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K12 Inc. (NYSE:LRN)

F2Q 2013 Earnings Conference Call

February 5, 2013 08:30 ET

Executives

Christi Parker - Vice President, Investor Relations

Nat Davis - Executive Chairman

Ron Packard - Founder and Chief Executive Officer

Tim Murray - President and Chief Operating Officer

Harry Hawks - Chief Financial Officer

Analysts

Jeff Meuler - Robert W. Baird

Suzi Stein - Morgan Stanley

Kelly Flynn - Credit Suisse

Trace Urdan - Wells Fargo

Paul Condra - BMO Capital Markets

Operator

Good day, ladies and gentlemen, and welcome to the Q2 2013 K12 Inc. Earnings Conference Call. My name is Sonia, and I will be your operator for today. (Operator Instructions) As a reminder, this call is being recorded for replay purposes.

I would like to turn the call over to Christi Parker, Vice President Investor Relations. Please proceed.

Christi Parker - Vice President, Investor Relations

Thank you, and good morning. Welcome to K12 Second Quarter Fiscal 2013 Earnings Conference Call.

Before we begin, the company would like to remind you that statements made during this conference call that are not historical facts may be considered forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties that could cause actual events or results to differ materially from those expressed or implied. In addition, this conference call contains time-sensitive information that reflects management’s best analysis only as of the date of this live call. K12 does not undertake any obligation to publicly update or revise any forward-looking statements. For further information concerning issues that could materially affect financial performance related to forward-looking statements, please refer to our filings with the SEC. These filings can be found on the Investor Relations section of our website at www.k12.com.

In addition to disclosing results in accordance with generally accepted accounting principles in the U.S. or GAAP, we will discuss certain information that is considered non-GAAP financial information. A reconciliation of this non-GAAP financial information 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 on our website for 60 days.

With me on today's call is Nat Davis, Executive Chairman; Ron Packard, Founder and Chief Executive Officer; Tim Murray, President and Chief Operating Officer; and Harry Hawks, Chief Financial Officer. Following our prepared remarks, we will answer any questions you may have.

I would now like turn the call over to Nat.

Nat Davis - Executive Chairman

Good morning everyone and thank you for joining us today. First, I’d like to congratulate all of our employees, our school board partners, and especially the teachers for great performance during this past quarter. I am truly proud to be working with such professionals who are all dedicated to producing great student outcomes and a high-quality education.

I’d like to start today by answering a question many of you asked me as I have gotten to know you. What is my vision for this business as a new member of the K12 management team? The answer to that question starts with a recognition that K12 and individualized online learning are both at a critical stage of their growth. Individualized learning is increasingly achieving mainstream acceptance, but like any disruptive industry is facing a series of challenges. As the industry leader, K12 needs to both continue to lay the groundwork for greater adoption of individualized online learning and to lead the way in addressing the rising challenges facing our industry.

As we grow the business, I see our mission is broader to just simply operating virtual charter schools. Our vertical product side is really about empowering individualized learning. From our pre-K learning curriculum to making multiple products available to school districts on to be as managing schools, K12 was all about bringing this individualized learning capability and technique to all educators and students. We have developed the most comprehensive online curriculum available and we have learned a tremendous amount about how to successfully operate our products and to advice schools on how to operate our products.

We are learning not only how to sell the products and how to be good consultant of city school districts on how to operate the products. My vision is that we will continue to sell more products whether inside the managed services contracts or the standalone implementation selling by course. The key to our success is a great curriculum with teachers and administrators who can help schools use our curriculum. At the same time, we need to sharpen our focus on executing with excellence, excellence in academically delivery, excellence in our operational delivery and excellence in our financials. And our speakers today are aligned with these three areas. Ron Packard, our CEO will discuss academic excellence and the state and local opportunities before us.

Our new management structure has designed specifically to free this visionary leader to continue to grow this sector and the company’s reach including in laying the legislative and regulatory groundwork for greater acceptance, while providing leadership on improving academic performance. Tim Murray, our President and Chief Operating Officer will then discuss how we are achieving operational excellence and finally Harry Hawks, our Chief Financial Officer will then discuss our financial results. So let’s get started with the report from our CEO and the founder of K12, Ron Packard. Ron?

Ron Packard - Founder and Chief Executive Officer

Good morning. When I reflect back on the 12 years since I founded K12, I am more enthusiastic than ever about the potential to benefit children who need more choices. As we continued to lead the transformation to individualized learning and educational liberty, we are not simply building a business. We are changing lives and giving opportunities to those children who previously had no opportunity. Our goal remains the same, which is to make available to every child an opportunity for a high quality individualized education regardless of geographic location or economic circumstances. As we have grown and the internet has become more ubiquitous, virtual schools have seen a significant increase in the growth in the number of academically at-risk students. We welcome the opportunity to serve these children and are rapidly making adjustments to every part of our delivery system to better serve these children as well as the students who come to us at grade levels or advanced.

One of the great things about the culture here at K12 is the speed at which we are able to change what we do. We are excited about our new Chief Academic Officer, Margie Jorgensen, who comes to us with an extensive background in assessment and in structural practices. Her objective is simple to analyze all the data that K12 has and to work with the management team of K12 to improve every aspect of our instruction including but not limited to curriculum, teaching practices, and information systems. One of our very first projects is to analyze the current industry models for measurement and then work to ensure that they adequately and fairly measure virtual schools, while ensuring students master everything they need to master not only for stage tests, but also for what is required for the excellent education.

Additionally K12 has formed an Education Advisory Committee of outside experts, which will meet regularly with K12 management and provide their guidance on continuing to improve our educational delivery. On February 7th we will release our academic report, which addresses how we measure the academic performance of students in K12 managed public schools and provides detailed information why and how we use the Scantron assessment method to measure academic performance of these individual schools. We hope that many of you would join us on Thursday at our academic and product day where you will have an opportunity to meet Margie in person as well as other K12 management, see demos of new products, meet K12 students, talk with K12 teachers and ask any questions you may have regarding K12 products or academics.

Two of the great advantages of technology-based education is that it scales and evolves rapidly. To that end K12 we are moving towards multiple programs and often multiple schools in every state. More specifically, we will have multiple learning pathways with separate programs that focuses on academically average students, gifted students and college prep students. And we can envision a world with many more options in the near future. These programs will differ in curriculum, teacher utilization and teaching culture, the intervention model and the engagement model as well as the course library and the focus of the school. We are moving towards every student having individualized learning plan, thus enabling more individualized intention, ensuring we are meeting the needs of every student and family’s unique goals for their child. K12 continues to renew charters and expand access to our high-quality learning options. Renewals are recently announced in Indiana and Virginia. We continue to work on a renewal plan for the Colorado Virtual Academy. K12 also currently serves students in Colorado through an inside program and through the several district programs.

Over the past decade, we have dealt with dozens of efforts to reduce reimbursement for virtual schools such as current proposals that are currently out there in a few states. It’s surprising that states would look to cut funding for one of their most efficient options. With regard to these efforts to reduce funding, it is important not to overreact and remember that they rarely end up in the form they are initially proposed. Often, nothing changes, because virtual schools are already such a great value to taxpayers. In fact, we are optimistic for the first time in five years about state’s budgets, which now occur to have stabilized and are actually increasing in some states.

The removal of this powerful headwind should allow us to deliver even more innovation and value for our students. We are proud that we have been able to grow and succeed throughout this period in spite of these powerful headwinds and we continue to invest in curriculum, systems, and people, so that we could better serve students. It is worth noting as this model not only helps the many students that are not being served (indiscernible), but it’s a benefit to society and a more cost effective option for taxpayers as well. Based on MPS data, these schools often receive 30% or 40% less funding than traditional schools in the same state. Our recent K12 report was suggested and might even be less than this.

With regard to web, we have extended our option to purchase no less than 51% of web to February 28, 2013. And as a result, we now have the option to purchase all remaining equities for some web between now and June 30, 2015 in one or two transactions. We have no current intentions to assume majority operating or manage control web as we are exploring partnerships with firms who have extensive investment experience in Asia and would assume much of the management over-search possibilities. As things progress, we will continue to update you.

We also continue to explore adding new states and expanding or eliminating enrollment caps in existing states. As most of you know by know, this process takes place over the next 6 to 8 months and is often difficult to predict. What I can say at this moment, however, is the environment at this time looks as favorable as it has in past years. In the 2014 school year, we are looking at the addition of four charters in Florida and a substantial cap expansion in Michigan which increases 1,000 to 10,000 students. I plan on spending a conservative amount of time in the coming year on these efforts even more so than in past years.

K12 has obviously added significantly to its management and operations team over the past year. We are now exceeding the goal I stated a year ago of growing EBITDA twice the rate of CapEx as EBITDA grew at 32% and CapEx grew at 10% during the first six months of fiscal year 2013. Additionally, our margins have grown more than 100 basis points.

Now, I will turn it over to Tim to talk about what we are doing to achieve that objective.

Tim Murray - President and Chief Operating Officer

Thanks Ron and good morning. With our second quarter results, we continue to take actions to improve our financial, operational, and academic performance. Harry will elaborate in more detail on our financial performance in a moment, but let me comment on a couple of highlights.

Revenue of $206 million grew 23.7% compared to the prior year period. Operating income of $16.3 million grew 129.6%. Looking at volumes, average enrollments in our managed public schools grew 13.6% as compared to revenue growth of 26.2% for those schools. Consistent with our plan for the year to favor higher funding states, improve our revenue capture rates and carry fewer unfunded students. We also benefited from rate improvements in some states.

Total enrollments and semester course enrollments in our international and private pay schools grew 10.9% and 1.5% respectively. Revenue on institutional sales grew 8.6%. When I look at our operational metrics for this team, I continue to skip growing pipeline, greater sales productivity than last year, and a growing backlog while we sign roughly 650 contracts in the first two quarters. We are not closing deals as we expected and they are getting pushed out. Our product mix of the sold product continues to shift toward annual subscription leases, licenses, which will over time reduce the lumpiness in our revenues. Adding to the press release comments that product development expense is down, let me further note that product development expenditures are down as a percent of revenue on a year-over-year basis.

We look internally at the cash outlay for a project and its expected returns without regard to how the capitalization works. We leave the cap rate to the accountants to figure out. Operationally, our employee track retention rate in our managed public schools was comparable to the prior year period. Our cost per acquisition was also comparable to the prior year quarter.

In the quarter, we optimized our owned media to include site search, increased our social media integration, and increased the capture of organic interest on our sites. We further optimized our SEO and paid digital media, all of these actions increased web traffic and leads. Further we implemented quick to call functionality on our mobile web advertising pages, driving higher call volumes to our enrollment center, but we typically see conversion rates that are generally doubled out of web forms.

We continue to make progress in improving student experience with K12. For the quarter, our student facing systems availability averaged in excess of 99.9% and we continue to work with key vendors to drive their availability up in recognition of our 7x24 operations. And better systems performance has reduced overall customer service call volumes some 30% compared to the second quarter of 2012, representing a 37% reduction on a per student basis. In addition, those who do call us are benefiting from improved IVR capabilities to allow for more effective self service. Improved customer service is translating into lower costs.

Turning to operating leverage, our approach is two pronged, acting on a near-term opportunities as well as unit cost initiatives that will help us scale more efficiently as we grow. In our last call, I noted one area of focus was on procurement and logistics. In the quarter, we implemented a vendor change for computer refurbishment, which will reduce our unit costs and also yield savings due to synergies and logistics, and distribution of the computers. Our materials and computer costs as a percent of revenue are down compared to prior year. Our largest supply contracts will come up for renewal over the course of this and next quarter providing an opportunity to leverage our buying power. Further, we consolidated all outbound freight shipment, some 400,000 parcels last year to a single vendor. In the quarter, we also put in place a revised procurement policy that will enable further automation of our purchasing with greater controls to the use of purchasing cards.

Shifting to academics and instructional execution, our product development team released two high school electives in this quarter, anthropology and forensic science as well as 15 advanced placement exam reviews in the quarter. We began piloting our pre-K program with very positive feedback. We also released a number of applications for mobile platforms with distributions through iTunes, Google Play, and the Amazon App Store bringing us to 16 mobile apps in total with over 600,000 downloads to-date.

We have a number of efforts underway to improve our measurement, management, and coaching of instructional performance. Achieving improved academic outcomes remains job one for all of us in every area of the organization. Those who are able to attend our academic and product day will get a sense for this.

Two specific areas I focus on are teaching training and compliance, a big part of academic excellence is the ongoing professional development and training courses we deliver via K12training.com to approximately 6,300 teachers and the school leaders across the K12 managed schools that include more than 300 proprietary training modules created and offered to our staff. Since July, we’ve held 73 orientation sessions for nearly 1,500 new teachers and staff members. We offer quality online teaching, K12’s own version of certifying teachers in accordance with iNACOL standards for quality online teaching and is completed 36 sessions for this school year. And we’ve held 23 face-to-face and a 158 virtual professional development sessions since the start of the school year on instructional planning and improving academic achievement.

Our focus on compliance is to provide our schools and our auditors better tools to collect and analyze data more efficiently, increasing productivity and accuracy. In the quarter, we implemented a new school analytic system and tighter processes that increase the efficiency of our reporting to states and boards. We estimate these will contribute several million dollars to our bottom line this year by improving revenue capture. Overall, we have significant traction in reengineering policies and processes creating a unified enterprise systems architecture and focusing on our unit cost improvements in our business. These are the actions that will enable us over time to achieve scale efficiencies, our ongoing challenges to accelerate these efforts.

And now, over to Harry Hawks, our CFO.

Harry Hawks - Chief Financial Officer

Thank you, Tim. Good morning to everyone participating in our call and webcast and a special K12 welcome to those of you joining us again on Thursday for Academic Day. This morning, we are reporting second quarter results that are in line with our previously communicated plans for fiscal 2013, and in particular, our second quarter guidance provided on November 9. Revenue of $206 million, an increase of $39.5 million or 23.7%; EBITDA of $32.5 million, an increase of $10.7 million or 49.1%; operating income of $16.3 million, a $9.2 million increase or nearly 130%; net income of $9.5 million, a $5.3 million increase or a 126%; and EPS of $0.24, a $0.13 increase or 118%.

In addition, this morning we are providing our third quarter outlook for revenue of $210 million to $220 million and for EBITDA of $28 million to $32 million. Based upon our reported results for six months ended December 31 and our outlook for Q3, we are also generally reaffirming our full year guidance for fiscal ‘13 previously given on October 17 with the following updates. The updated fiscal 2013 revenue guidance is $840 million to $860 million. We estimate depreciation and amortization will be $64 million to $67 million. We have reduced our estimated full year tax provision to 41% to 42%. Previous guidance on EBITDA and operating income is unchanged at $107 million to $115 million for EBITDA and $45 million to $50 million for operating income. Based upon our comparison of our EBITDA outlook to consensus estimates, we observed that while our full year guidance appears in line with posted numbers, we believe Q4 will likely be stronger than estimates indicate therefore Q3 appears to be slightly over-weighted.

In anticipation of some of your questions, let me address a few topics that frequently come up in our ongoing dialogue with many of you. Accounts receivable, given some concerns last year about the prospect for slow pay in a few states, we are asked about accounts receivable aging and collection. Our Q2 balance of $223 million represents a reduction in DSO of approximately a week, a 14% increase in AR balance compared to one year ago was well below a 24% increase in three-month revenue and 18% increase in six-month revenue. And incremental buildup and accounts receivable this year equals about 40% of incremental revenue while a year ago it equaled 57% and an improvement in cash collections.

Next, cash flow, cash from operations for the six months year-to-date was a positive $32.1 million compared to the same period a year ago was negative $19.5 million and two years ago was $7.1 million. Cash, as a direct result of the foregoing, we know that net cash at 12/31 was $9 million higher than cash at 12/31 a year ago, notwithstanding our ongoing investments in curriculum software and infrastructure. Seasonality, while we are very encouraged with our solid (technical difficulty) was not necessarily indicative of longer term trends. A complete business cycle for us spans in entire school year.

Next, depreciation and amortization, as you know from fiscal 2010 to fiscal 2012, depreciation and amortization more than doubled from about $26 million to about $58 million, largely a result of acquisition related purchase accounting. This year, our depreciation and amortization expense through six months is $31.9 million representing a 15% increase over the same period last year, down from 42% increase over the year before that. Our updated guidance for the year of $64 million to $67 million would at the midpoint of the range represent about a 11% increase over the last year, clearly indicating its growth is slowing down.

Furthermore, we believe that our stated goal of slowing the rate of growth of capital expenditures will contribute to a further slowing of growth in depreciation amortization relative to other metrics. Of course I should point out we always consider investing in strategic opportunities with compelling ROI characteristics. As you are wondering capital expenditures plus capitalized leases, which is the way we think about CapEx for the six months year-to-date totals $45 million, which is a 10% increase over the comparable number for the prior year.

Next, tax provision, our year-to-date provision of 43.3% is higher than statutory rates and higher than our updated annual guidance of 41% to 42%. So, it can be expected that the next two quarters will not only be less than the full year provision, but less than the Q2 provision of 41.8%. Lastly, EPS I am sure you have already noticed, but to be sure we are reporting year-to-date EPS of $0.36 after reporting Q1 EPS of $0.11 and Q2 of $0.24. The extra penny is due to rounding of the quarterly results and is not a type up. Certainly, I have preempted all your questions, so will now be a good time for Nat, Ron, Tim and I to respond to your questions and comments. Nat, back to you.

Nat Davis - Executive Chairman

Thank you, Harry. Operator at this time we would like to open the call to questions. This is Nat Davis speaking I will direct the question to the appropriate person in the management team, so call is now for the questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) The first question comes from the line of Jeff Meuler. Please go ahead, your line is open.

Jeff Meuler - Robert W. Baird

Good morning. First I appreciate all your extra detail under the new call format. I guess the first question on revenue, I know you guys don’t give revenue guidance by segment, but given that I guess revenue was near the low end of your guidance range of this quarter and you are reducing the top end of the full year guidance range could you talk about what business line drove the reduction in the top end for the full year?

Nat Davis

Yes, Tim wanted to take that?

Tim Murray

Thanks Nat. Jeff thanks for the question. I think the area where we have obviously seeing some weakness is in the area of the institutional segment. As we noted last quarter that business is a product software and service business selling into school districts nation wide, as such revenues tend to be somewhat lumpy. As we continue to lead with subscription based offers and take fewer deals as perpetual licenses, we think some of that lumpiness will decrease. As I noted in my comments while we have closed over 650 sales in the first half of the year, there is no question we are seeing softness in that segment, our close rates are below expectations. We are seeing purchase decision being pushed out. The funnel is growing, the issue is our ability to close that business in period, so virtually given the size of that segment related to the overall business, we think that’s manageable, but that’s the one segment where we are seeing some weakness in top line revenue growth.

Jeff Meuler - Robert W. Baird

Okay, thanks for that. And then what’s driving instructional costs growing I guess materially faster than enrollment growth, is it increased investment in instruction or is it mix between states, teacher utilization, if you could discuss that please?

Tim Murray

Jeff, Tim again, I think it really comes down to a couple of things, that’s mostly teacher costs as you imagine and specifically we on-boarded teachers earlier in some schools are coming into this year. With the expectation that that would improve the quality of the initial experience with those schools will have a positive impact on academic outcome. So, early on-boarding and a little higher staffing in some of our schools is really the drivers of instructional cost increase.

Jeff Meuler - Robert W. Baird

Okay and then just finally a question full year guidance you are maintaining your EBITDA guidance well increasing your EBITDA guidance, but it looks like your EBIT guidance is unchanged if you could address that discrepancy please?

Nat Davis

Okay Jeff, Harry is going to handle that question.

Harry Hawks

Let me make sure I understand your question, our EBITDA guidance for the year remains…

Jeff Meuler - Robert W. Baird

Well, alright but you took up your DNA guidance or it seems that your EBIT guidance would come down but it’s unchanged?

Harry Hawks

Right, well we have not – we standby the EBIT or excuse me, the operating income guidance and our estimate of EBITDA in terms of the guidance if you will is pretty much still in line with our regional expectations internally. So, I guess I’m just saying that internally the budget numbers we have are still in line so we just sharpened up our annual guidance.

Jeff Meuler - Robert W. Baird

But wouldn’t the math suggest that if you are maintaining your EBITDA guidance and increasing our DNA guidance that your EBIT guidance should be reduced to reflect the increased DNA?

Harry Hawks

Well, our expectations internally of course were at a point within the range and so our internal expectations remain within the range.

Nat Davis

And this is Nat speaking, when you look at math, of course the math has worked that way, but what we are suggesting is as we don’t give specific EBIT without that guidance. So, I think the real issue here is yes, you should see operating income have a slight change, we are just – in other words you will see a mix change between the operating income and the depreciation and amortization. And what we are doing is refining how much of it happens in earnings and earnings from operations and how much of it happens in depreciation, that’s just a mix change that we are signaling.

Jeff Meuler - Robert W. Baird

Okay, thank you.

Operator

Thank you. The next question comes from the line of Kelly Metzler. Please proceed. I’m sorry Kelly has pleased to clear the line. The next question comes from Suzi Stein. Please proceed.

Suzi Stein - Morgan Stanley

Hi, can you provide an update on Colorado and Pennsylvania given some of the issues that you have in those two states.

Nat Davis

Yes, Ron, you can handle it.

Ron Packard

Hi, Suzi, so Colorado is going through a renewal process as I think everybody is aware of. And we’ll have I believe the meeting on February 6th that will look at the renewal of COVA and then if that is – does not succeed, it would go to a state board for appeal. We also as I mentioned have another school in Colorado for students in grade 6 through 12, so that process is moving forward and it’s hard for me to speculate on the outcomes of any of the – those board meetings that I wouldn’t like to do at this time. With regard to Pennsylvania, there was a bill that was introduced that would look at the funding of virtual schools that we’ve seen several bills like that in Pennsylvania over the years. This one will move it’s way through the process and it’s tough to comment much more than that other than it’s a legislative process and so its difficult to predict the outcome of that and because the way that bill was awarded it’s even impossible to predict the exact effect on funding that would occur if that bill will pass as it has a lot of calculations, districts would have to do, but it again we’ve seen lots of these over that 13 years since I’ve been doing this at least. And we believe virtual schools are already significant discount to what tax payers pay for education and delivering a great value.

Suzi Stein - Morgan Stanley

Okay. And then I just had two questions about how you reported, so it looks like there were some reclassification of expenses to train instructional and SG&A. Could you may be just address what the change was there and then also it looks like there was some kind of a restatement and enrollments in the international and private pay business, could you maybe address that as well?

Harry Hawks

This is Harry. I’ll take the first part of your question. We had a previously disclosed re-class where basically we consolidated some enrollment expenses from instructional cost and SG&A to one place which was in SG&A. So, the comparable periods or apples-to-apples, so and what you are seeing in the press release and in that line item is those are apples-to-apples comparisons.

Nat Davis

And this is Nat speaking. I’m not sure your second question but if I got it right, I think you’re just seeing on the chart the difference from international and private pay business line to we just changed the name the schools, but I think that’s all you are seeing, but maybe I’m missing your questions.

Suzi Stein - Morgan Stanley

Okay, I’ll follow-up after the call on that.

Nat Davis

Okay.

Suzi Stein - Morgan Stanley

Thank you.

Ron Packard

Thank you.

Operator

The next question comes from the line of Kelly Flynn. Please proceed.

Kelly Flynn - Credit Suisse

Thanks. I have a couple of questions. First question just follows up on what Nat said at the beginning of the call, I think you may need it clear Nat you intend to focus a lot on products. I just want to understand, would you characterize this as a strategic shift to focus more on products going forward or do you feel like this is the same strategy you guys have had for the last couple of years? And then maybe you could just indicate as you look five years out, how do you hope ideally that revenue mix will look between your managed schools products and other?

Nat Davis

Yeah, let me up, what I was thinking was that when most folks look at K12 what they see is that the institutional businesses are only products part of the business, but in fact within the managed schools, there is a significant amount of revenue that comes from selling product. So, it’s not just that we sell our service of managing facility, we have to sell products to the school and work in them. And I was highlighting the fact that we are going to continue to enhance that product that is sold inside the managed services contract. And as a matter of fact, I think one of the upside to managed services contracts is that many schools are going to be looking at the schools like remediation tools, extra map tools, things like that, that would continue to allow us to sell more products. So, some of our products sales will not just be coming from the institutional line of business, it will also be coming from within the managed schools area. So, that’s the primary change. And then I also signal that we have something in pilot that is our pre-school, pre-K and the reason we do that is because we think there is an opportunity there to sell more products in that category as well. Again, that’s brand new. It’s not efficiently been in launch. It is something we are in pilot with and we are actually going to show at any academic day. So, we are focused on developing more and more products, because we think that’s the way of getting more revenue and it’s not just in the institutional business.

Kelly Flynn - Credit Suisse

Okay. And then could I just ask a follow-up on the institutional comments, I think you indicated a couple of times, that, that was weaker than expected. I am unclear on why that was the case, can you just talk a bit about what’s going on there and kind of why that doesn’t have, why you are not seeing the same thing in other parts of your business? Thanks.

Tim Murray

Kelly, it’s Tim. From an operating perspective, we always assume first of all that the issue was an executed issue on our part. And so we are looking hard obviously at sales execution and the quality of experience we are providing those customers, etcetera. So, that’s the first point. As we do inspect deeper on that and I expect some time out in the marketplace with our customers as well. There is a lot of uncertainty on the part of the districts right now as budgets are being contemplated for the coming year and they are dealing with the levels of funding that is coming from federal government or state governments as well as grant funding. And if you are reading the press, trade press you are seeing more and more articles about that these days. So, what we are seeing and hearing from customers directly as well as our sales people is just that, that uncertainty is translating into some delaying of purchase decisions. The opportunity in our sales funnel is clearly there. So, we don’t see a diminishment of opportunity, we are just seeing a delay in closing decisions.

Operator

Okay, thank you. Next question comes from the line of (Gary Herman). Please proceed.

Unidentified Analyst

Thanks. Good morning everybody. Tim, you had talked about marketing and customer service efficiency and also some opportunities with regard to some contracts coming up here. Can you maybe help quantify in some way what those savings might be?

Tim Murray

Yes, and no, I certainly can. On this call, I don’t think I want to get into the practice picking out small line items or even big line items that we would provide guidance on, but as you look at areas like our materials costs, that is a large segment of our income statement as you look at marketing enrollment costs, those are large segments of our income statement. And so we are clearly focused on where the dollars are and we are focused on what we can do to improve unit cost efficiencies. And so whether it’s an area such as unit costs of materials per student, unit costs of computers per student. We are watching those with the intent of reducing the ratio of those cost to revenue and we are seeing favorable improvement on a year-over-year basis on those line items, but I would leave it to Harry as we roll that up to articulate on those line items that we do disclose and how you will be able to see those flow through the income statement to the bottom line. I know that’s not a completely responsive question, but that’s the way we are looking at those expenses. That’s the way we are managing those. And we are seeing at that more microscopic level progress on a year-over-year basis.

Unidentified Analyst

Okay, great. You guys have talked more recently more about serving the different types of students, can you maybe spend a minute just give some clarity on what you’re thinking about there in terms of servicing at-risk advanced in college prep students with regard to the model, brand, name, etcetera?

Ron Packard

Sure, I’ll be happy to do that. So, as I mentioned we’ve seen a change in the student mix. We have a lot more, when I described at-risk I mean students that are coming several years behind grade level. So, the kind of school to serve those kids might be a little difference in the sense that curriculum you gave maybe different, but also even the teachers certain there are certain amount of teachers that love nothing better than doing interventions with kids that are three years behind grade level. There are other teachers that want to work with highly gifted students. So, the idea is whether its separate school or its programs in a school to create this higher school culture, the curriculum, the teachers, higher teachers who want to work with those types of kids, who want to those types of interventions. In that way we can really fine tune all the services and the offerings to those students. And it also includes how do you recruit the students for the various schools. So, really with K12 technology is about is driving an individualized education for every child. So, they can be whatever they we want to be in life and so we’re continually working to refine that to be even more and more individualized. So, that’s what we’re speaking about and there could be programs of inter-school, but I know there is going to be multiple programs within schools that are already are. But it will also be separate schools with different brand names as well.

Unidentified Analyst

Okay, great. And then just one last question, if I might for Nat. Nat in the press release you specifically mentioned driving increasing returns on investment capitals and profitable growth of the business. Now that you’ve been able to be more actively involved your full year guidance suggests that the operating margin of this business this year would be like 5.5%. How do you think about that level in a long run, how do you think about an acceptable level of profitability or returns in this business?

Nat Davis

Well, first of all we will start by looking at what we think the market opportunity is and what are the kinds of margins in that particular segment? So, as Tim talked about the institutional business, the business of selling standalone products to schools is a higher margin product but the margin dipped, business is growing a little bit slower. So, I think that’s going hurt up margins in the near-term. But long-term, we think that’s a great opportunity for us and we should see better margins. Then as Ron talked about he has seen a great environment for rates right now in the managed school business as well. So, I think that over long run, we should see slightly improvement, but I don’t see a heavy slope of improvement there I see a modest slope of improvement in those margins. When you see the margins modestly improve from managed services and long-term more significantly in the institutionary we should see good margin improvement. That tells us that we’re going get better return. Now there is other things you can do obviously to affect your return on invested capital. And so we’re looking at all kinds of options there. But just looking at the core of the business itself, we think improving the margins is the greater thing we can do to help deliver better returns. We have got to take more of the dollar that comes in as revenue and drop it down to the bottom line. So, improving our cost structure makes sure that we get better rate capture and then lastly talk about improving the sales of the institutional business because that’s a very profitable products business for us. All of those things dropped something to the operating income line and make us to have a better return on investment.

Unidentified Analyst

Great, thanks. I will turn it off.

Operator

Thank you. The next question comes from the line of T Urdan. Please go ahead your line is open.

Trace Urdan - Wells Fargo

T Urdan, I like that. I wanted to ask about the specialized dollars, it seems an issue that has come up in the context of COVA and then it also seems to be one of the areas to reform that the Pennsylvania legislation very concerned itself with. Can you talk about how much revenue you derive from I guess its title one specialized dollars? And then maybe talk about how much additional incremental expense you incur servicing those particular students and maybe how many of those students you are currently serving and what the rate of growth of those students has been over the last few years?

Nat Davis

I will ask Ron to talk about that someone who will track the dollars exactly to that. Okay, Ron you can talk broadly about.

Ron Packard

Yes, so Trace it’s a good question, so over the years and you’ll see this from me again on the academic day the specialized population of the virtual schools has been increasing. In some states it’s quite significantly to now it’s much above the average. And how that gets funded varies a lot by state-to-state. We’ve looked at it from time-to-time and we’ve looked at it holistically across the country in recent times that I’ve seen as to look at it. We generally are losing money on special needs kids being a cost more to serve them than we actually do get receive for them. There maybe exceptions of that for certain types of special needs for certain states, but generally across the board like other school districts, it’s generally a money losing venture, but it’s okay, because if we are helping the kids that’s what matters to us. I’d also just point out that we deliver the same special ed services that are required by their IEP that a district would. So, we were no different than a large school district. These children have IEPs. I mean, we have an extensive network of providers that we contract with throughout states to provide which required their IEP. So, we serve in the way district would and consequently what our results are financially are not that different. I also mentioned there are certain types of special needs. We have seen tremendous results with things like ADD and high-functioning autism where we have parents that are holistic – it’s completely transform their child. So, with regard to that, we are doing a valuable part of what we do and these children want our services in health and we are going to provide them.

Nat Davis

And remember, Trace this is Nat speaking and remember that the definition of special education is so broad from visually impaired to hearing impaired to physically impaired and some other way, all the way to just learning difficulties, a child you see walking down the street, it’s no different than the other but simply have some learning difficulties. When you categorize all of those together, I have seen schools in some of our staff that they were as high as 30% on some schools in terms of disability and then down as low as 5%. It really depends on the state that we are in. It varies, but that’s the range.

Trace Urdan - Wells Fargo

If I could just ask a follow-up, because it seemed to have a criticism that’s being levied that suggest that you guys are making disproportionate profit. So, I just want to understand that you are insisting as that’s not the case that in fact you are inquiring more in expense than you are receiving in additional dollars writing to those children? We do expect to be able to present that data, for example, in Pennsylvania as they start to go through this process with a legislation?

Nat Davis

What I would expect Trace is that nationally what I said is true with the last time we looked it. There maybe isolated instances where that is not the true, but we clearly are providing everything required in the IEP. It’s an important part of what we do and we’ll treat it case by case if necessary.

Trace Urdan - Wells Fargo

Okay, alright. Thank you.

Operator

The next question comes from the line of Kelly (indiscernible). Please proceed.

Unidentified Analyst

Hi. Good morning. This is Kelly (indiscernible). I was wondering if you could talk about the seasonality in the international pay business. I am just wondering on the dollar basis, is there any potential to see a pickup in the second half?

Harry Hawks

It’s Harry, good morning Kelly. It’s possible because of the change in some of the mix of activity there. We have had some increase in full-time students. We have had a higher growth in some of our higher cost, higher price point offerings. Obviously, there is some private school offerings within that group. So, it’s possible to see some pickup in the back half of the year, but not material. Of course, it’s not a particularly large percentage of our company. So, on a consolidated basis, I wouldn’t want you to have a takeaway than its material. However, the trend lines right now are positive.

Unidentified Analyst

Right, okay, thanks. And you get some of your long-term cost initiative, can you talk about some of the near-term cost plans and expectations for the second half and into 2014?

Nat Davis

Tim, won’t you have a look?

Tim Murray

Yeah, thanks Kelly. I think as I noted last call and implied in this call we continue to focus on opportunities to impact unit cost on supplies and materials. We continue to look at ways to prevent calls coming in to our customer service center by dealing with the root causes of those. We continue to implement steps such as improved IVR technologies to allow our customers to self-service themselves as able which in turn reduces our cost. We continue to look at staffing models across our schools both for the purposes of ensuring we have the right skill set and the right resource levels to meet demand, but also to make sure that labor costs are being managed effectively. So, those are the big items. We are experimenting wherever we can with marketing tactics to be able to find more effective and more efficient marketing tactics, whether that’s in our owned media, our paid media, and importantly we are increasing our emphasis on social media to improve the return on earned media if you will to reduce our cost of acquisition on the marketing side. So, those are some of the things that we are very, very focused on at this point in time.

Unidentified Analyst

Okay, that’s helpful. If I can just squeeze in the last one, for fiscal year ‘13 you raised your D&A guidance, but lowered CapEx guidance, I was just wondering if you could provide some color on that? Thank you.

Harry Hawks

Well, the lower CapEx guidance is we are – in fact we are trying to manage that and be very disciplined about how we spend money. And as we pointed out, the trend lines there suggest that it is growing slower than either revenue or, excuse me, EBITDA. And as I pointed out in my comments, we remained open. However, of course, compelling opportunities with a great ROI will consider those investments as they come along. As it relates to depreciation, yeah, I wouldn’t consider a material change the actual point estimates internally that we are managing to is, maybe a $2 million swing. And as we look at that updated guidance on depreciation and amortization, clearly we had a point within the range that we were managing too in the earlier guidance and we have a point that we now are estimating in the current guidance and the differential between those two points is I would submit immaterial as in a couple of million bucks and that doesn’t change the range of operating income estimates that we have provided. So, it’s just a – I think that’s all of it. Is that answered your question?

Unidentified Analyst

It does. Thanks.

Harry Hawks

Okay.

Ron Packard

Yeah, this is Ron, I just want add on that, if those of you who were at Investor Day a year ago, we talked about in addition to EBITDA growth, we were going to move more towards an EBITDA minus CapEx measure and how we measure ourselves. And I think the reduction in CapEx combined with EBITDA growth is that’s what we are talking about.

Unidentified Analyst

Right. And you are seeing it in the cash balances going up.

Operator

Thank you. The next question comes from Jeff Meuler. Please go ahead.

Jeff Meuler - Robert W. Baird

Yeah, thanks. This is a follow-up, I think it was Kelly’s question, but you talked about the ability to sell more products in the managed school business. How much of the per pupil funding that the non-profits get that you contract with, are you capturing just wondering how much opportunity there is to move that up? And are they buying other products from other providers right now and you think you have an opportunity to gain share there is that how we should think about it?

Nat Davis

I don’t think it’s a share gain, this is Nat speaking, Jeff. I don’t think it’s a share gain issue, I think in terms of others who are buying product in the same school, I actually think it’s an additional services opportunity for students that are in the programs. So, we have got students that are in the programs that need, I am going to pick on one example may need more remediation. And as our software is able to better recognize that a student is struggling in a particular area that may go offline into a specialized remediation program and that’s a service that we can sell. We will develop some of that ourselves, as well as we can buy some remediation capabilities from others and fill that. Ron has talked about in the past this is a trial that we have been doing with math labs. And it’s something that we haven’t rolled out, but it’s something we tried as we learn more about it. I think that’s another program they can put back into the schools that we are already in and sell them some particular math programs to help students do better at math. So, it’s those kinds of programs that we continue to develop that are course specific, topic specific, remediation specific that we can sell back into the same school that we are in. And that’s where I think the opportunity is.

Jeff Meuler - Robert W. Baird

I guess maybe if I could ask in a little bit different way, where does the funding come for that? Are they currently spending funding on an alternative product or do you have to go out and negotiate with the state to get increased per pupil funding in exchange for those higher services?

Nat Davis

It happens in two places. In some schools as they can apply for particular grants, they can apply for additional funding for the next year. And in some schools, they actually want to trial these opportunities and when they trail the opportunity, they can go back to next year and say we think this is working we would like to roll it up to more students, I mean, they can ask for additional funding. So, some of the schools do have a surplus they run and they have the flexibility at that point with that surplus to change your teacher ratios or buy additional products and we think that’s an opportunity for us.

Jeff Meuler - Robert W. Baird

Okay, thank you.

Operator

The next question comes from the line of Paul Condra. Please proceed.

Paul Condra - BMO Capital Markets

Hi, thanks. I wondered if you could talk a little bit about the revenue per student and how you spoke about the mix last quarter improving, but I wondered if you could talk specifically about which component seemed to be driving that this time around?

Nat Davis

Harry, you want to just start off and Tim can add.

Harry Hawks

Okay so Tim and I will tag team on this one. A couple of things growth in certain states and certain programs can influence that. So, in other words say state ship – state mix, high school to K to 8 mix and one of the things that we have pointed out previously is better we call it capture or it’s the inverse of reducing the amount of unfunded students that we have. Those of you that went to the academic excuse me the Investor Day in Chicago earlier this year excuse me earlier in 2012 will follow that we pointed out at that time we had almost 7,000 students that we were teaching, that we were not getting paid for. We are on pace right now to cut that number about in half for this year. And frankly that does make a big difference for us. And so some of the funding, some of the capture, some of the mix those were all of things that have resulted in what you observed from the press release is just taking the enrollment number and dividing it into the revenue number of course we manage it on a much more granular individualized basis. But those are the key drivers, but let me bounce it over to Tim to elaborate.

Tim Murray

Thanks Harry. I think you’ve hit the key ones and this was as we rolled our initial plan for this year. We explained it was a conscious strategy to try to focus on marketing to states that had a higher funding rate. We have invested in some of the systems and the tools and processes too. In fact, the revenue capture rates as Harry mentioned, if we look outside of managed schools as one of the earlier questions also called out, we have also seen in the private pay and international segment a shift towards more full-time students versus part-time students, which has been beneficial and also a shift in some cases towards higher priced products that we are selling as opposed to lower priced products. So, mix is a big driver here and then of course the things that we don’t control completely we have seen some rate changes in some of the states, that’s contributed to the increased revenue per student.

Paul Condra - BMO Capital Markets

That’s great, that’s really helpful. How comfortable are you feeling with the state funding you said stabilization up a little bit of increases in some states, are you optimistic about that or is this something that I mean I don’t know if you can just give a little more detail about that?

Harry Hawks

Well, it’s hard to give more details of that because these kind of things it’s hard to determine over the six to nine months on what the funding will – in per child will be going forward. What I would – what I said was that state budgets aren’t under the same pressure they have in the past five year and normally that would translate into increased education funding which is good for every sector of our business. So, that will be decided over the nine months but you – I mean you guys read the Wall Street journal as well as I do. You can see that the state budget even California is looking at a surplus, so when you look at it from that way obviously the environment is much better than it has been in the past five years.

Paul Condra - BMO Capital Markets

I was hoping you’re getting your news from somewhere else but alright. Thank you.

Harry Hawks

Thanks Bob.

Operator

Thank you. There are no further questions. I would now like to hand the call over to Nat Davis for closing remarks.

Nat Davis - Executive Chairman

Well, I would like to thank everybody for being on the call today. And as I mentioned in the very beginning, I always like to thank especially the teachers, the school boards, the school administrators spoke of what you guys would think of as principals and superintendents for the great work that went on this quarter. Our results were reflective of people who are dedicated to providing great individualized education and good student outcomes and that will remain our key focus. Thank you for your time today and look forward to seeing some of you in the next few days.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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