Stride, Inc. (LRN) Q1 2017 Earnings Report, Transcript and Summary

Greetings and welcome to the K12 First Quarter Fiscal 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Mike Kraft, Vice President of Finance for K12. Thank you, you may begin.

Thank you and good morning. Welcome to K12’s first quarter earnings call for fiscal year 2017. 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 2016 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?

Good morning everyone and thanks for joining us on the call today. This morning I want to provide you with our guidance for fiscal 2017 as well as an update of our cap date enrollment. For fiscal 2017 we expect total revenue in the range of $885 million to $915 million. We believe that demand for Online and Blended Learning options remained strong. We saw this demand result in an increase of 3.9% in managed public school enrollment to more than 108,000 students. While fall enrollments continue to be very important and provide a strong directional indicator of our full year revenue, the reality is that two thirds of our partner schools are funded by mechanisms that are tied to alternative measures. These mechanisms include multiple campaigns, average failure attendants, average failure enrollment or membership and accounting periods. This mix allows providers like K12 to align with schools to drive second semester enrollments and further build upon last year's successful retention efforts to both positively influence student outcomes and financials for the year. Again, fall enrollment is still by far the most important season and does provide a directional indicator of our full year revenue. Importantly, we have returned to enrollment growth for the first time in three years. We believe that's occurred for a number of reasons. First, our strong commitment to academics, we continue to partner closely with our independent charter or school boards to ensure that enrollment growth was balanced with school performance. We worked hard to turnaround those schools with the biggest needs and to raise the academic performance of all the schools we support. As a result, this year we faced fewer academic related headwinds and schools we manage were able to increase enrollments in many states where they weren’t able to do so in previous years, such as in Tennessee and Nevada. At the same time, in some cases, we worked with the independent charter school boards or districts to responsibly manage new enrollments to effectively balance growth and academic progress. For example, we saw tremendous demand in Alabama which is a new school, but worked with the School District Board to self cap the growth this year. We wanted to ensure that the people processes and support systems were in place and running smoothly to support higher enrollment levels over time. Together with our partners, we believe the short-term action will lead to stronger performance and growth rate in the state over the long run. However, enrollment caps, both self-imposed or governed by policy charter or contracts, did somewhat dampen growth this year, but implied potential actual long-term opportunity. Just to give you an idea of the level of latent demand in some states, 16 of our partner schools hit their caps this year which put thousands of families on waiting list for virtual programs. In a state like Georgia, the statewide online school we manage reached its cap in August and saw a waiting list of more than 1000 students and in North Carolina which is in just its second year the school quickly hit its cap and had a waiting list. The next message here is that growth would have been significantly higher if those caps were not in place leading us to feel that demand for fully online schools continues to be broad-based and the market continues to be underserved. In conjunction with our partner schools we plan to use this data to help advocate for the easing or elimination of these enrollment caps. Second, we continue to refine our marketing efforts to attract students who are most likely to flourish in an online school environment. This effort has resulted in better informed families and improved conversion rates. We saw increased enrollment in nearly 65% of our schools which is far greater than the last few years. However, in some of our more mature states where we've had programs for 10 or more years we saw penetration rates topping out at around 2% to 3%. In those schools we saw a flat or in some cases slight declines in enrollment. While 2% to 3% penetration may not seem particularly high, let me put it into perspective for you. If online schools were available nationwide, more than 50 million school-aged children would have had access to this option. 2% to 3% of this population would equate to 1.5 million potential online students. That is about five times the number of students who attend fully online schools today across all providers in all states. Over the coming years we expect these macro trends to continue with increasing growth rates in the majority schools in states to complement more modest trends in more mature early adopter markets. That said, we also feel that as the category for fully online schools becomes more widely adopted, the feeling on penetration rates could also increase, which of course would bode well for our business over the long run. Lastly, we continue to look for ways to improve our operational performance. For example, we improved the parent enrollment experience by implementing online chat, automating document processing and driving many other self-service enhancements. These all contributed to measurable efficiencies, speedier application processing and an improved parent experience. Going forward we believe the demand for management programs is likely to grow. We are working closely with potential partners in states like Nebraska, Maine, New Jersey, Pennsylvania, Nevada and others to help open new virtual or blended offerings. While these efforts may take time to ramp, we believe the demand for further educational choice by students and families will increase. Turning to our institutional business, FuelEd, we see increases in demand from school districts for the educational software and services we provide. FuelEd has been able to leverage its significant capabilities and platform, content, and services to deliver simplified yet customized enterprise wide solutions that scale. School districts of all sizes are using digital content to supplement classroom instructions, provide unique blended learning opportunities, deliver targeted remediation, address the needs of English language learners and provide career pathway programs. This year we expect to see revenue gains in both non-managed public school programs and institutional software and services. However, while the revenue trend is positive I want to point out that we started off the year with non-managed public school enrollments being flat year-over-year. This is the result of a number of factors. First, in Georgia, there was a change in the statutory framework that related to district run online schools which resulted in the closure of two sizable programs supported by FuelEd. This impacted more than 2000 families. While over time we expect to find ways to build FuelEd partner programs in Georgia, the change this year had a significant impact. Second, while there was an increase in larger programs which use FuelEd as a comprehensive solution for services such as platform, curriculum, instruction, marketing and enrollment, we did see more enrollment pressure on smaller programs that consume fewer services. The key takeaway is that we were getting better at driving growth in scale programs where we are more involved and are thus focusing on supporting and growing these larger programs and partners. Overall, we are excited about the prospects of FuelEd this year and we will drive towards low double-digit growth year-over-year for this business. Over the long-term we expect FuelEd to be well positioned for continued growth as the nation's schools shift to digital learning options. Our private pay business is also a segment that we see as a contributor to long-term company growth. We have recently reorganized this business under new management and have built a strong pipeline of opportunities both domestically and internationally. We are working on expanding our brand affiliations, launching online options for adult learners and developing and driving partnership growth across the Asia-Pacific. However, much of this activity is in the early stages and may not have a material effect on current year results. As such, for the current fiscal year we see revenue for private pay as being largely flat excluding the impact of the UK operations which we closed late last year. Turning to overall company profitability, we added two new metrics this year, adjusted operating income and adjusted EBITDA. James will discuss these in more detail, but the key is that these metrics provide insight into our business trends without the fluctuations that can be associated with staff compensation expense. For fiscal 2017 we expect adjusted operating income in the range of $39 million to $45 million. As you can see, we are constantly seeking to drive better analytic and further efficiencies across all of our business. For instance, in our marketing activities for film and operations and customer service while being mindful of our need to invest in student academics training and support initiatives for our teachers and school leaders. Regarding capital expenditures, this year we will roll out the next phase of our summer curriculum following the recent launch of our initial eight courses this back-to-school season. We will commence a multiyear upgrade of our student information system which will allow us to further improve our analytic capabilities. Also we will address our elementary school learning management system to complement higher upgrades of our middle and high school learnings methods, thereby creating a highly engaging standards alliance and simplified user experience up and down the grade level. So this would mark the final phase of that particular capital project. However, back over to our capital expenditures, we are also mindful that this is the fourth consecutive year of spending at this level as rolling out a new platform curriculum and functionality is an enormous undertaking. This year, we did have a few typical technical glitches in the deployment of our new platforms which created some challenges for schools and students during back-to-school. While we have fully remedied these issues, we are evaluating whether to stretch some phases of these projects into later fiscal years to better manage the full rollout, but we will make that decision later in the year and we'll keep you informed of any changes. In closing, we are excited to see the results of many years of hard work to improve enrollment. Our mission remained to transform learning for every student we serve with the core focus on improving academic outcomes. We believe this focus will enable us to create operating leverage in our business and develop consistent earnings growth over the long-term. Thanks very much and I will now hand the call over to James to review first quarter results in more detail as well as our second quarter guidance. James?

Thanks Stuart, and good morning, everybody. I want to start out with a quick review of our new disclosures that Stuart already highlighted. As you all know in our release and as we've previously discussed, we will begin disclosing both adjusted operating income and adjusted EBITDA. We will also provide guidance on adjusted operating income. The only difference between the adjusted numbers and the non-adjusted numbers is stock based compensation. As we move towards more performance-based incentive compensation, some of our stock based comp will be more variable in how we account for it. So it is more difficult to predict the period in which it will hit. Therefore, depending on the actual stock based comp we account for this year, our operating income number may have more variability relative to our guidance. So while providing you with the adjusted amounts you can see the underlying results without this variability. Also as I mentioned last quarter, we have changed how we are talking about our capital expenditures. Historically, we've defined CapEx to include curriculum software development infrastructure and computer leasing costs. Including these costs in our CapEx calculation was confusing for some of our investors when they tried to understand how much capital we deployed and tie that back to our cash flow statement. So we believe this will be a much cleaner way to talk to you about our capital expenditures, nice and easily tied in now to our cash flow statement and obviously calculate free cash flow. Now let's turn to a review of our results for the quarter. Revenue for the quarter was $229.1 million an increase of 3.6% from the year ago quarter. Revenue growth was largely driven by increases in our managed public school programs and our institutional business, somewhat offset by declines in our private pay business. As we discussed with you last year, the private pay business declined as a result of closing our UK operations. Revenues for managed public school programs increased 4% compared to the year ago quarter of $184.5 million. The increase was largely a result of the 3.9 increase of student enrollments with the revenue with current enrollment flat to last year. As we discussed last quarter, we continue to see a positive overall rate environment, however not as strong as in the past few years. We would anticipate given the current climate that rates would be on average flat to up maybe one or two percent in the coming years. However we do see greater uncertainty in the rate outlook given the political and economic landscape. At the same time, our revenue per enrollment this year will be pressured by mix. When new states open up often the rates start out below average and edge up over time. This year we indexed a little bit more in newer states such as Virginia, Alabama, and North Carolina, where rates are below average, so that mixed shift will in the short term depress our overall rates. But we believe in the long term provides us with a nice upside opportunity. In our institutional business, which includes both non-managed public school programs as well as our institutional software and services business, revenue grew 18.2% on a year-over-year basis. Non-managed public school program revenue increased 16.5% versus the prior year helped by increases in our Agora program that we discussed previously and offset somewhat by challenges we specifically had in Georgia that Stuart referenced where policy change impacted our business there. Institutional software and service revenue rose 20.1% as school districts continue to leverage our online courses content and materials to deliver academic programs for their students. In the quarter we saw strong performance from our career pathway product which we just lunched at the end of last fiscal year as well as the impact of the LTS acquisition we made last year. In our private pay business revenues declined 30% to $10.3 million. As I've already mentioned, we shutdown our operations in the UK and the declines in the quarter are largely as a result of that change. Excluding the impact of that change revenue was largely flat year-over-year. However, as Stuart already mentioned, we see an interesting opportunity to our space and we believe have the potential for growth in this business unit over the long term. Gross margins were 37.1% in the quarter and relatively flat compared to the year ago quarter. We expect gross margins for the full year to be in this range with some seasonality between quarters; so much what we saw last year. Selling, administrative and other expenses increased 5.4% for the quarter to $104.6 million. The increase is largely a result of the timing of marketing and advertising spend as well as costs associated with our increased revenues. As with prior years we expect a sharp sequential decline spending in Q2. Product development for the quarter were $3.1 million a decline of 0.3 million year-over-year. However, for the full year these costs will likely be a bit higher than last year. You may remember that Q4 of last year was lower than we've historically seen for a fourth quarter, so we probably won't see as much of a dip in the fourth quarter of this year. Our operating loss was $22.7 million or $2.2 million worse than the prior year operating loss of $20.5 million. Adjusted operating loss was $18 million or $2.1 million worse than the prior loss of $15.9 million. Both of these decreases were largely a result of increased depreciation associated with capital projects such as our new Learning Management System and our new curriculum. EBITDA and adjusted EBITDA were both worse year-over-year by about $1 million. EBITDA was $5 million loss for the quarter and adjusted EBITDA loss was$0.3 million versus an adjusted EBITDA profit of $0.7 million last year. The declines were largely as a result of the higher advertising spends in the quarter. Now let's turn to some other items. We ended the quarter with cash and cash equivalents of $135.1 million a decline of $78.9 million. While we easily see a sharp decline in cash balance in the first quarter of each year this decline is slightly larger than normal seasonal trends due to some of the timing of our expenses as payments related to the settlement of our California Attorney General and some phasing of the tax payment that we made in the first quarter. CapEx using the definition I've already reviewed which includes curriculum and software development and infrastructure was $14 million which is basically flat to last year. For the year we expect to invest in the range of $60 million to $65 million, that's compared to full year CapEx on the same basis last year of $63 million. Our tax rate for the quarter was 38.9% which is in line with our guidance of 38% to 42% for the full year and flat from the year ago quarter. I also want to address our current tax rate guidance versus last year's actual. As I highlighted in last year's third quarter conference call, we were able to benefit from certain losses and some subsidiaries as well as in our international operations, which will not recur in fiscal 2017. As such, this year's tax rate is likely to be a bit higher than last year. Now turning to guidance, let me first recap our expectations for the full year. This guidance excludes the impact of any performance based stock based compensation and other nonrecurring charges we may incur during the year. For fiscal 2017 we look for revenue in a range of $885 million to $915 million, operating income in the range of $23 million to $29 million, the midpoint of which is consistent I believe with the consensus, capital expenditures of $60 million to $65 million, a tax rate of 38% to 42%, adjusted operating income in the range of $39 million to $45 million. And for the second quarter we look for revenue in the range of $210 million to $220 million, operating income in the range of $15 million to $18 million, capital expenditures of $14 to $16 million and adjusted operating income in the range of $19 million to $22 million. With that, I'll hand the call over back to Stuart.

Thank you. We'd be happy to entertain any questions that you might have at this time.

Thank you. [Operator Instructions] Thank you. Our first question comes from the line of Corey Greendale with First Analysis. Please proceed with your question.

Good morning.

Good morning.

Congratulations on getting back to a growth mode. A few questions, so first of all, interesting point, the cap in some states, as we think about the longer term growth rate do those caps, do some of those caps kind of naturally increase the time or is some sort of political change required in order to lift the cap that you are talking about?

I think the answer is both. If we at least look to history they are based that as they gain comfort with new programs, that naturally lifted caps over time and then certainly we work very closely with our partner charter school and District Boards to help in that process as well. So it's a little bit of both historically and we certainly think that that's a pretty good indicator for how it will continue to work.

And I'm not sure if you'd looked at it this way, but can you give us some sense of what percent of your managed program enrollment is in schools that have capped?

Yes, I think it's just I think over 50% have capped. Some sort or another and again I think as Stuart mentioned some of those are self imposed i.e. the board really want to keep a growth trajectory that they feel comfortable with and all those are sort of more regulatory caps, but in aggregate those caps are just a tick over 50.

Okay and then on the non-managed, you mentioned the impact of the Georgia closure, I think it has over 2000 families were impacted. If we try to figure out what those would have been and excluding that should we just assume 2000 more students are, I imagine some of the families might have had more than one student, or how should we think about that?

Yes, I mean, you know, it's always hard to identify the single client, but yes, I mean 2000 [indiscernible] for the impact that Georgia singly would have had.

Okay, and can you give us a little bit more on what drove the strong increase in revenue for non-managed program enrollment and what we should expect for the rest of the year?

Yes, that's, so the non-managed per enrollment was really sort of a mix for Agora for example, which is part of the most relevant example our mix or our service portfolio in Agora is just, it's broader than in many of our other non-managed programs. So this year I think as Stuart mentioned in our last call, we sort of expanded our service portfolio to them and that will sort of create a higher non-managed revenue per enrollment. So for the balance of the year, you know, what you see I think is that will drive revenue per enrollment up, certainly year-over-year, probably for the full year though, because just of the way that the mix for Agora front loads a little bit, you won't see the amount of increase for the rest of the year as much as you see this year. So Agora just happens to which drives some of that increased pay take service is that really Q1 focused like the marketing acquisition and things like that, that don't recur as well to the same extent.

And on the demand, I just, could you put a little kind of punch in so what you were saying is that, should the expectation be that revenue per managed enrollment is about flat for the year?

Yes, excuse me, I think revenue per managed enrollment for the full year actually will be, we believe that it will be slightly over flat. So may be a little bit better than flat for this year and then sort of I think the ongoing rate environment will be a little more challenging than we've seen in past years, may be a little more consistent with what we see this year.

Part of that revenue per enrollment flat that has a lot to do with mix as new programs come on typically at lower average rates and build over time.

Yes, I get it. And then on the institutional software business, sorry if you gave this, but what was the growth excluding the acquisition?

Sorry, I did not give that, but the institutional business did have about double-digit growth even excluding that acquisition.

Okay and is that attributable to your new products or to just a better environment or what do you attribute that growth to?

Yes, sorry it’s a little bit of combination. You know, we did see some good new products revenue, we had some good mix.

Yes, we're seeing some interest in some of our new complex programs, the combination of district interest in blended programs, our career pathway programs and kind of other large complex enterprise opportunities.

Okay and then just one last one from me and on the cash flow I just want to make sure, you didn’t change how you are funding for the computers or you just changed to that…?

That's right. The cash flow itself won't change. The cash flow statement, the way we budget things won't change and the way that we finance computers has not changed.

And James, for the rest of the year as I understand, I think I understand the impact of the cash flow in Q1, as we look to the rest of the year, if EBITDA is growing, should we expect cash flow to grow commensurate with that?

Excluding the impact of any timing related items, yes. This year we did get a low sort of negative impact in Q1 with some time related income which will flow through sort of for the full year, but I think excluding that yes.

Okay great, thanks very much.

Welcome.

Thank you.

Thank you. [Operator Instructions] Our next question comes from the line of Henry Chien with BMO Capital Markets. Please proceed with your question.

Hey, guy, I am calling in for Jeff. I just wanted to have a followup question to the [indiscernible]. In terms of the enrollment caps do you have a sense of what growth would be like if the enrollments caps weren’t in place?

Well, as we said, we did hit our caps in 16 states, some of them very early in August. So certainly we had some lost opportunity there that we hope to access and realize over time.

Yes, it's hard and you can see actually what happens as Stuart mentioned some of those caps get hit pretty early in the season and we're not actively seeking enrollments. So it's really hard to say how much of the trajectory of growth would have occurred throughout the rest of the season when they sort of shut it down mid season. But certainly and Stu, you just extrapolate what Stuart said in just even a couple of states it was more than 1000 or so enrollments and I don’t think it's a pure extrapolation through 16 states, but certainly it was probably in the thousands.

Okay great. And just looking out through the bids for the year, any update on the political environment for moving those caps or expanding any, just trying to get a sense of any potential for additional growth in enrollment or either way? Thanks.

Well, you know we are obviously always working in an ongoing process with our school boards and district partners on those caps, but that's an ongoing process that's irrespective of what's going on in the political environment. Obviously we'll see there'll be some changes federally pretty soon. We don't expect that any of the national election issues should have any particularly impactful, any particular impact on our operations because we're primarily running a business that's state driven. So, you know, we continue to watch all of the local election closely and work with folks to make sure that we maintain a positive environment for virtual and blended programs.

And Henry, just to make sure this, we actually question appropriately that, so in the year, this year fiscal 2017 we don’t see any cap issues easing up like normally for the year the caps would be set. So, any cap changes that we sort of probably this year will really impact for next year.

Okay, got it. Okay, and just last one from me, in terms of the institutional business, can you just give an update on some of the growth drivers there, are you still seeing managed and non-managed, is it the curriculum that you are seeing a lot of demand for, any kind of update you can give there, that would be great?

Well, you know, obviously as we mentioned earlier some of the growth in non-managed comes from expanded services with Agora. We've also had some expanded service with other significant non-managed, existing non-managed providers. We've not seen really any recent new shift to non-managed from our currently managed programs which is terrific, nor do we expect much of that to happen on a forward basis. And then as I mentioned just a couple of moments ago, in terms of other growth drivers, we see a lot of interest in blended learning programs, you know, how do we help school district implement programs that, the variety of scale but of course world language across career pathway opportunities, across AP and even across kind of targeted remediation. We really continue to work with district in a customized way to meet their needs, but fortunately due to our breadth of kind of our library, our content, there really isn’t too much customization we have to do, but just proceeded to be that. So we work very closely in a solutions oriented way to meet their needs.

Got it, okay. Thanks for the color.

Thank you, Henry.

Thank you. [Operator Instructions] Mr. Stuart Udell, there are no further questions. I'd like to turn the floor back to you for any final remarks.

Well, I just want to once again thank you everyone for their time and we will continue to work hard to make a difference for both students and investors. Thank you. We look forward to talking next quarter.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.