Stride, Inc. (LRN) Q2 2009 Earnings Report, Transcript and Summary

Welcome ladies and gentlemen and welcome to the second quarter 2009 K12, Inc earnings conference call. (Operator Instructions) I would now like to turn the call over to Mr. Keith Haas, Senior Vice President of Finance and Investor Relations. Please proceed.

Thank you. Good afternoon and welcome to the K12 second quarter fiscal year 2009 earnings conference call. Before we begin, the company would like to remind you that statements made during this conference call and that are not historical facts may be considered forward-looking statements, made pursuant to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties that could cause actual events or results to differ materially from those expressed or implied. In addition, this conference call contains time-sensitive information that reflects management's best analysis only as of the date of this live call. K12 does not undertake any obligation to publicly update or revise any forward-looking statements. For further information concerning issues that could materially affect financial performance related to forward-looking statements, please refer to K12's Form 10-Q filing and 10K filings filed with the SEC, on the investor relations sections of our website, www.k12.com. In addition to disclosing 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 and 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 web cast simultaneously on our website, and will be available for replay there for 60 days. With me on today's call are Ron Packard, founder and Chief Executive Officer and John Baule, Chief Operating Officer and Chief Financial Officer. Following our prepared remarks we will answer any questions you may have. I will now turn the call over to Ron Packard.

Thank you Keith. Welcome to K12’s second quarter 2009 earnings call. It is with great pleasure that I announce our financial results and report on other significant business developments during the quarter. Top line revenue was up over 42% from the same quarter last year hitting $77.6 million. Revenue for the first half of fiscal year 2009 was $166.2 million a 46.2% increase over the first half of fiscal year 2008. Our business continues to scale as EBITDA is growing even faster than revenue. In fact EBITDA for the quarter grew $10.5 million, an increase of more than 68% from the second quarter of last year. For the first six months of fiscal 2009 EBITDA was $24.2 million, a 66.3% improvement as compared to the same period fiscal year 2008. These results demonstrate that market demand for K12’s high quality offerings has not diminished during these difficult economic times. We had significant increased enrollment as more students realize the value of our offerings and online education in the K-12 space becomes a more accepted mainstream option. We recognize that current student funding levels may be reduced this year in several states and already have taken this into account in our models. I will talk more about this later. Even with such reductions we are maintaining our guidance of $310-320 million for fiscal year 2009 revenue and $19-22 million for operating income which implies EBITDA of approximately $38-42 million. For the first six months of fiscal year 2009 EBITDA margin increased by 170 basis points which is at the upper end of our stated goal of improving EBITDA margins by 100-200 basis points per year. If non-recurring costs are omitted EBITDA margins would be significantly higher. However, this level of EBITDA margin expansion does not tell the whole story about how…

Thanks Ron. I’m going to briefly walk through some of the highlights of the second quarter and then spend a bit of extra time discussing the company’s potential for operating margin expansion and free cash flow generation, two topics that investors have expressed interest in recently. During the second quarter the business continued to grow rapidly with revenues increasing by 42.7% and operating income increasing by 80%. Operating margins expanded by 150 basis points for the quarter to 7.7% and EBITDA, which is the measure we use to manage our business internally, increased by 68% to $10.5 million with EBITDA margins expanding by 210 basis points to 13.6% in the second quarter. The 42.7% growth in revenues was driven by average enrollment for the quarter of 55,076, a 35.4% increase over last year. You might note that while enrollments were up substantially over last year there was a slight sequential decline from Q1 to Q2 which is attributable to three factors; First, from a comparative standpoint last year’s sequential growth between Q1 and Q2 was significantly impacted by the late approval of a new school in Georgia and an expansion of the enrollment cap in Texas. Both of these events had the effect of pushing enrollment into October, our second quarter, and accounted for almost all of the sequential increase from Q1 to Q2 of last year. Second, during our first quarter when all schools opened we strived to maximize enrollment in all states in which we operate. When it comes to enrolling students after the school year has started, the second quarter and beyond, we have become more sophisticated and discriminating in the manner in which we allocate our marketing dollars, considering each state’s enrollment funding level and enrollment count dates to ensure that we generate a reasonable economic…

At this time we will take any questions.

(Operator Instructions) The first question comes from the line of Sara Gubins – Bank of America. Sara Gubins – Bank of America: Just a couple of clarification questions. Thank you for providing the details about the impact for operating margin. Just to make sure I got it, John were you basically saying that only the expedited shipping costs go away in the second half but all of the other areas that you mentioned will continue to impact operating margins in the second half of the year?

That is correct. Sara Gubins – Bank of America: But then also the discussion around efforts to lower costs where possible, would we presumably therefore expect to see some form of benefit from that in the second half of the year or is that more 2010?

You would see some benefit in the second half of the year but the larger part would probably come in 2010 just as you go into the next cycle it will be more powerful. Sara Gubins – Bank of America: Is there any way to give us even a broad range of the kind of impact you are talking of in those cost savings?

I don’t think we can give you that at this moment in time. As I said we have gone through several already to achieve some reductions but we are very optimistic we will be able to adjust our cost structure. Sara Gubins – Bank of America: John when you mentioned you expect to be at or near free cash flow positive next year did you mean fiscal year 2009 or 2010?

2010. Sara Gubins – Bank of America: So presumably negative this year and then flat to positive next year?

That is correct. Sara Gubins – Bank of America: I know it is early given the budget cycles and the uncertainty, but can you give us any sense of what on an aggregate basis you think it might be reasonable to see in terms of lowered student funding rates across the board for 2009 and 2010? I’m just trying to get a sense of whether or not you mean negative 5% next year or flat next year in the aggregate.

That is a fair question. It is very difficult to determine because there are a lot of variables in the equation. One of the biggest ones is the stimulus bill that is going through with the aid to state education funding. We follow these closely and obviously the situation with regard to state budgets over the last few months has changed significantly. Where we see the various budget bills we see funding from a lot of states flat. We see some states proposing things as much as 4-5% a year. So we see a range. For this year we believe there will be several states that will actually reduce funding. Then next year potentially more. It is tough. Probably three months from now we will have a lot more information on that. But right now we see funding proposals out there anywhere from flat to down 5% in the various states.

The next question comes from Kelly Flynn – Credit Suisse. Kelly Flynn – Credit Suisse: Just some follow-up on the details, John revisiting what you said about why the enrollments declined sequentially can you elaborate on what you said as points two and three? The being more prudent with your investments was the second point. Can you get into more detail on that? Then for the high school, do the same thing? I think you said you made a decision to start people in January but can you get into more detail on that and also reiterate what you said you expect enrollment to do in the third quarter?

First of all what I meant on the part about being more sophisticated and discriminating in the way we allocate our marketing dollars, we have to look out at the different schools and every state has a different funding mechanism. I think I talked about it on the last call. For example, in some states if a student isn’t enrolled in the beginning of October then they won’t get funded for the entire year. So obviously if you are looking at adding students in year after October that wouldn’t be a state where you would necessarily want to invest your marketing dollars. So we just carefully look at the funding levels and the mechanisms that are in states to make sure that we are being smart in the allocation of our dollars there. That is what I mean by that. In terms of the high school question that you asked basically what that is it is just better for us from an academic standpoint. In K-8 it doesn’t really matter when they start. They can start at any time during the year with no problem. But in high school when you have semesters and a more credit oriented orientation it is just better to start them at the beginning of a semester if possible. So what happens is we might get enrollments in November and December but we hold them until the beginning of January so they start fresh. Kelly Flynn – Credit Suisse: You said 57,199?

Yes. If I look at my enrollments in January which kind of reflect that impact among others my enrollments at the end of January were 57,199. I would expect that our third quarter enrollment will be up sequentially from our second quarter enrollment. Generally we see a little bit of tailing off in the fourth quarter because we don’t try to replace students at all because we are close to the end of the year. Kelly Flynn – Credit Suisse: On the point about how you are allocating marketing I just don’t understand why that would result in a reduction in enrollment. I would think if you allocated it correctly some states would benefit and others wouldn’t. Why is that?

Remember, like any school we have students withdrawing in all schools across the course of a year, right? So what can happen is we can replace those students. We can by marketing and recruiting new students and in most cases that is pretty much what happens. But in some states we may elect not to replace those students who have withdrawn and so the enrollment across the year actually declines. Kelly Flynn – Credit Suisse: On the separate issue on the margin discussion, on the shipping costs am I correct that happened last year also and can you help us understand why that is not going to be a chronic issue in years to come?

It was a different issue last year. The issue we had two years ago was we had underestimated the level of demand. We just underestimated the level of enrollment. So what we had to do was go out and buy a lot of extra inventory at non-economic optimal quantities. We paid more for that inventory and still had to ship more of it faster because it came in late. So that is where it was. This time we had the inventory. Our biggest challenge was getting it into the boxes and shipped on time. So it is a different problem but the same.

Just to add to that we put a great deal of emphasis on that right now and are working the process and we are pretty comfortable that will not be a recurring item. Kelly Flynn – Credit Suisse: Another question on the investments, for 2010 and beyond can you just frame out in more detail what drag you expect in those years from the new investments? I can see if you continue to invest that could also be somewhat of a chronic drive on margins.

If you look at the new investments this year what we said is at least in the first half of the year they had about a 200 basis point reduction. Then you really have to kind of break them up. The new schools tend to be less of a drag as they become non new schools. Whether we have additional drag from new schools depends upon how many new schools we add. The positive of that is that with each new school you add you have a bigger base. Right? So we are in 21 states now so the next state doesn’t have the same impact that we used to get from a new state when we had six states. So that is one of the factors on new states. The other piece is the international investment. We are not only hoping that won’t have a negative impact on margin, we hope that is going to have a positive impact on margin down the road. We are happy with that investment.

As it achieves some scale it will no longer be negative and will hopefully turn to positive territory.

I’m not ready to say when exactly these things all happen but what I would say is that drag should be reduced over time. Kelly Flynn – Credit Suisse: On the state funding decisions, Ron, I know you are saying that discussions continue on that front at the state level. I thought that the decisions were made kind of late in the calendar year consistent with their fiscal year turnover. Obviously the economic environment is impacting that but can you just give us a little lesson how the timing works relative to the beginning of a new fiscal year and why it is still up for grabs given that we are well into the 2009 fiscal year?

I will tell you the lessons I have learned. I have people with me who have worked in public education for 30 years and they have never quite seen anything like it where states actually go in mid-year in the school cycle and actually reduce funding. I think this is an unprecedented situation that we haven’t seen before. Certainly since the 30’s with regard to the economic environment. Normally that would not be an occurrence where in the middle of a school year you would see your funding reduced anywhere. This funding reduction is not unique to us. All public schools in those states are seeing those reductions. So we are just one school out of tens of thousands that are seeing this. So this is an unusual event. With regard to fiscal year 2009 I would not have seen it three months ago as likely to occur. I would have considered it a very unlikely event. With regard to 2010 those budget cycles are now being determined over the next 3-5 months on how schools will fund the following school year. So we don’t know what those are but we are getting some indications at various states based on what budget bills have come out of governor’s offices and various financial committees in the various states. So they should be set for next year and barring continued worsening of the economic climate then we should have those numbers and they should be stable for the following school year.

The next question comes from Suzi Stein – Morgan Stanley. Suzi Stein – Morgan Stanley: Can you just clarify on your per pupil funding for your 2009 guidance what you are assuming there?

Take $310-320 and take the mid-point of that divided by…let me just calculate…roughly $5,600 per student. Suzi Stein – Morgan Stanley: I don’t have my model open but is that mostly…

Flat with last year. Suzi Stein – Morgan Stanley: Flat with last year? Okay. I know you don’t really comment on this in terms of potential new states but what is your sense about the attitude of new states approving you in this kind of climate? Are you getting more interest given the economic benefit or not?

I’m not sure I’d say we have more interest but I would say last year we had a very good year with regard to new states and I would say while nothing is ever certain the horizon and outlook from where I stood would be equivalent to what I saw last year. I think in some ways the incredible savings to tax payers we offer helps us. In other cases states are focused on other things. As far as right now if you asked me I would say there is no effect positive or negative on the possibility for new states at this point in time. Suzi Stein – Morgan Stanley: In Florida could you be a little more specific about how you are doing there? If you look at where you are now versus where you were before the changes were made going to a more local strategy where are you relative to that?

At this moment in time I believe we will have more enrollments in Florida next year than we had before when we were at a state strategy based on our agreements with local districts.

The next question comes from Ariel Sokol – Wedbush Morgan. Ariel Sokol – Wedbush Morgan: The first question is with respect to your guidance for the full year fiscal 2009. Is it safe to say that Q2 was better than what you had budgeted and then the back half of the year is impacted by declining or issues with state funding?

I would say that it was in line with our expectations. I don’t know if I would say better. Ariel Sokol – Wedbush Morgan: With respect to elaboration thanks for the detail regarding margins. What happens if a managed school changes the relationship with K12 and becomes or enters into a vendor relationship?

If it goes from a managed school to a non-managed school which has happened a few times it actually increases the operating margin because we don’t have as much revenue from that school because we don’t have all the services but you are basically selling them the curriculum and materials and those tend to be higher margin but lower revenue. Ariel Sokol – Wedbush Morgan: Wouldn’t that affect you with respect to operating profit or EPS?

The way we think about it is we want as many kids using our curriculum and the materials. If it is through a managed school or a non-managed school we don’t really think about it. We just want them to use it.

The next question comes from Gordon [Lasik] – Robert W. Baird. Gordon [Lasik] – Robert W. Baird: A quick question on the revenue per student. I just want to make sure I understand this correctly. You said flat revenue per student for the year and it has been up 5% in the first half of 2009 so we are assuming it is down for the second half. Is that a mix issue or is that just because states are going to be cutting funding for the second half of the year?

I kind of look at it annual to annual. Sometimes the quarters can be misleading because remember your revenue can fluctuate. For example, in the first quarter we have a lot of revenue related to materials which would tend to give you a little bit higher revenue per enrollment if you were just looking at it quarter by quarter. The way I look at it is I look at the total year and the total year average enrollment. Gordon [Lasik] – Robert W. Baird: In the past you have indicated you expect product development costs to increase about 10% annually. Is that still a reasonable estimate? Year-to-date I think it is down 8% so would we expect a ramp up in the second half of the year?

It is down primarily because it is like a consulting firm. When you have very clear projects that you are working on like right now with the high school courses you are able to maintain a very high level of utilization. So that tends to offset the expense. I would say that the 10% we said before is probably good guidance for the year. Gordon [Lasik] – Robert W. Baird: Then just one final question. Can you talk about enrollment trends within your younger class levels? K-4? Have you seen any increased drop outs there as parents are maybe forced to go back to work given the economic downturn?

No. I would say we have not seen that and I think that is kind of pulling out an isolated stat in the sense that we know that there is a higher propensity to do this when you actually have an adult at home and mathematically because of unemployment going up there are a lot more adults at home today than there were one month ago even. So we actually expect potentially a shift the other way.

The next question comes from Tom [Zyfang] – [Leukam]. Tom [Zyfang] – [Leukam]: Going into the shipping costs, if it was up over $2 million and just doing simple math on revenue times market increase is it safe to assume that all else being equal you might actually get a benefit going forward given what is going on in shipping, i.e. truck load and Fedex of the world all have excess capacity?

Possibly next year but this year remember that the bulk of our materials get shipped in the first quarter of our year. Tom [Zyfang] – [Leukam]: I’m saying on calendar 2009.

Obviously as those prices go down we would benefit from that. Tom [Zyfang] – [Leukam]: Can you tell me what your absolute dollar was associated with shipping?

It was $2.2 million in expedited shipping.

The incremental amount is what we expected which had the 130 basis point impact was $2.2 million. Tom [Zyfang] – [Leukam]: On what type of number? In other words what was your total shipping cost?

I think we don’t disclose that. Tom [Zyfang] – [Leukam]: Have there been any changes in caps? State caps we are not aware of?

Not at this moment in time. We should have more clarity on that in the next quarter.

The next question comes from Jeff Silber – BMO Capital Markets. Jeff Silber – BMO Capital Markets: I hate to go back to the funding environment but I am going to. Are you seeing any different types of conversations between the states you are already in and the states you are targeting and where I am going with this are you finding the states you are already in being a little bit more receptive on the funding side since you already had experience with them? They can see the cost benefits, etc.

No I wouldn’t necessarily say that because I think now that we operate in a lot of states it is easy to present to new states what the cost benefits are and we can talk about what the price of delivering this is versus what their funding is on a per child basis. So I don’t think that is necessarily true. Jeff Silber – BMO Capital Markets: How about on the competitive side, again going against your competitors for some of these contracts? Are you seeing some of your competitors maybe being a little bit more price sensitive, low balling, etc.?

Because the pricing and the funding level is generally determined formulaically it doesn’t set itself up for that kind of environment. It is really this is what you get paid on a per child attendance basis just like brick and mortar schools get paid on a formula basis. So they don’t compete. It is the same thing here. This is what the funding level is. It is a huge discount to what the average per pupil funding is and then who can provide the best product and services for our customers in the district. So I think right now the competition is much more on quality because of the formulaic funding of it.

Ladies and gentlemen I show no further questions at this time. I would like to turn the call back over to management for any closing remarks.

Thanks everybody. I want to also let everyone know we will be presenting at Deutsche Bank Small and Mid Cap Growth Conference on February 11 in Florida. Thank you.

Ladies and gentlemen thank you for your participation in today’s conference. That does conclude the presentation. You may disconnect. Have a wonderful day.