Stride, Inc. (LRN) Q3 2018 Earnings Report, Transcript and Summary

Greetings and welcome to the K12 Third Quarter Fiscal 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mike Kraft, Vice President of Finance. Please go ahead.

Thank you and good afternoon, everybody. Welcome to K12's third quarter earnings call for fiscal year 2018. Before we begin, I would like to remind you that in addition to historical information, certain comments made during this conference call may be considered forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and should be considered in conjunction with cautionary statements contained in our earnings release and the company's periodic filings with the SEC. Forward-looking statements involve risks and uncertainties that may cause actual performance or results to differ materially from those expressed or implied by such statements. In addition, this conference call contains time-sensitive information that reflects management's best analysis only as of the day of this live call. K12 does not undertake any obligation to publicly update or revise any forward-looking statements. For further information concerning risks and uncertainties that could materially affect financial and 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 Nate Davis, Chief Executive Officer and Chairman of the Board; 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 Nate. Nate?

Thank you, Mike. Good afternoon, everyone. Thanks for joining the call today. As you saw in our press release, we delivered solid results for the third quarter. Revenue was $232.9 million and our adjusted operating income was $24.3 million. Our revenue, adjusted operating income net of the cost of transitioning CEO and capital expenditures met or exceeded the guidance we provided last quarter. Our performance this quarter is a result of a multi-year strategy to balance growth with profitability. We successfully instilled discipline in the assignment of resources, the funding of content, program, and systems investments that supports students and teachers, while also building a strong foundation for growth in our business. For the fourth quarter, we are tightening our full-year guidance with a slight increase in our revenue guidance as James will detail later in the call. Now, since I resumed, reassumed the position of CEO earlier this year, investors have been asking me what my vision is for driving shareholder value. Let me spend a few minutes detailing our priorities, how I believe we can drive continued growth and profitability. The short version is that I want to mine the significant opportunity to continue improving our base business. And I also want to focus on growth in the Fuel Education business. First, it starts with strengthening our core, which is our public school business. We served nearly 1 million students through these programs since we started this business. Over time, we expect to reach 2 million or even more, as we deliver on the parents' academic expectation and the academic needs. When we meet or exceed those expectations even more parents will seek out our personalized education approach. Along with delivering academic success for our students, we also need to retain more students because the longer they stay in the programs we manage, the better they do academically. As we previously outlined, students in grade 3 to 8 enrolled three or more years in K12 managed public schools, achieve higher proficiency compared to students enrolled for less than a year, 16 points higher in English language Arts, and 11 points higher in math and read. According to the state test data from school year 2016-2017, it shows we delivered this expectation and this improvement. I'm happy to report that on a year-to-year basis, retention has increased 140 basis points. We're also quickly approaching the retention levels we saw in FY 2016. With the addition of the new programs this year, I expect positive trends to continue next year as well. Now, while I remain optimistic about the strength of the core business and its potential for growth, that doesn't mean we won't face headwinds from time to time that could blunt some of this opportunity. Given more than 70 schools we now manage in 30 states and the District of Columbia, one would expect in any fiscal year there will be school closures, additions of new schools, expansion of existing schools, enrollment caps, enrollment caps increase and reduced, issues of per pupil reimbursements, school boards that choose to move all or part of their school to managed, to non-managed and vice versa. Simply stated, it's the ebb and flow of this business at this stage of our maturity. Taken in total however, for fiscal year 2019 and beyond, I believe the core business will see enrollment growth at higher levels than in the last two to three years. And we won't know if I'm right until October, but early internal signs are positive. As far as new business, I'm excited about delivering Career Readiness and Career Pathway options to our students. With low unemployment rates, many businesses are finding it hard to fill skilled jobs. Whenever we talk to state governors they invariably bring up the need for higher trained skilled workers and the need to fill more jobs in their state. So what are we doing differently than what we've done in the last two years to address these needs? To date, we focused on building career-oriented schools and curriculum. But the next step will be developing partnerships with corporations, two-year schools, trade association and even four-year universities. We want to work closely with corporations to directly align our curriculum to their ongoing needs in jobs like coding and IT management, healthcare services, healthcare administration, among many others. By building a strong link between these groups and our schools, students graduating from our Career Readiness program will have a clear path to the next step in life. They can enroll in two year or even a four year college, intern apprenticeship program or go directly into the workforce. The key is that they will graduate with applicable skills, understand their career option, make informed decision, and most importantly, succeed in their chosen profession. If we create a more comprehensive offering linked directly to these corporations, higher education, institutions and trade associations, we could actually expand the number and the type of students who want to enter our Destination Career Academy, where we already have 1,800 students enrolled. In fact, we want to build a separate brand with the significant demand for our Destination Career Academy, because it's a different value proposition. So we will shift some of our marketing funding into a new campaign, developed to enroll high school students into these Destination Academies to attract students who previously hadn't considered the blended and online programs that we manage. This new approach is designed to give incremental growth above the current market expectation for enrollment in full-time online programs. Third, I'll be focused on turning around the institutional business with the new Fuel Ed management team. As our results show in the past few quarters, we have lost ground in both our non-managed and our software services business. We need to change our approach to the software services business. We will be focused on becoming a trusted advisor to public school districts, private schools, religious schools, institutions of learning and dropout [ph] schools. What do I mean by that? In the managed online schools K12 has learned all of the components necessary to manage in a digital environment. We do it for 70 schools and our program management skills are core competency for this company. We need to take those skills and we need to help other public schools move smoothly from educating students in an analog world, to providing a robust digital learning experience. I won't complete this migration just by buying low-cost, low-priced single math reading or remediation courses. We need to help them answer the questions that are needed to manage in a digital environment, things that we learnt. For example, what's the professional development is necessary for teachers and administrators to teach the best technology in a digital environment; what tools are needed to monitor their performance; how does one choose the equipment to be used, is it PC or Mac, Chromebook; how does one handles students who want to bring their own device; what software need to be placed on these devices; what security and student protection be good in place; what learning management system or SIS should be used; what data analytics should teachers be using to monitor student performance, to enable the personalized learning environment. Content is what one piece that they need. And we've been selling content. We have to shift to selling the entire integrated services. We have to shift to being a program manager for the digital conversion in schools. That's our expertise. And when we sell the entire service, we're going to help schools understand, how to go through the transformation from to an interactive platform, classroom that is delivering personalized learning experiences, which is our core competency. Learning to sell as a trusted advisor is a strategic change that I like to make in the Fuel Ed business. And I feel confident that over the next few years, we'll prioritize many of our solutions that we are already use in-house, including professional development, data analytics, monitoring tools. We will also part with others to acquire the skills we need to help schools make LMS and SIS decisions as well as other skills where we currently don't have the expertise. Our objective will be to shift from being a content vendor to being a trusted advisor, who provides a holistic digital learning solution. When that transformation is complete, I believe we'll have stronger, healthier, more sustainable competitive advantage in the institutional business. Fourth, with very little investment, I think, we can expand internationally. We are also in contact by others seeking to do in their country what we've done in the U.S. And we stated previously, our international focus going forward is a partnership strategy, whereby we work as a trusted advisor with an in-country country-based organization, often a school but to use our content and to be our sales partner within that country. A perfect example of a developing international opportunity is an announcement we made last month with the Beijing Royal School. When we first started working with Beijing Royal School several years ago, their enrollment was 2,000 students. They've since grown by acquiring other schools. And they now have about 8,000 students, while they only have 600 of those students currently enrolled in our online program they want to roll it out to all of their students in China. As part of the agreement Beijing Royal will manage sales, value-added training and implementation as well as Chinese translation, the first-line customer support to private schools throughout China. Chinese business will access K12 courses and will have the opportunity to earn both Chinese and U.S. high school diplomas through our program. We think this type of partnership is a big opportunity on a global scale, not just China, but also other countries across Asia, South America and Africa. From a K12 perspective, this is also a cost effective build strategy. Our prime investment is in solely and business development personnel. K12 is only stepping up to investment when a partnership agreement is in place. And much like in the other areas of our business, we're trying to find ways to leverage what we do well within our core business as opposed to making major brand-new investments. So in summary, the four cornerstones of my current plan to move the company forward are: continued growing the core business, improving academic outcome and retaining students; second, build a more comprehensive career readiness program with a distinct brand and better linkage to corporations, trade associations and higher education institutions; and finally, we frame our institutional business from a constant sale into project and program management of the end-to-end digital transformation that must go on in schools; and I should add last one, develop the international opportunities when they present themselves. To support these priorities, we will leverage our balance sheet selectively by investing in, partnering with or maybe even acquiring companies that can help us to accelerate our business goals without driving up capital expenditures. Now, before I hand the call over to James, I want to discuss the news that the California Virtual Academies and a local California union reached a collective bargaining agreement a few weeks ago. This agreement is still subject to ratification by the CAVA board and also by the CAVA employees now represented by the union. And to clarify some misreporting that happened, it is not an agreement with K12. K12 does not employ the CAVA teachers. Also the union did not negotiate with K12, it negotiated with the CAVA schools. Now, as a service provider that manages more than 70 schools on behalf of independent not-for-profit charter boards and also school districts around the country, we work with more than 5,000 teachers and administrators. Some of these educators are represented by unions already, as it now in the case in California. Other schools, charter schools that manage are often not unionized as the concept of a charter school often rests on the state legislation, designed to allow for innovation and alternative instruction without being bound by rigid workplace rules. To the extent that we mange what we manage is a district based program, which many are, it may already be unionized and subject to collective bargaining. A key takeaway here is that every state, every school board is different. So I don't see the CAVA settlement as some standard for other states. That said, we support the CAVA and their decision to work with local union. And we'll continue to encourage teachers to go arm-in-arm with us to ask legislators to protect these important school options and ensure their fair and equitable funding. Going forward, K12 will remain focused on putting students we serve and their academic success first and foremost in everything we do. CAVA's agreement with the union will not change our ability to achieve success in our mission, which is delivering effective, personalized education to all students we serve. Thanks very much for your time this afternoon. And I'll now hand the call over to James to review the third quarter financial results as well as fourth quarter guidance. James?

Thank you, Nate. Good afternoon, everybody. First to quick recap of our results for the quarter, revenue was $232.9 million, an increase of $10.4 million or 4.7% from last year. Adjusted operating income was $24.3 million, an increase of $6.3 million or 35% from last year. And capital expenditures for the first nine months of the year were $33.3 million, which is flat compared to last year's first nine months. As Nate mentioned in each case, these results met or exceeded the expectations we provided in our guidance last quarter, with the caveat that for adjusted operating income, we exceed our guidance when you exclude the severance charge we took for outgoing CEO. We've updated our revenue guidance for the year and are keeping the rest of our guidance unchanged excluding the charge, I just mentioned. Revenue of $232.9 million was overall stronger than we expected driven by strong enrollments in Ohio and solid student retention performance in our Managed Public Schools. However, this was somewhat offset by continued disappointment in our institutional business, it make just addressed. In our Managed Public School Programs revenue was $200.6 million, increasing 7% compared to the prior year, this performance was a result of 6.7% increase in student enrollment and a slight increase in revenue per enrollment. From an enrollment standpoint, as Nate mentioned, and as we have previously indicated retention has improved well over 100 basis points, this in year period, and we have essentially validated at this point, our belief that we are able to turnaround last year's disappointing performance. In addition, in year new student enrollment has also been strong. Our Q3 average enrollments are 6.8% higher than last year. That year-over-year growth is the highest growth, we've seen since fiscal 2013. We are also entering Q4 at the highest level we've seen since 2015. which is set us up for a strong jumping up point as we enter fiscal 2019, while, there always puts and takes in any enrollment season, we are encouraged by the level of enrollments we have at this time of the school year. Revenue per enrollment rose slightly for the quarter, as states continue to increase education funding. As we've indicated full year revenue per enrollment should be largely flat to modestly up, which implies we anticipate strong mid-single-digit year-over-year growth in revenue per enrollment in the fourth quarter. In our institutional business, which includes both Non-managed Public School Programs as well as our institutional software and services, revenue declined 13% on a year-over-year basis. Non-managed Public School Program revenue decreased 17.3%, as a result of enrollments declining 17.1%, and slightly lower revenue per enrollment. With some of our larger customers continue to experience enrollment softness, we did not expect to strength to update this year and possibly continue into fiscal 2019. Institutional software and service revenues declined 6.1%, as a result of software sales at the beginning of the season that we've already discussed in previous quarters. As Nate outlined we are embarking on more holistic approach to this market, we should take some time to develop. For the current fiscal year, we anticipate institutional revenues declining closer to 20% on a year-over-year basis, as in-year sales activity has been slow to develop. In our private pay business, revenues increased 6.5% to $9.4 million, and as we highlighted last quarter, while we remain bullish on the longer term prospects for this business. We anticipate revenues to be largely flat fiscal 2018 compared to last year, will begin to grow starting next year. Gross margins were 36.1%, down 260 basis points due to lower mix of institutional revenues, upfront costs associated with onboarding student into our Ohio school and other school related cost. On a full-year basis, we continue to look for margins that are about 200 basis points below fiscal 2017 due to the decline in our institutional business and ongoing investments and instructional staff as well as some school mix issues. Selling, administrative and other expenses were $62.3 million, a decline of $7.5 million from a year-ago. Our results this quarter included $4.3 million in costs associated with our CEO transition, and then the year-ago quarter, we booked $11.4 million charge relating to reducing our real estate exposure, lowering our human resources costs and reporting some additional reserves for receivables. On a pro forma basis, removing the aforementioned costs and charges from both years, selling and administrative, and other expenses were largely flat year-over-year and this represents 140-basis point improvement as a percentage of revenues. Product development expenses declined 43% year-over-year to $2.0 million and as we've discussed previously continue to investment behind our products for the finding ways to do, we have lower unit costs and we have greater discipline. EBITDA for the quarter was $38.1 million, an increase of 16.5% compared to the third quarter of last year, on a pro forma basis that $42.4 million, which is largely flat from the same quarter of last year. Adjusted EBITDA was $42.7 million compared to $38 million in the third quarter of last year pro forma that was $45.6 million versus $47.3 million. The decline was largely due to lower gross margins somewhat offset by lower stock-based compensation expenses. Operating income was $19.7 million, an increase of $6.9 million. Pro forma was $24 million, which is largely flat to the prior year. And adjusted operating income was $24.3 million, or $6.3 million higher than last year. Pro forma adjusted operating income was $27.1 million, down $1.6 million and largely again the result of lower risk margins. Turning to some other items, we ended the quarter with cash and equivalents of $227.9 million, an increase of 17.1% compared to the third quarter of last year. We would expect as normal seasonally our cash to increase during the rest of this fiscal year, excluding the impact of any investment or M&A activity we might do. DSOs have tried to down this quarter, but I don't want to focus too much on any given quarter given timing issues with payments. We see a significant change and over the quality of our balance sheet, our collectability of our AR. We will let you know, but as of now, we don't see any significant issues with either. And just to highlight at this point, we started the year with Q1 DSOs at the highest level we've seen about five years, while we ended this quarter Q3 at lowest level, we've seen for Q3 in about five years. And historically Q4 will trend down from here, as we continue to receive payments for fiscal year. CapEx, which includes curriculum and software development and infrastructure was $9.5 million, which was largely flat compared to the third quarter of last year. And we remain on track to deliver new system and product investments plan for the year, while achieving our CapEx spending guidance. Our tax rate for the quarter was 34.7% and our year-to-date tax - effective tax rate was negative 11.5%. As we have previously mentioned, we are seeing the benefit of the tax law as well as the accounting for stock-based compensation on our tax rates. And we continue to believe our full year effective rate will be 10% plus or margin 3 percentage points. As I mentioned last quarter on a very preliminary basis, excluding the impact of the stock-based compensation tax impact, next year's rate should fall to around 30%, plus or minus 15%. And of course, we will update this, when we provide formal guidance in October. Let me summarize our guidance for the full year, we are reaffirming and tightening our forecast as well as raising revenue. You should note that the outlook for adjusted operating income excludes the Q3 CEO transition we talked about earlier. So for the full year, we are looking for revenue in the range of $906 million to $912 million, adjusted operating income in the range of $46 million to $50 million, and capital expenditures of $43 million to $47 million. Thank you. And now I'll hand the call back over to Nate. Nate?

Thank you, James. Mike, I think we can actually move to Q&A.

Okay. Operator, if you'd like to poll for Q&A.

Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions] One moment please, while we poll for questions. Our first question comes from the line of Corey Greendale with First Analysis. Please proceed with your question.

Hey, thanks a lot. This is Ken Wang on for Corey. Hey, guys, how are you?

Hey, Ken, how are you doing?

Doing well, doing well. Thanks. So just a couple for me, any update on ECOT? Just wondering if you can speak to maybe how many students ultimately ended up enrolling it, K12 schools?

Yeah, we try not to disclose on a per school basis, what's going on in each individual school. I can just tell you though it's a couple of thousands students that have enrolled from ECOT into our schools. It's been - a lot of students that are struggling to try to find a solution and more than a couple of thousand have come to us.

Okay. Thanks. That's helpful. And you had also mentioned during the last call, from last quarter that some teachers from ECOT were also contacting you. So just wondering if you can maybe speak to that a little bit. Maybe specifically did you end up bringing any on? And if so, any sense of what expenses this might drive?

I don't know the exact numbers. But, yes, we did hire teachers from ECOT. We went through a very sort in-depth analysis of each teacher's background. We interviewed those. And when you're taking on that many students from one school, you obviously need more teachers. So, yes, it drove up some expenses in the quarter. It's not just the expenses from teachers by the way. When you take - you got to think of this as - in the beginning of the school year when we bring students into our program, we have to have materials, computers, teachers. And then, for the rest of the year, we enjoy the revenue, but all those expenses are upfront. And that's what happens here. We got some expenses from students who came on from ECOT, from teachers and material early on. And so, yeah, we did get some increase in expenses from that.

Okay. Thanks. That's really helpful. And maybe just one more quick one and then I'll jump back in the queue. So just again on ECOT, I assume that the updated revenue guidance increase any of the upside.

Yes, that's correct.

Okay. Great. Thanks a lot.

Thanks, Ken.

Operator, next question, please.

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

Hey, guys. Good afternoon.

Hi, Henry.

Hey, just thanks for sharing the strategic vision of the four - I guess, the four legs that you're focusing on. I was wondering if you could chat a little bit about the first one and then growing the core business. There are some reports out there of schools being closed. I was wondering if you could just kind of elaborate on just kind of the dynamic between school closures and school openings and any kind of trends you're seeing there.

Yeah, I covered that in my comments a bit, because we do see from time to time, more schools you have, the more schools you're going to see opening and closing. We have people come to us all the time if they can open a new school. We also help some folks who decide they want to move a school to their own management. And by the way, for whatever reasons we also see schools are closed. So you know already that one of the insights - I'm sorry, one of the schools that Hoosier closed and one of the Insight Ohio schools closed. So we do have school closures from time to time. We also opened up two new schools this year. And we have schools expanding in the enrollment. Tennessee for example expanded as well. So it's about at every year - and this has been the same way by the way since I've been around the business for, I don't know, nine years. There's always been some school that was closing for a reason and new schools are opening in the states throughout. So we think it's a balance. But yeah, we did experience a couple of closures in Hoosier and Insight Ohio.

And, Henry, this is James I would just - I would add, in the past couple of years we've seen, as Nate said, some schools closing and reopen new schools. Part of our strategy that I think we've talked to you guys about before is that in many states we have a multi-school strategy. It helps buffer any sort of - any closure sometime. And over the past couple of years, while we've had the same thing happen, we've grown in spite of it. And I think Nate mentioned it, we think we're set up well for growth in next year as well. So we don't see it as a new thing or a new trend necessarily. And we think we're going to grow through it.

And just to add to that, Henry, one last point. I mentioned one of our Hoosier schools closed. But at the same time Indiana Digital Learning School opened. So right there, we have school that closed and school opened in the same stage and it balances out. So this is just the ebb and flow of our business.

Yeah, got it. Okay. Yeah, that's helpful. And sorry to point or sort of dig in this, the non-managed side as well. But I was just wondering if you could share a little bit more color on what's sort of driving the softness in the non-managed. And I know you mentioned a large customer there show some weakness there. I'm just curious why that's sort of extending and what's kind of driving that?

Well, the first thing you remember is that, in some cases we have responsibility for the marketing effort for a school, in other cases we don't. So some of these - and I'm talking in the Fuel Ed area in the non-managed category. Some of those schools have taken on their own marketing responsibility. And when they do, we don't control whether they can grow or not grow, because they're doing their own marketing. In the cases, where we do, do marketing for them, it's very budget limited. In other words, did they have the budget to spend on marketing, we spend it and we try to go school. One of our large partners, I think it's just was in the past year in a position where they didn't want to spend this much money, so they weren't growing as much. But I think they will be spending a little bit more going forward. But there is certainly - those ups and down happen and are out of our control, because we're just the provider of their marketing. But it's up to them how much they spend.

Henry, I will just state similar to what Nate said around the marketing. We also in most cases don't control their efforts to reregister kids from one year into the next or retain the kids in the course of the year. And so, those are really - largely managed by the schools that are clients of ours. And so, we did see in those two vectors as well some softness. And again, those are a little bit up to each school to manage and monitor themselves.

And it's difficult to predict what will happen in the next year. But I got to tell you that, I actually sat down with at least two of these folks in the non-managed category. And I am actually optimistic. I feel a lot of stability in the programs we're putting in place. I think they understand where they want to go. And I think we'll see a little bit of growth in a couple of months, so I actually like what some of them are doing.

They're good partners, Henry.

Okay, cool. That's good to hear. Great. And just last one to clarify with the union agreements. So I understand that, it mostly have an impact to I guess the charter. Is there any impact to K12 at all?

Yeah, so they're - because we do help manage these schools and we operate pretty closely with them supporting those boards, there will be some residual carry-over impact to K12, the company, when something like this happens. And as Nate mentioned, we're hugely supportive of, in this case, the CAVA board and teachers and what the CAVA board has tentatively at least reached an agreement with the teachers. But as we indicated from our guidance, where our guidance - we're holding firm to our guidance. So we don't think it's been material enough to us at least to change our guidance. But certainly, it does have some residual impact. But we're hugely supportive of the decision that they're making.

That impact is financial and happens in the second half of the year. But we also, we're able to reduce expenses to offset it though. It hasn't had a dramatic impact in our bottom line, as James said, not material. But we did see cost increase, because of teacher expenses that we have.

Got it. Okay, great. Thanks, guys.

Thanks, Henry.

Hey, operator, is there - we're ready for another question if there is one.

[Operator Instructions] Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to Mr. Davis for closing remarks.

I just want to thank everybody for getting on the call today. Questions were very insightful and hope that explains to our investors where we are. I appreciate all investors who hung in there and I'm pleased that we are able to give you good results this quarter, and we'll continue to do so. Thank you for your time today and have a great day.

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