Stride, Inc. (LRN) Q4 2017 Earnings Report, Transcript and Summary

Greetings and welcome to the K12 Fiscal Year 2017 Year-End 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. Thank you, sir, you may now begin.

Thank you and good afternoon. Welcome to K12’s four quarter and year-end 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 operating 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?

Thanks, Mike. Good afternoon and thanks for joining us on the call today. I'm pleased to say we ended fiscal 2017 with solid results both for the quarter and the full year. Revenue for the year was $888.5 million. Increasing 1.8% year-over-year. Our operating income for the year includes $11.4 million of charges that were booked in the third quarter and $3.8 million in additional performance based stock compensation expense related to our long-term incentive plan. Excluding those charges, we would've reported operating income of $28.4 million for the year. This is an increase of 35.2% year-over-year when you exclude the net impact of a non-recurring legal settlement from the 2016 results. When we look at adjusted operating income again excluding the charges in both fiscal 2016 and 2017, we ended this year at $46.4 million, an increase of 17.2% year-over-year. Our capital expenditures were $48.2 million, a reduction of $14.7 million from the prior year. The majority of our capital went toward upgrading software and curriculum to improve the student online learning experience. Notably, we generated over $40 million in free cash flow and ended the year with nearly $231 million in cash on hand. These results are tightly aligned with the guidance we gave last fall when including the updated guidance of the capital expenditures we provided during the year. Performance in each of the quarters and for the full year consistently met or even beat the guidance we provided. Our investment philosophy going forward will include making targeted expenditures to drive academic excellence and outcomes while simultaneously focusing on growing free cash flow. Therefore, as I’ve said previously, we believe that our capital outlays for fiscal 2018 will remain below $50 million and then tapper down to the $40 million to $45 million range in subsequent years. We anticipate that this trajectory in capital expenditures coupled with ongoing growth in operating income will help us drive sustained increases in free cash flow over the long-term. Now, today I want to focus on three key topics. Our continued focus on academics, exciting progress in our core managed public school business and our vision for delivering consistent growth over the longer-term. Starting with academics, in fiscal 2017 we implemented a number of programs to drive improvements in student outcomes. For instance, last fall, we introduced a new academic excellence framework which provides a roadmap for schools to develop a comprehensive academic plan. When adopted by school boards, the framework allows customization to meet specific market and school needs while being grounded in best practices from across our K12 schools as well as research based practices of other high performing schools, importantly it creates a common set of expectations and allowed K12 to more efficiently support an ever expanding set of school partners across the nation. We also introduced a new graduation planning tool for our customers with the goal of more efficiently providing all high school students with a customized plan to meet individual students needs and keep students on track for graduation. This year our partner schools graduated nearly 6,600 students. Not only will this tool helps support improving graduation rates, but it's also critical in our efforts to drive better overall student retention rates. In addition, we introduced a new nationwide instructional coaching program that includes a teacher observation and feedback mechanism to facilitate the creation of personalized action plans to improve teacher effectiveness. The instructional coaching team observed more than 26,000 class sessions this past year. We expect that our unwavering focus on these academic programs will generate measurable improvement in student outcomes and as a byproduct drive long-term growth and profitability. Now, let me share some good news on our managed school business. This past quarter new legislative actions in several key states have opened up growth opportunities in which we can work with partners to expand the number of K12 powered school and reach more students over the coming years. First, in Pennsylvania, the Pennsylvania Department of Education recently authorized a new charter school that will be powered by case well. The Insight Pennsylvania Cyber Charter School will serve students in grades K-10 in fiscal 2018 adding 11 grade in fiscal 2019 and 12 grade in fiscal 2020. Over time the school has plans to differentiate itself with an emphasis on career and technical education. So while we continue to work closely with agora and other important non-managed partners, we are pleased that the Insight Board recognize the value of a fully managed school in this very important state. Second, in Florida, the legislature passed an education bill, which clarifies that the requirement for student transfer rules put in place last year does apply to online schools, not just to traditional brick and mortar school. The result is that students may now enroll in an online district program or charter school regardless of where they reside in the state, in effect it’s the first state-wide open enrollment for virtual programs. To put this into perspective, this past school year we were only able to offer virtual charter school enrollment in four of Florida’s 67 counties. With this change, all students from across the state will now have access to a full time online option. And third, West Virginia enacted legislation to allow school districts for the first time to implement an online model within their district borders. This model will allow K12 to partner with school districts in West Virginia to provide curriculum, technology and a menu of services such as instructors’ program management and professional development. We look forward to working with school partners in the near future to provide online school options for families. While we are very excited about these entirely new opportunities, they are at an early stage and therefore we are not changing our view for enrollment growth for fiscal 2018. Of course, we also continue to focus heavily on strengthening and extending partnerships with our existing school boards. For instance, we recently signed a new 5-year contract with the Ohio Virtual Academy, one of our largest fully managed school and look forward to working with the OHVA board and leadership to reach more kids and drive better outcomes. Now moving onto our vision for delivering consistent growth over the long-term. First and foremost, we will continue to focus on growing our core managed public school business. We believe that the uptick in manage public school enrolments in fiscal 2017 combined with a renewed tension on school choice and virtual education as indicated by the developments I shared in Pennsylvania Florida and West Virginia translates into a favorable environment for long-term growth. While opening new schools and programs is often a multiyear process, we remain optimistic about continuing our successful track record of working with school boards to bring new virtual school option to more families. Second, we will invest in Career Technical Education or CTE, which we believe offers a significant market expansion opportunity. Incredibly by 2020, there will be a projected $55 million job openings. However, the U.S. will fall far short of producing skilled workers to fill those jobs. Our nation's persistent skills gap or the mismatch between employers’ needs for skilled talent and the skills possessed by the available workforce has a direct effect on the U.S. economy. Reduced productivity from unfilled jobs results in $160 billion a year in lost revenue. This skills gap is a critical issue to governors, mayors, industry leaders and parents. Per recent survey by Edge Research, parents have a strong preference for experiential career focused learning opportunities for their children over traditional forms of education. For example, three times as many parents said that a couple years of work experience was more valuable than a four-year liberal arts degree. In developing our CTE curriculum, we carefully analyze workforce needs to create 24 specific learning pathways and 115 course options for students to obtain the skills needed for high demand occupation and they can work towards obtaining any of 45 industry certifications before high school graduation. These career readiness pathways provide an innovative approach to college and career readiness in eight career clusters: agriculture, architecture and construction, business management and administration, health science, hospitality and tourism, information technology, manufacturing, and stem. K12 already operates a half dozen highly innovative managed career academies specifically designed to bridge local skills gaps. For instance, in the past I've mentioned the destinations career academy of Wisconsin, the state's first ever CTE focused online high school. This groundbreaking school was actually launching a quadruple partnership between K12 and the McFarland School District, the International Union of Operating Engineers Local 139, which is the heavy machinery operators and Fox Valley Technical College. Students have the opportunity to earn a technical and specialty trade credential as well as college credits that will position them to earn industry certification and possible apprenticeships. High quality flexible and engaging CTE programs answer the call from employers across the nation to better prepare students to work in today's complex global marketplace. Taking CTE classes has other important benefits. Notably in our first year of delivering this curriculum, we found that the withdrawal rate for students who were enrolled in full time CTE program drops by half. We also found that students who took even one CTE elective improved their retention rate on average by a few percentage points. CTE is an opportunity that promises to cut across all of our businesses from fulltime managed CTE programs to electives in our traditional managed public schools, to unique field lead partnerships with school districts, to career oriented private pay offerings and perhaps even down to the middle school level. We are excited by the potential that CTE holds for K12’s growth and helping close the nation's skills gap. Third, we will diversify our business by driving adoption of new and innovative models. This includes investing behind the potential of blended programs in which K12 works closely with school districts that are looking for innovative ways to meet the needs of their students. Blended models allow districts to offer students a more flexible alternative to the standard classroom instructional model. As we've mentioned, we are already working with some large city districts like Omaha, Nebraska and Richmond, Virginia to implement blended offering designed to meet their specific localized needs. In these innovative partnerships, K12 provides curriculum, technology and a menu of service options such as instructors’ program management and professional development. We see these blended models as increasingly attractive alternatives for school districts around the country to really innovate and better serve the individualized needs of students. We will also continue our overall investment in the institutional market. As we look forward to the potential for this business over the long-term, we see a few key trends that are significant. First, a growing number of districts are looking to digital partners to solve complex problems that require multiple solutions knit together with wraparound service support. For example, Fuel Ed is working a school district in Texas to support its adult education and literacy program. This program serves adults of varying educational backgrounds who are seeking to improve their English language capability and obtain skills to further their employability. Fuel Ed created a custom solution using project-based English language learning modules with career exploration and readiness curriculum tied to the specific needs of local business partners. This is just one example of why we believe Fuel Ed’s peak platform and broad service expertise uniquely positions us to capture these complex scale opportunities. We are also seeing more and more districts interested in consolidating their digital offerings from many providers to a select few or even to a single partner. For example, we just significantly expanded relationship with a major school district in Florida where they are in the process of consolidating from three providers to one. They will now be partnering with Fuel Ed to serve their dropout recovery, credit recovery, and course elective needs. The Fuel Ed solution includes a custom enrollment portal along with integration and instructional services. We believe that the breadth of our catalog combined with our deep service capabilities positions us well to capitalize on this trend to consolidate providers. Now as I look back on fiscal 2017, I believe we accomplished quite a bit. First and foremost, we posted solid financial results in each quarter and for the year. We met or exceeded the guidance we set back in the fall of 2016. The K12 managed public school footprint is growing moreover we anticipate our ongoing work with legislatures and independent boards will further expand the number of schools we support over the coming years. The national policy environment remains generally positive and could provide more choices to parents and students. We implemented a comprehensive set of programs to address the student and family experience and drive student retention. Key pieces of the K12 technology platform and curricula were significantly enhanced. Going into fiscal 2018, I feel confident that the team is well posited for a seamless back to school launch. We ended the year with almost $231 million in cash. We're in a strong position to capture strategic opportunities as they arise while also investing in the organic growth of our business. And importantly, we have a clear vision of how K12 will continue to grow over the long term by expanding the core managed public school business, by leveraging a significant market opportunity and our unique position in career technical education and by investing in new models including blended programs in the school districts transition to digital offerings. I'm excited about where K12 has ended the fiscal 2017 year. We were keenly focused on delivering the best learning experience to the students we serve. We believe our focus on academics and innovation in education will translate in continued growth and profitability for our shareholders for many years to come. Now before I hand the call off to James, I wanted to mention that Liza McFadden has been appointed to K12’s Board of Directors. Liza will be replacing Jon Q. Reynolds junior who will be retiring from K12 board after more than six years of service. Jake’s expertise and contribution have been deeply appreciated. Liza is currently the President and CEO of Barbara Bush Foundation for family literacy, an organization that like K12 believes in empowering families through education. She was appointed by President George W. Bush to serve on the National Institute for Literacy Board. Liza’s experience and education is well rounded, she is a former high school teacher, Florida Department of Education administrator, and served in Governor Jeb Bush’s administration where she spearheaded efforts to encourage 200,000 mentors to support public school children. We're privileged to have Liza join the board. She brings to K12 a dedication to the education community and expertise in both policy and its application in schools. Thank you for your continued support and I’ll now hand the call over James to review fourth quarter and full year results.

Thank you, Stuart, and good afternoon, everybody. First, I would like to recap our reported results. Revenue for the quarter was $215.8 million, a decrease of 2.5% from the prior year. For the year, revenue was $888.5 million, an increase of 1.8% from the prior year. For the quarter, operating come was $4.7 million, an increase of $4.2 million from the prior year. Operating income was $13.1 million for the year, a decrease of $0.8 million, compared to the prior year. Adjusted operating income was $12.8 million, an increase of $17.4 million from the prior year. For the year, adjusted operating income was $35.7 million, a 9.9% increase from fiscal 2016. As a reminder, adjusted operating income and adjusted EBITDA excludes stock-based compensation. Capital expenditures were $48.2 million, a decline of $14.7 million from the prior year. As Stuart already mentioned, our operating results for the year includes $11.4 million of charges from the third quarter, a small piece of which is stock-based compensation and depreciation. So when you do your add backs to EBITDA on operating, it won’t tie it exactly and $3.8 million of additional performance-based stock compensation expense related to our long-term incentive plan. Excluding those charges, operating income would have been $28.4 million for the year and adjusted operating income would have been $46.4 million. For comparison purposes, if we look at fiscal 2016, excluding the $7.1 million in charges recorded relating to the settlement with the state of California, our fiscal 2016 operating income would have been $21 million for the year. Adjusted operating income would have been $39.6 million. And excluding the charges discussed in both periods, operating income would have grown $7.4 million or 35.2% and adjusted operating income would have increased 17.2%. Our fiscal 2017 results exceeded our guidance on profitability and CapEx and we are in line with our expectations for revenue. I also want to point out that this quarter, we took a $10 million non-operating charge related to an investment we had in a Chinese company called Web International. We exercised our put option on the shares we own back in April of 2013 and I've been working with Web to find a structure to efficiently return our money. However, given how much time has elapsed, our auditors encouraged us to write this down. We continue to be in active discussion on recovering this investment and any recovery would be recorded as a gain in a manner similar to the impairment we recorded this quarter. So let me turn to some additional details for the quarter and the year. I'm going to focus the remainder of my remarks to stay on the results excluding the charges and additional performance based stock comp expense reported in the third quarter and fourth quarters of this year as well as those relating to the settlement in fiscal 2016. Revenue for the fourth quarter was $215.8 million, a decrease of $5.5 million or 2.5% from the year ago quarter. For the full year, revenue was $888.5 million, which represents a 1.8% increase from the prior year. Revenue growth was larger driven by increases in our managed public schools and institutional businesses somewhat offset by declines in our private pay business. Revenues from managed public school programs decreased 2.2% per quarter for the quarter yet increased 2.3% for the year. The changes in the quarter and the year align with the enrollment trends for the year. Enrollment for the court declined 1% versus the year ago quarter and for the year enrollments have rose 0.8%. As we've discussed on previous calls, we believe we have addressed the root cause of retention issues and retention should improve in fiscal 2018. From a revenue per enroll standpoint, we ended the fourth quarter at $1,841 per student, a decline of 1.2% from the previous year. For the year, revenue per enrollment was $7,075, an increase of 1.5%. Full year, revenue per enrollment rose as a result of a combination of factors including school mix, improved funding in some states and improved revenue capture as well as some other variables. For the quarter, the decline relates to timing and is not an indication of an ongoing negative trend. Going forward we continue to believe the overall funding environment will remain positive. Our current mix of schools and where we anticipate growth may tamper somewhat our overall revenue per enrollment growth next year as it did somewhat this year. We view this as a positive longer term trend as we open new states and grow in those states where the early years of funding are traditionally low. Moving onto our institutional business, which includes both non-managed public school programs as well as our institutional software and services revenue was largely flat for the quarter, but grew 9.7% on a year-over-year basis. Enrollment for non-managed programs increased 7% to 28,900 for the year and revenue per enrollment rose 9.9%. Those increases for the quarter and the year were largely a result of the continued success in some of our larger programs, which have scaled throughout the year. Institutional software and services revenue decreased 12.5% in the quarter, but rose 1.4% for the year. The decline in the fourth quarter was a result of an unusually tough compare from fiscal 2016. For the year, the increase in revenue is largely the result of sales of curriculum credit recovery courses and our acquisition late last year of LTS. We continue to believe in the long-term prospects of the institutional business’ world [ph], the changes we have been making to structurally set this business up for long-term growth. That said, I do want to emphasize that in the near-term, we continue to expect revenue growth for software and services will be in an uneven pace. Additionally, we probably should not expect the same level of growth from our larger non-managed programs next year. In our private pay business, revenues declined 16.2% in the quarter and 24% for the year. As with previous quarter’s, this year the reductions are largely due to closings in our U.K. operation last year. When we look at revenues excluding the impact of the U.K. operations, revenue declined 3.1% year-over-year. As we've previously mentioned, we're focused on both growth and long-term profitability in this business and we will invest in the private pay business in the coming years. With that in mind, I see a lot of profitable growth opportunities both domestically and abroad. Moving on to gross margins for the quarter, we posted gross margins of 35.5% and 37.3% for the year. For both the quarter and the year, margins were largely flat compared to the previous year. We continue to invest in academic programs and new programs like CTEs as Stuart mentioned previously to drive growth, improve retention and higher academic outcomes. Selling, administrative and other expenses decreased by 6.5% year-over-year to $65 million. For the year, expenses were $290.4 million, which declined by 1.6%. As we have for the past few years, we've been able to hold selling, administrative and other expenses relatively flat as we sought to contain costs. As we look forward, we face a number inflationary pressures on third-party costs in such areas as our enrollment center, product development and IT that we will continue to try and minimize, but may put some upward pressure on these costs that we've not seen in the past few years. We will also be increasing our focus and investments in areas like CTE, adult education and dual credit as we build out those product lines. And looking out a couple of years, as we continue to expand, we'll spend some money to drive long-term revenue opportunities. Moving on to product development expenses for the quarter, we increased costs by $1.9 million to $3 million. On a full year basis, product development expenses were $12.5 million, an increase of $2.4 million for the year. Most of our increases we've seen in the fourth quarter which if you look year-over-year we had a low P&L comp last year and our sequential trend throughout the year has been fairly consistent. I will note that our overall cash outlay on product development is down materially year-over-year with most of the benefits showing up in our lower CapEx number. EBITDA for the quarter was $26.5 million, increasing $1.2 million over last year. For the year, EBITDA was $101.2 million, $12 or 13.5% higher than the prior year. As we highlighted earlier this year, we introduced adjusted operating coming and adjusted EBITDA, as those metrics exclude the impact of stock-based compensation and would better represent the underlying trends in our business. You should note that for fiscal 2018, we may have additional performance based stock compensation that we will vest just like we did in Q4 of fiscal 2017. As we foresee vesting criteria being met, we will disclose our best estimate of the impact of the financials. Adjusted EBITDA for the quarter was $30.7 million, an increase of 2.2% from the prior year and for the full year, adjusted EBITDA was $119.3 million, an increase of $11.5 million or 10.6%. For the quarter and for the year, adjusted EBITDA rose due to our strong operating results. Operating income for the quarter was $8.5 million, an increase of 11.8%. And for the year, operating income was $28.4 million, an increase of $7.4 million or 35.2%. Adjusted operating income for the quarter was $12.8 million, which is largely flat with the year ago quarter and for the year, it was $46.4 million, an increase of $6.8 million or 17.2% from fiscal 16. Turning to some other items, we ended the quarter, as Stuart mentioned, with cash and cash equivalents of $230.9 million. This is an increase of $16.9 million from the fourth quarter of fiscal 2016. Importantly, we were able to increase cash on hand even with more than $16 million in outlays related to payments for the settlement with the State of California in Q1 and with the purchase of the minority stake in Middlebury Interactive in Q2. CapEx, which includes capitalized curriculum and software development and property and equipment purchases was $48.2 million for the year, a decrease of $14.7 million, compared to last year. This is lower than our guidance and already in the $40 million to $50 million range we signaled earlier this year with our longer term goal. So we’re ahead of schedule on lower our CapEx and as Stuart mentioned, we believe we should be able to get closer to the $40 million to $45 million range a year, which is the lower end of our long-term guidance. Having said that, we continue to actively invest in products and software and will in fact accelerate investments more innovative or growth areas such as CTE while staying within this long-term guidance. Our tax rate for the year excluding the charges that we described as well as the web right off would have been 36% or about flat with last year. If you simply added back the $10 million in web write-off to pretax income and the tax expense did not change, that's how you would calculate the 36% in effective tax rate for this year. And moving forward, given some changes in the accounting for stock-based compensation, vesting of stock-based comp can impact our effective tax rate. When our stock price is at a premium to the grant prices, the effect would be to low our tax rates and vice versa for stock price was lower than the grant prices. Therefore, we may see some additional volatility in our effective rate moving forward that we cannot predicted as it is driven from our stock price at the time of vesting. At current stock prices, this would be favorable to effective rate all other things being equal. I want to again remind everyone that as we did in for fiscal 2017, we will report both our fall enrollment numbers and Q1 results at the same time toward the end of October. We will also provide full year guidance at that time as well. Thank you. And I will hand the call back over now to Stuart. Stuart?

Thanks very much, James. I want to also thank everyone on the call for your time. Darren, we'd be happy to take any questions that folks might have.

At this time, we will be conducting a question-and-answer session. [Operator Instructions] Our first question comes from Corey Greendale of First Analysis. Please proceed with your question.

Hi, thanks. This is Ken Wang on for Corey. Thanks for taking my question. So, just looking at the – this is from a couple of months back when your 8K was published with some details on the Ohio Virtual Academy contract renewal, it look like you may be offering a volume discount, which would mean lower revenue per student for higher enrollment levels that looked like it wasn’t in the prior contract. Just wondering what effect might the volume discounting have and do you expect higher enrollment levels to fully or more than fully offset the discounting?

So the discounts are – we did offer some volumes discounts. The right enrollment levels that we feel that as long as the Ohio Virtual Academy board wants to achieve those levels, they will be more than offset by higher fees to us. So we think the economics of that contract are really very attractive for both us as well as for the Ohio Virtual Academy board.

And I would just add that notwithstanding the comments that James just made, materially the contract is renewed on very similar terms.

Okay, thanks. That’s very helpful. And then just wondering when is the – is there any other large contract that's up for renewal anytime soon, when would that be – what percentage of revenue would be associated with that contract?

I certainly don't have the full schedule in front of me, but typically our contracts are five years, some go a little longer, some go a little shorter, so as you would expect about 20% of our contract turn in any given year to be a little higher, to be a little lower, which means that there are always a bunch that we’re working against. And that's just a constant piece of our business.

All right. Thanks. That's helpful. And then just one last one for me. So just looking at Pearson’s – its recent earnings call, they had made some comments that their Connections Education segment saw some of its school partners taking some noncore services in house in 2017, so I’m just wondering whether you're seeing anything similar and maybe also if you could comment on any changes and competitive behavior from Connections?

We certainly don't see too much happening in terms of a move from managed public to non-manage, it’s not to say that it can't happen again at some point in the future. I think that the situation at Agora is one that has suggested, we’ve been able to continue to work with them as a partner and they obviously had challenges a year or so ago that were very visible. So, we don’t expect to see too many folks moving in that direction. In terms of Connections, we don't see too much difference in terms of competitiveness, it’s a large market, we are the only two significant players. So, we’re frankly much more focused on expanding the marketplace through new offerings like our blended programs and our CTE programs. We believe that we are a little bit ahead of competition in that area.

Thank you.

There are no further questions at this time.

Okay. Well, once again, I’d like to thank everybody for joining us today and we appreciate your time. We look forward to speaking with you in three months. Thank you.

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.