, it's been growing well, 30%-plus. And where would you characterize your position as far as in your evolution of FlexPath as we move forward? Are we in the early innings? And then how should we think about maintaining this growth rate as we look more longer term in your outlook? And then following up -- no, go ahead.

Karl McDonnell -- President and Chief Executive Officer

Sure, just on that question FlexPath, I'd say it's still probably in the early innings, so to speak. FlexPath has an enormous value proposition essentially enabling students to get through a degree program in half the time and therefore, half the cost. So there is substantial value being created for the student. And as more and more people are looking to improve their economic condition that's a value proposition that speaks volumes to them. And so I personally, I'm very confident that FlexPath will continue to grow and Capella and eventually, we hope Strayer will look to expand FlexPath offerings.

Chris Howe -- Barrington Research -- Analyst

That's helpful. And then following up on a previous question about competition. More specifically when it comes to FlexPath, are you seeing any change in the market this past quarter? Or has your competitive position or strength been maintained?

Karl McDonnell -- President and Chief Executive Officer

No. With regard to competition for FlexPath, I should note that Capella is 1 of only 6 institutions in the country that is approved by both their accreditor and the Department of Education to participate in Title IV programs for direct assessment programs, which FlexPath is. So the company is clearly advantaged by having FlexPath in our product portfolio.

Chris Howe -- Barrington Research -- Analyst

Okay. And then my last question is just kind of as it relates to what you're doing in regard to the physical locations for Capella in Atlanta and in Orlando. As we look further out into 2020, should we look at your short-term goals as establishing these campuses or will you launch -- are you planning to launch more campuses in conjunction with the development of the existing recent campus openings?

Karl McDonnell -- President and Chief Executive Officer

Before I answer that, I just wanted to clarify, when we use the phrase campus for Capella University, it's really a student support center. There are no on-ground classes. So there's not on-ground instruction in their locations, the way there is in Strayer's. But to get to your question, I suspect, we will open additional locations for Capella University in 2020. It's too early to put a number on that.

One of the last integration revenue synergies that we intend to test, hopefully before the end of this year, is a facility that is branded with both Strayer and Capella Universities together, just to see what the dynamics are around that kind of operation. But typically, it's between now and the end of the calendar year, when we start sizing the number of locations that we were target to open in the following years. So we're just a little ahead of that right now.

Chris Howe -- Barrington Research -- Analyst

Great. That's exciting. Thank you for taking my questions.

Karl McDonnell -- President and Chief Executive Officer

Sure. Thank you, Chris.

Operator

There are no further questions in the queue at this time. I would now like to turn the call back to Robert Silberman for closing remarks.

Robert Silberman -- Executive Chairman

Thank you, operator. And thank you all, ladies and gentlemen, for participating. As I said at the outset, we look forward to seeing all of you on November 7th in Washington, DC. We'll have a full Investor Day, where Karl and the University Presidents will be able to showcase some of the academic initiatives that we have and how those are helping our students and alumni. So we look forward to seeing you then. Please contact us if you have any other questions, and thank you very much.

Operator

[Operator Closing Remarks]

Duration: 25 minutes

Call participants:

Terese Wilke -- Manager, Investor Relations

Robert Silberman -- Executive Chairman

Karl McDonnell -- President and Chief Executive Officer

Daniel W. Jackson -- Executive Vice President and Chief Financial Officer

Jeff Silber -- BMO Capital Markets -- Analyst

Corey Greendale -- First Analysis -- Analyst

Chris Howe -- Barrington Research -- Analyst

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