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Capella Education (NASDAQ:CPLA)

Q2 2014 Earnings Call

July 29, 2014 9:00 am ET

Executives

Heide Erickson -

J. Kevin Gilligan - Chairman and Chief Executive Officer

Steven L. Polacek - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Analysts

Jeffrey M. Silber - BMO Capital Markets U.S.

Corey Greendale - First Analysis Securities Corporation, Research Division

David Chu - BofA Merrill Lynch, Research Division

Adrienne Colby - Deutsche Bank AG, Research Division

Jason P. Anderson - Stifel, Nicolaus & Company, Incorporated, Research Division

John D. Crowther - Piper Jaffray Companies, Research Division

Jeffrey Y. Volshteyn - JP Morgan Chase & Co, Research Division

Trace A. Urdan - Wells Fargo Securities, LLC, Research Division

Timothy Connor - William Blair & Company L.L.C., Research Division

Operator

Good morning, ladies and gentlemen. My name is Ryan, and I will be your conference operator today. At this time, I would like to welcome everyone to the Capella Education Co. Second Quarter 2014 Earnings Conference Call. [Operator Instructions]

I would now like to turn our call over to Heide Erickson, Director of Investor Relations. Please go ahead.

Heide Erickson

Thank you, Ryan, and good morning, everyone. Welcome to our second quarter conference call. Kevin Gilligan, Capella's Chairman and Chief Executive Officer; and Steve Polacek, Senior Vice President and Chief Financial Officer, are here with us today to discuss this quarter's results.

Please note that this call may include information that could constitute forward-looking statements made pursuant to the Safe Harbor provisions to the Private Securities Litigation Reform Act of 1995. Any such forward-looking statements may involve risks and uncertainties. Although the company believes that the expectation reflected in such statements are based upon reasonable assumptions, the company's actual results could differ materially from those described in the forward-looking statements and are subject to a number of uncertainties and risks that the company has identified in the second quarter news release.

These and other factors are discussed in the company's most recent 10-K and 10-Q filed with the Securities and Exchange Commission. Other unchanged factors may also be discussed in future 10-K and 10-Q filings. All filings and reconciliations of non-GAAP financial information presented in this call are available for viewing on our website at capellaeducation.com.

Following our prepared remarks, we will take your questions. With that, I'd like to turn the call over to Kevin Gilligan. Kevin?

J. Kevin Gilligan

Thanks, Heide, and good morning, everyone, and thanks for being with us this morning. We're very pleased with our second quarter results and our continued ability to execute. Our performance was at or slightly better to slightly above our guidance, and new enrollment growth of 11% was higher than anticipated. With our strong second quarter performance and our positive outlook for the third quarter, we expect to achieve a significant milestone in the third quarter, the return to total enrollment growth. This is a milestone have been working toward diligently, and we can now expand on the solid foundation we've built to deliver long-term growth.

Steve will take you through the second quarter performance and our third quarter 2014 outlook in more detail in a minute. For the rest of the call, I'd like to address why we have confidence in the sustainability of our strategies.

First, we believe we have a differentiated value proposition that we're offering to our learners. Second, with our shift to a relationship-focused brand marketing strategy, we believe we're able to better reach and better demonstrate our differentiation to prospective learners. Third, we have data and analytics capabilities in place to drive marketing efficiencies and further improve learner success. And finally, we are well positioned to drive innovation to further differentiate Capella and expand our addressable market. FlexPath is a good example of our capacity to innovate.

The basis of our confidence is our high-quality educational offering and the differentiated career outcomes of our graduates that are consistently reflected in outcome surveys and confirmed in data released as part of the initial Gainful Employment rules. These are fundamental elements for sustainability.

Our marketing challenge has been to create awareness of our attractive value proposition among prospective learners. Strategically, we focused on deepening our understanding of the learners we want to attract to Capella and when and how to interact with these prospective learners; building Capella's brand awareness; interacting with the learners earlier in the decision cycle to build relationships; and finally, having a motivating a positive experience at the point when learners consider enrolling.

By shifting to a longer-term marketing focus, we've been unlocking Capella's underlying brand power, improving our brand awareness over the last 2 years and attracting more of our new learners through direct marketing channels such as natural search, direct visits to our website and through our employer relationships. These efforts are expected to deliver solid annual new enrollment growth while decreasing our cost per new enrollment for fiscal year 2014. Our marketing model today is more sustainable and creates opportunities to build further Capella brand awareness.

At the same time, we focus on improving our marketing execution by investing in analytic tools to help us be more efficient and effective with our marketing spend and by increasingly personalizing the experience for prospective learners. As we build out these tools, we believe we can continue to gain efficiencies while reducing marketing costs and cost per new enrollment to support learner lifetime value.

The return on new enrollment growth and improved learner success have been key strategic focus areas for Capella. Our learner success strategies have continued to improve early cohort persistence, including a 4% improvement this quarter compared to the same 4 rolling quarters last year. This improvement has been possible because we have been implementing processes to identify learners that need intervention and support, particularly during their early experiences at Capella.

We believe there's an opportunity to improve and expand how these interventions occur and further improve learner outcomes and persistence. Our extensive experience in use of data, analytic and predictive modeling is helping us develop actionable and successful interventions in the course room. Currently, we're scaling and optimizing these capabilities across the University.

At the same time, we're continuing to invest in new pilots and initiatives to identify additional opportunities. The results to date show that we can successfully motivate and support learners that are struggling to persist and graduate. We're excited about the progress we're making while recognizing that future improvements will become increasingly challenging.

Finally, I'd like to touch on FlexPath, our competency-based direct assessment program. This is a critical innovation and has the potential to drive long-term growth for Capella. Today, this new education model remains the only offering in the country at the bachelor and graduate level with Department of Education approval. Our first priority was understanding how to best support learners in this new model. Based on our experiences thus far, we believe we have a very solid foundation from which we can continuously improve.

With 3 full quarters of data, here's what we've learned so far. About 95% of FlexPath learners would recommend FlexPath and are particularly satisfied with the faculty feedback they are receiving. Learners currently enrolled in FlexPath are able to move through the program at a much faster pace, completing courses on average in 5 to 6 weeks, while taking on slightly more courses per quarter than in our traditional programs. Initial indications are that about 20% to 25% of adult learners considering traditional education are attracted to the FlexPath offering, and FlexPath is likely to expand the total available market to learners that are currently not consuming higher education.

We are now focusing more of our attention on optimizing the FlexPath business model, including understanding what will drive the adoption rate of a competency-based direct assessment model, which marketing channels will be the most productive and efficient, the scale we need to achieve and the timing and amount of investment necessary to achieve attractive growth and financial returns and how to partner with regulators and accreditors to create a responsible governance framework that supports new models like FlexPath. Based on our learnings to date, we're confident that FlexPath has the potential to be a game-changing new education model. But as with all new innovation, it will take time to build the adoption rate of FlexPath.

Capella has an offensive strategy in place to deliver long-term sustainable growth. We have delivered strong new enrollment growth in the first 2 quarters, are carrying this momentum into the third quarter and expect to return to total enrollment growth during the third quarter. While the market environment may be improving slightly on the margin, we believe the results we're delivering are primarily due to our execution. We're on track to meet our annual performance goals, including solid annual new enrollment growth and an improved operating margin and will continue to make investments across Capella to sustain growth, improve operating performance and most importantly, support the success of our learners.

Steve will now provide you with additional details on our operations. Steve?

Steven L. Polacek

Thank you, Kevin. Earlier today, we reported a solid 2014 second quarter, with new enrollment up 11.1% and total enrollment down less than 1%. Revenues were up 1.1%, and operating income was up 50 basis points compared to the prior year's second quarter, excluding lease amendment related charges. All results were within our expectations, with total enrollment slightly above expectations and new enrollment stronger than we had expected. Our organization continues to execute very well against our strategies as we positioned and build a solid foundation to enable long term, sustainable growth for Capella.

Revenue for the quarter was $104.8 million, up 1.1% year-over-year, primarily due to a tuition increase of 2.9% in July 2013 for Capella University, offset by degree mix and lower total enrollment. Revenue per learner for Capella University was up slightly, also related to these factors. Total enrollment declined by 0.6% for the second quarter. Early cohort persistence improved 4%, calculating the change based on a 4-quarter moving average from the learner's first quarter census date through fourth quarter census date. This is the first quarter that our master's Degree Programs returned to year-over-year total enrollment growth. This is primarily based on very strong new enrollment performance in our health care and business-related programs. As expected, our doctoral programs will be the last degree offering to return to total enrollment growth. These degree programs take the longest to complete and have extended decision cycles for prospects. It will take multiple quarters of new enrollment growth to offset headwinds from stronger doctoral graduations in 2013 and 2014.

In addition, as part of our learner success efforts beyond the first 4 quarters, we are paying particular attention to how we can better support our doctoral learners through the comprehensive exam and dissertation portion of their education.

FlexPath new enrollments were less than 100 learners on a quarterly basis, as we continue to refine our competency-based direct assessment model, as Kevin outlined earlier. While we still expect volatility in new enrollment growth across all degree levels on a quarterly basis, we believe we have the right strategies to return to steady total enrollment growth starting in the third quarter.

The consolidated operating margin for our second quarter was 14.8% and 17.3%, excluding the lease amendment charges. As you may recall, we announced in April that we'll record a charge during the second quarter due to consolidating our lease office space, which was $2.7 million. The related cost savings through October 2018 is expected to be approximately $400,000 per quarter for a total of about $7 million through 2018.

Operating performance was within our expectations. We are gaining efficiencies in marketing and continuing to invest in learner success. In addition, we are investing in enrollment counts with tools and staffing to continue to engage with prospective learners in comprehensive conversations.

Bad debt expense for the quarter was unchanged from the second quarter of last year at 3.2% of revenue, and depreciation and amortization expenses were below 2013 levels.

From a cash flow perspective, we generated $18.4 million in cash from operations during the quarter and ended the quarter with cash and marketable securities of $159 million. During the quarter, we paid a cash dividend of $0.35 a share, or $4.3 million, and repurchased 110,000 shares of common stock. The remaining share repurchase authorization as of the end of the second quarter is approximately $39 million.

Let's turn now to our outlook for the third quarter of 2014. We are expecting year-over-year new enrollment growth for Capella University to be similar to the growth we achieved in our second quarter and total enrollment and consolidated revenue to increase 1% to 2% year-over-year compared to the 2013 third quarter. The main driver for our year-over-year new enrollment growth expectation is strong execution in the current market environment.

Total enrollment in the third quarter is expected to be positive due to expected new enrollment growth and continued early cohort persistence improvements. This is a significant milestone for Capella. During the past few years, our strategies have been focused on building Capella to deliver sustainable growth. Despite significant pressure on new enrollment growth, the low point for our annual total enrollment decline was just 4%. This speaks to the strength of our business model. We expect year-over-year revenue growth to be up primarily related to strong new enrollments and average tuition increases of about 2.5%. Revenue per learner is also expected to increase primarily related to the tuition increase.

Operating margin in our 2014 third quarter is expected to be about 10.5% to 11.5% of revenue compared to 10.4% during last year's third quarter. Due to seasonality, the third quarter of the year has historically been our lowest margin quarter for the year. 2014 will be no exception. We anticipate marketing and general and administrative expenses as a percent of revenue to be below third quarter 2013 levels. This is the first quarter we expect expense savings of about $400,000 relating to the lease amendment.

Based on our performance year-to-date and our momentum into the third quarter, we believe we will be able to deliver for fiscal year 2014 solid new enrollment growth and positive total enrollment and revenue growth. In addition, we have -- we believe operating margins on an annual basis, including lease amendment charges, will be in the 14.5% range. The impact of the lease amendment charges is approximately 0.5 percentage point and would therefore exceed our 2013 operating margin performance of 14.4%.

The tax rate for the third quarter and for 2014 is expected to be about 40% to 40.5%. We've worked hard to move from new enrollment declines to growth. We're about to return to total enrollment growth. Operating margins are expected to improve again in 2014, all while continuing to make investments to drive future growth.

With that, we will take your questions. Ryan, please open up the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Jeff Silber, BMO Capital Markets.

Jeffrey M. Silber - BMO Capital Markets U.S.

You said in your prepared remarks that your new enrollment growth was much stronger than you expected. Can you give us a little color exactly where that came specifically by degree component, if possible?

J. Kevin Gilligan

This is Kevin. So, we saw the strongest performance at the master's level. We also saw positive performance at the bachelor's level. PhD was still a negative territory, and we can share some thoughts on that in a minute. At the program level, we saw strength in our business programs, MBA in particular, and -- health care related programs. And we also saw some strength in a number of our education programs, our master's and our professional doctorate.

Jeffrey M. Silber - BMO Capital Markets U.S.

You mentioned the color on the PhD, if can you provide a little bit more.

Steven L. Polacek

Yes. So Jeff, this is Steve Polacek. So really into our PhD programs, as I said in my prepared remarks, this is the degree level that's obviously a significant decision for our prospects and so their decision cycles are much, much longer than at the bachelor's or the master's level. And so although we have seen some quarters of PhD new enrollment growth, it has been not as consistent, clearly, as what you've seen in the bachelor's level, as well as the master's level. So it's going to take some time as we continue to work with our -- in our brand relationship strategy to differentiate ourselves in the market, show the value of our PhD degrees. And we're also looking at how do we redesign our PhD programs to improve affordability. So that can be in the connection with -- or success grants, redesigning them. We're also, obviously, focusing in on our comp/diss phase, which is always a challenging point for our PhD learners. So for us, it's the 1 degree program that, as expected, will take some time to return to total enrollment growth. And we have some headwinds there, part of it is related to graduations. But we think we do, obviously, have good differentiation in the marketplace. And I think that's where our focus is going to be here in the near term to return to that degree of level, which is very important to us to a sustainable new enrollment growth. And then that will turn positive sometime in the future.

Jeffrey M. Silber - BMO Capital Markets U.S.

Great. And just a quick numbers question. Which share count should we be using for the third quarter?

Steven L. Polacek

So for the share count, I think if you look at the outstanding shares that we had from a basic perspective at the end of the second quarter, we obviously have our repurchase authorization that we continue to use in the second quarter. We continue to follow using some of that in the third quarter. The difficulty in the share count is related to the stock price. And as stock price changes, your diluted shares are going to change. So we can't give you an exact number because we can't predict the stock price, but I would start with the basic level that there's an expectation. So at the end of the -- I think at the filing of the Q, if you go to the phase of the Q through our filing date, we had about 12,250,000 or so that was outstanding.

Operator

Your next question comes from the line of Corey Greendale from First Analysis.

Corey Greendale - First Analysis Securities Corporation, Research Division

First, Steve, I apologize if I missed this. But did you give the change in revenue per learner just based on Capella University?

Steven L. Polacek

Yes, Corey. What I said was that we had a slight increase in revenue per learner for Capella University. It's both in the second quarter and in the third quarter, and that's largely related to the net price increase that we've had. Our discounts for the second quarter were relatively flat. We're expecting them to go up a little bit in the third quarter as we expand some learner success grants to more learners. But overall, we see a slight increase for Capella University student revenue per learner for both second and third quarter.

Corey Greendale - First Analysis Securities Corporation, Research Division

Okay. And then Kevin, can you elaborate on the commentary about the ways you've changed your marketing approach and the sustainability of that as opposed to -- I mean, clearly, you've made some very positive changes and are a step ahead of other universities now. But why do you think other universities won't see that you've succeeded with those channels and then try to replicate that?

J. Kevin Gilligan

Yes, so I think we've talked about this in the past. I mean, the essence of the change we made was to move away from buying lease from aggregators and begin to invest that in building our brand, and we're seeing very nice improvement in brand awareness and consideration. And then it was to follow that with a relationship marketing strategy where we could interact with learners -- prospective learners earlier in the decision cycle to not only help them better understand Capella, but better understand our differentiation and then to be providing them the support and resources they need as they enter a decision cycle so they can make the best decision for them and often cases, we believe that's Capella. So it's really -- it's a brand-focused, relationship-focused marketing strategy, and it's supported by the use of analytics. As our analytics get more sophisticated, we're able to create a more personalized prospect experience for prospective learners, and we think that's helping us. And I think that's one of the reasons why it has sustainability. The other thing I would add is that we're driving inquiry flow and application flow but we're driving those through channels that have higher conversion rates and channels where we have more strategic control over our messaging. I think that also supports sustainability.

Corey Greendale - First Analysis Securities Corporation, Research Division

And then quickly on FlexPath, sort of related. I know you're capping enrollment in FlexPath right now. Do you have any sense that you're getting a halo effect in FlexPath and maybe that's helping enrollment in the non-FlexPath part of Capella? And then, could you give us some sense of where you think FlexPath would be in terms of enrollment if you just allow -- if you kind of open those floodgates and allowed anybody who's interested to enroll?

J. Kevin Gilligan

Yes, so the first part of your question, I would say there's definitely synergy between the messaging we do in the market around FlexPath and Capella's core value proposition. We're serving working adults who want to practice at the top of their profession. They're looking for the most direct path to accomplish that without -- but they also want a rigorous academic experience. FlexPath gives a more flexible option, but our traditional programs also provide a direct path because of the way that they are professionally aligned and the ability of our competency-based model to allow our learners to immediately apply what they're learning rather than waiting for the completion of their degree. So there's definitely synergy between the messaging. And so the second part of your question, we're now beginning to focus more of our effort around market development and some of the commercialization issues that you raised. And I think what you'll expect to see going forward is we're going to be doing some experimenting in the market around messaging and channels. Some of that is intended to get -- create learning around adoption rate and scaling the business model, and we also believe there will be some benefit to our core business because there is synergy between that messaging.

Operator

Your next question comes from the line of David Chu from Bank of America Merrill Lynch.

David Chu - BofA Merrill Lynch, Research Division

So can you tell us what you're seeing in terms of lead flow and conversion rates in the quarter and -- I guess in 2Q and so far in the third quarter?

J. Kevin Gilligan

Yes. So David, it's Kevin. So we saw -- in the second quarter, we saw healthy inquiry flows and healthy application rates, and we saw those inquiries and applications coming through our higher converting channels. And it was those 2 dynamics that contributed to the strong 11% growth we saw in the second quarter. And that trend has continued into July, which is why we are characterizing our outlook as comparable to the second quarter.

David Chu - BofA Merrill Lynch, Research Division

Okay, great. And can I go back to Corey's question? So are you currently turning away a significant number of prospective students in FlexPath?

J. Kevin Gilligan

I would say that -- I would say, no. I think we are -- we've been focused, again, on the academic model. We weren't out actively promoting FlexPath. I don't think there's broad market awareness of this type of flexible offering in the market yet. So it was more a case as we interacted with prospective learners, we would make certain learners, based on their credentials, aware of the alternative. And when we were confident and they were confident that it was a good fit, we moved them through. But we didn't -- we're not in an active selling mode. So I don't think -- that's not where the focus has been. It's been, up to this point, on the academic model. As we go forward now, we're going to start to address some of those commercial questions.

David Chu - BofA Merrill Lynch, Research Division

Okay. And just a follow-up on that, I mean, I read that there is -- that the Department of Ed is in the process of granting federal aid to, I guess, many more competency-based programs across higher ed. Just wanted to see if you heard that and if you think there's going to be a lot of schools that kind of enter your arena in terms of competency-based learning.

J. Kevin Gilligan

Yes, so I would say that of the expansion of competency-based learning as an alternative in higher education is a high priority for the Department of Education, and we support that because we think it's going to take more than 1 institution to be able to develop the market. So I do expect others to be emerging over time. I think we come from a very strong competitive position on this, given the fact that we've been investing in our competency-based infrastructure for over 10 years. And it's really around the direct assessment of learning married to a competency-based model that we think creates the real differentiation. The other thing I would say, there's some work to be done in the regulatory environment. We have been talking to both Congress and the Department of Education about experimental sites and demonstration projects to try to create a regulatory environment that can allow these types of programs to develop. For example, today, the federal financial aid system is based almost entirely on the credit hour. So if you're in a direct assessment program, you have to create equivalencies to the credit hour in order to qualify for federal financial aid and that adds a lot of cost and complexity, and the department knows that. And so I think they're looking at establishing some experimental sites where they can begin to test different methods for addressing that problem. And we are very active in those conversations. So I think competency-based learning is going to develop over time. More institutions will come into the space. I think we're well positioned to compete there.

Steven L. Polacek

David, this Steve. Let me just maybe add 1 comment as it relates to the regulatory framework and some of the flexibility that we need. As you know, our FlexPath programs for the MBA and for the bachelor's are now we've introduced the psych and IT programs, which hasn't yet been approved for financial aid yet. But because we have to -- we do a subscription model where they pay once for a quarter and they can take as many courses as they want, what typically happens is most of our learners are starting only in the first month of the quarter. We really don't even let anybody in for the third month of the quarter. So that flexibility needs to kind of come through the financial aid system so that we can provide starts on a monthly basis and more flexibility for our learners. That right there would be significant sort of opening the door for attracting more learners into more consistency like we do in our traditional program.

Operator

Your next question comes from the line of Adrienne Colby from Deutsche Bank.

Adrienne Colby - Deutsche Bank AG, Research Division

I was wondering what you would guide us to think about in terms of bad debt, given that we're starting to see some growth in your bachelor's enrollment line. It did come down a little bit in the quarter, but just wondering again what we should sort of be thinking as we move forward.

Steven L. Polacek

Yes, Adrienne, this is Steve. So from a bad debt perspective, it was flat year-over-year for the second quarter. As we look through the year, you are going to see that sort of seasonality, and the third quarter for Capella University is typically going to be the higher point. We would expect that again happening in '14. But from an annual basis, we see that trending about where we were in 2013. We don't see a significant difference there. Yes, we have had growth in bachelor's, but now you're seeing the master's turn positive from a total enrollment perspective and we obviously have more learners at the master's level. So I don't think you're going to see as much of that impact as you may have seen in the past as bachelor's was growing while others were not growing yet.

Adrienne Colby - Deutsche Bank AG, Research Division

Great. And I was wondering if you could comment. A leader of another institution that offers competency-based programs recently commented that some of the enrollment growth in these types of programs has been more moderate because there's some uncertainty about how these programs are viewed by employers and graduate institutions. And I was just wondering if you could comment whether you see that acceptance as a barrier to adoption.

J. Kevin Gilligan

Yes, Adrienne, this is Kevin. I would say, as a point of clarification, we're the only institution offering direct assessment competency-based offering at the bachelor and master's level. And I would say, our experience thus far, that's been a non-issue. Employers, what they're looking for are skilled workers that can demonstrate competencies, and this model directly aligns with that need. And it is exactly the same degree. It's the same curriculum. It's the same faculty. It's the same assessments, it's the same academic standard. The only difference is that in a FlexPath model, learners are able to move at their own pace and it's a really great solution for working adults who bring a lot of competency from the workplace into the course room. So I would say that I think employers are excited about the prospects of a FlexPath solution for their employee base.

Operator

Your next question comes from the line of Jason Anderson from Stifel.

Jason P. Anderson - Stifel, Nicolaus & Company, Incorporated, Research Division

On the direct assessment, is there -- are you aware of any others that are pursuing direct assessment, any competitors? Or do you have any sort of shelter or protection on that in the bachelor and master's area for a period of time?

J. Kevin Gilligan

Clearly, there are people interested in pursuing it. And I expect over time, more institutions will be offering programs in this area. I think we're at the point now where the department and the accreditors are trying to figure out what's the right process they should be using to review and approve eligibility for these types of programs, and they're trying to get their arms around that. We're trying to be helpful in that process with them based on our experience. So I think what you're going to see over time, more institutions will come into the space, and I think the market opportunity is plenty large enough that there's room for more than 1 player. And I just would emphasize that Capella has spent over 10 years developing the infrastructure, the assessment capability, the curriculum design, the role of the faculty in a competency-based model, all the technology to support that. And it's going to take time and money for -- if an institution is going to be serious about a competency-based direct assessment model, it's going to take significant time and money to build that capability. I think they're capable of doing that, and we would welcome that because that will then build more market awareness of the offering.

Steven L. Polacek

Jason, this is Steve. The 1 comment I would add is, is that just because you are competency-based doesn't mean that you have the direct assessment capabilities that the Department of Education and the regional creditors are looking for. It is a very -- it's very different. And there's a number -- there's a few institutions that were competency-based, did the applications, get approvals from the department but they have not received that because they don't have the robust direct assessment processes that somebody like Capella has. That's a clear difference when institutions are going to be applying. Just because their competency-based, doesn't mean you can get away from the credit hour. You need to have the direct assessment capabilities that we -- as Kevin laid out, we've been doing that for 10 years in our traditional programs. That's why we were able to get the approvals as quickly as we did.

Jason P. Anderson - Stifel, Nicolaus & Company, Incorporated, Research Division

Great. That was very helpful. I don't know if you talked about it awhile in your corporate travel, I know you're alluding to relationship marketing and that sort and I know that probably encompasses some corporate. Can you size your corporate channel or/and also maybe what the start growth in this quarter look like from that area?

J. Kevin Gilligan

Yes, I can, Jason. So the employer channel has always been an important channel for Capella, and it's growing in importance. We've been seeing healthy new enrollment growth through that channel in the second quarter, and we're doing different things with employers. We -- in some cases, we're working with them to maximize the use of their tuition reimbursement dollars. In other cases, we're creating custom cohorts and group enrollments to help them address company-specific competency requirements. And in some cases, we've actually tailored some of the content to integrate company-specific competencies into our delivery. We're also doing some limited business development work with certain employers around non-degree learning where they're trying to close some skill gaps that impact their business performance. So we have, today, over 200 employer partners. It's an important channel for us and will continue to be and something we pay a lot of attention to. And I would say, employers speak a competency language. So our ability to grow and talk about our competency-based capabilities, our ability to directly assess learning, our ability to measure learning outcomes, I think, is differentiated in their eyes.

Jason P. Anderson - Stifel, Nicolaus & Company, Incorporated, Research Division

Any chance you can size that by enrollment, a percent of enrollment?

J. Kevin Gilligan

Yes, so we haven't typically provided that level of channel detail. I would just say it's an important channel for us. It's growing and will continue to be so.

Jason P. Anderson - Stifel, Nicolaus & Company, Incorporated, Research Division

Okay, great. And one last one. It sounds like from your discussion on revenue per learner there that maybe this isn't the case, but was there any increase in the level of grants? I know you put out a new PhD grant. Was there any impact on that in the actual start performance this quarter or looking into next?

Steven L. Polacek

So from a historical perspective in the second quarter, the new enrollment from grant programs was a little bit less than 50% of our new enrollments where individuals have learner success grants. As we moved into the third quarter, we're expanding it into some master programs, particularly in our public school -- public service leadership. So we're expecting a little bit of an increase relating to grants from a revenue perspective in the third quarter. The other grant that you're referring to at the PhD level is something we just recently announced, and that is exclusively related to our PhD in education for learners who start their program in August through November. And it's a typical learner success grant that you need to pass first course and then stay with your program and it's spread over 11 consecutive quarters. But I would say from the second quarter, pretty much discounting was flat year-over-year. We're going to see a little bit of an uptick in the third quarter, our expectations for the third quarter and the full year taking into account those expected levels of grants and programs that we have them in.

Operator

Your next question comes from the line of Peter Appert from Piper Jaffray.

John D. Crowther - Piper Jaffray Companies, Research Division

You've got John Crowther on for Peter. Just real quick, obviously, it sounds like you guys are gaining share in the market based on your differentiated offering and your efforts around marketing. But it did sound like in your comments that you said that there might be some peripheral signs of market improving. I wonder if you can talk just a little bit more about that.

J. Kevin Gilligan

John, this is Kevin. So I would just say that the demand environment is still weak. I wouldn't say that demand environment is strong. But I think there's less -- we see less volatility today than, let's say, we saw a year ago. So it's still very much a -- it's still very competitive market. It's still a market where you have to go out and create the demand and create your growth. But I think we're seeing less volatility, and we're watching very carefully economic news around improving unemployment rates and improving housing market and trying to understand as the larger macroeconomic environment improves, how that might flow through into future demand generation. At the same time, I think the economic environment is still mixed. So unemployment rate is lower, but job participation rates are still not where they were or not where they would typically be during a healthy expansion. So our view is it's mostly on the fringe, and we think the growth we're getting has more to do with our execution differentiation. Now if the environment improved, that would just create more opportunity for us.

John D. Crowther - Piper Jaffray Companies, Research Division

Great. And then just obviously, you guys have made some very strong improvements here in the early cohort persistence over the last year or so. Just wondering, you guys, obviously, are towards the top of the industry in terms of enrollment and getting back to enrollment growth quicker than everyone else. But I would have thought that some of that early cohort persistence might have helped enrollment a little bit more in the current quarter. Is there any sort of onetime things that's maybe impacting it? Or is graduation rate still maybe a headwind here for a couple more quarters?

Steven L. Polacek

Well, I would say -- this is Steve, John. From a persistence perspective, the early cohort persistence, you have to recognize that we have relatively longer degree programs than most other institutions. So our early cohorts, those first 4 quarters they're with us as a portion of our learners, it's not like the majority of our learners. So it's a little bit of you need to move it up in the front end so that you get those benefits as they kind of flow through their degree programs. So that I think is one thing that -- maybe take into account. When it comes to the question relating to graduations, we're seeing overall graduations starting to stabilize or decline a little bit just because of the number of people that have came through in the late 2000s or 2007 to 2009. That's different at the PhD level, which is our longest degree program. We have seen double-digit graduation increases in '13, which continues in '14. That's creating much more of the headwind as it relates to our PhD programs to turn to total enrollment growth. So bachelor's turns positive in total first. Master's happened in the second quarter, and then the PhD is going to take some time yet, but they have more of a headwind relating to graduations.

Operator

Your next question comes from the line of Jeff Volshteyn from JPMorgan.

Jeffrey Y. Volshteyn - JP Morgan Chase & Co, Research Division

Could you give us an update on RDI and how is it -- how the operation is doing with the new degree grants and status?

Steven L. Polacek

Sure, Jeff. This is Steve. So I don't think much has changed since our last earnings call. At that time, we had just announced that we had received Taught Degree-Awarding Powers from the U.K. higher education authorities, and then we went through a period where we needed to apply for university title. It's going to be the name of the university, as well as some other requirements to obtain that. We've gone ahead and filed that application subsequent to our last call, and it's going to take probably at least 6 months or so for them to go ahead and review and do that. And then we'll then be able to issue or enter -- enroll students into our own sort of degree program, alongside partnering with other universities. I think it's important to note, here in the near term, we don't see a dramatic shift in their business model. We are going to continue with this -- these partnering relationships, and we're going to ease into -- our current intention is to ease into awarding -- enrolling and awarding our own degrees. But that will take some time as we build our own sort of university brand there and that. So right now, RDI is performing. They've got good revenue growth, good enrollment growth, but that does not have anything really to do with the university title. I think what the TDAP awarding process and going to university title demonstrates is just the quality of RDI offerings in the U.K. and broader marketplace. So we're pleased with the progress down that front, consistent with what we expect from something like Capella University from a quality perspective.

Jeffrey Y. Volshteyn - JP Morgan Chase & Co, Research Division

That's helpful. I might have missed it, I think you talked about a tuition increase. When will it take place this year?

Steven L. Polacek

So our tuition increases always take place on July 1, beginning of the financial aid year. So it was around 2.5% effective July 1, 2014. It's a little bit less than what we had a year ago.

Jeffrey Y. Volshteyn - JP Morgan Chase & Co, Research Division

Great. When I look at the G&A line going forward and excluding the savings from your lease, do you have to invest in G&A functions as your total enrollments will grow in the quarters ahead?

Steven L. Polacek

So a little clarification just on the lease benefit. The lease benefit, we allocate our lease expense across the expense categories depending upon headcount. So the vast majority of it is going to be in our instructional cost and services line. And then in our admissions and advisory line, it's a smaller portion that gets allocated to G&A because we have a much smaller headcount there. So that's just one sort of point of clarification. As relating to leverage in the G&A line, as we see a revenue growth, we would expect leverage happening in the G&A line.

Jeffrey Y. Volshteyn - JP Morgan Chase & Co, Research Division

Great. Last question for me, could you give a little bit more color on trends in your military student enrollments? I know the percentage is small, but how are they doing given the challenges with government funding?

J. Kevin Gilligan

Yes, Jeff, it's Kevin. Military is not a focus of ours. We tend to focus more on professional end markets, and we do attract some small percentage of our learner population from the military. It tends to be officers as opposed to enlisted personnel. So it's not a meaningful part of our portfolio today. We're very proud to serve the military people we do, but it's not a market focus.

Operator

[Operator Instructions] Your next question comes from the line of Trace Urdan from Wells Fargo Securities.

Trace A. Urdan - Wells Fargo Securities, LLC, Research Division

Sorry to obsess on this, but I wondered -- I wanted to ask another FlexPath question. Can you describe what the timeline looks like for the development of FlexPath as best you can tell? And if you can't actually attach dates to it, maybe just describe the sequence of events that we might look forward to in the kind of further development and growth of that program.

J. Kevin Gilligan

Trace, it's Kevin. Thanks for the question. It's a good question. So the way I would think about it is our primary focus up until now has been on the academic model. We're going to -- we feel good about where that is. I think there's more work to be done, and we'll continue to refine that as we get more experience. And now we're shifting more of our focus to the market development and the model and the commercialization of FlexPath, and there's a number of things that we need to better understand. I tried to address some of that in my prepared remarks. For example, we need to figure out what are these variables that are going to drive broad-based adoption of a new model like this and try to figure out how we might influence them and what's the appropriate level of investment and the pace of investment to figure that out. So that's an important question that we're looking at right now. I think the second question connected to that is which channels are going to be the most productive for us and what messaging is going to be more -- the most efficient for us. So I think you should expect to see us in the market experimenting around messaging and channels. And then I would say, thirdly, the regulatory environment, as I mentioned earlier, there's strong support at the department and I think in Congress to see direct assessment and competency-based learning expand, but we need to have a regulatory framework that encourages the development and expansion of these models and remove some of the barriers that exist in the current regulations. And the departments -- they're well aware of that and they want to work on that. So those are the kind of streams -- the big streams of work that we're are focused on, and this is obviously very important to our future. We're paying a lot of attention to it, and our commitment is that we're going to be reporting our progress on a quarterly basis. And when we are able to sort of put some stakes on the ground, we'll share that with you.

Trace A. Urdan - Wells Fargo Securities, LLC, Research Division

Okay, fair enough. And then I wondered if -- sort of given that things seem to be sort of solidly back on track and I know you're focused on FlexPath, but I'm wondering what the prospects might be for additional vertical offerings. Is that -- I mean, do you guys have stuff in skunkworks that you're working on to sort of expand the range of program offerings? Or is that not a focus at the moment?

J. Kevin Gilligan

No. So we're looking to grow both our traditional credit hour programs, as well as our FlexPath program. And by the way, our -- we think our traditional credit hour programs are differentiated, and they are also contributing to growth. So it's not -- at this point in time, in terms of the performance, FlexPath is a very small contributor, so I want to make sure we don't lose sight of that. We're always looking for new areas to expand into. I still think there's a lot of room in health care, health care-related areas. And so that's an example of what I'd characterize as a growth vertical, where we look for ways to add more programs and more specializations. So I'd say we're focusing on both trying to develop growth verticals within our traditional credit hour programs and leverage the opportunity that FlexPath represents.

Trace A. Urdan - Wells Fargo Securities, LLC, Research Division

Okay. And then last question, Kevin, is it too soon to ask you guys to -- what your view is in terms of long-term sustainable growth going out into the future, given that you've sort of gotten back on pretty solid footing here?

J. Kevin Gilligan

Yes, it might be a little early. We came into this year with an expectation of achieving moderate new enrollment growth. And obviously, we're pleased that we're going to outperform that. But the market environment is still quite challenging, and visibility is a little better but it's still limited. So I would just say, we feel really good about our momentum, and we're focused on building growth for the long term. We'll be talking with you in the next call or 2 about our thoughts on growth for 2014. And by the way, some of that is going to be a function of how much FlexPath investment we want to bite off. So it's definitely on our radar screen, Trace. And when we have more to share, we will.

Operator

Your next question comes from the line of Tim Connor from William Blair.

Timothy Connor - William Blair & Company L.L.C., Research Division

You just mentioned investment in FlexPath and you're considering adding some new programs as well. But it sounds like x the lease charges, your operating margins expanded pretty nicely above plan or expected it to beat plan for the full year. How much of the investment have you put into place in terms of FlexPath, given that you already have the curriculum, the competency-based models? And when you think about investment in that, is that more marketing investment than sort of technology and curriculum?

Steven L. Polacek

Timo, this is Steve. So our investments here in back half of or maybe in the later part of '13 and into '14 was more related to the academic side of the equation as far as the support and what we were providing there, less to do with the marketing. And the reason I say that, even though you may see FlexPath ads out there, you will see them out there, that was -- if we were only looking for FlexPath enrollments relating to that, it wouldn't have been a great investment. But really what it did was just to get sort of the broader message out there of some of the things that we're looking at from differentiation, affordability, direct path to your career objectives, to your degree, things of that sort. And we got that -- actually that halo effect. So I wouldn't put the marketing like an investment. It was just a different sort of message out there. As we move into 2015, if we're going to go and expand that, it is going to take some additional investments that's incremental to what we did to '14. The timing, the amount of that, yet to be determined. But I think what we've said in the past is that a couple of important assumptions that we have focused in on and that is, is that because we have a slightly less revenue per student or learner in the FlexPath model, we're going to need better persistence rates. We're encouraged with what we've seen thus far with the learners that we have. We also need to look at how we're going to get better efficiencies even from a marketing perspective. We believe that there are opportunities to do that in certain channels, but that's that going to be part of the piloting that we're going to go ahead and do. But we do think that if we can get those 2 figured out, we think we're going to have attractive margins for the business and for shareholders.

Timothy Connor - William Blair & Company L.L.C., Research Division

And then this has been asked several times over the last couple of quarters, but it's more of a self-pay, self-directed learner in the direct assessment programs and in many ways, maybe a more advanced learner. So are you seeing anecdotal evidence that this is a new market for you?

J. Kevin Gilligan

Yes. So I think it has potential I think in 2 regards, Timo. I think it is a very attractive alternative, we believe, for adults that are already participating in higher education. We've seen that. And we believe that there is a part of the market it's not consuming today because a traditional credit hour structured program just doesn't work for them, and I think we've seen some anecdotal evidence of that. We've done research around that. So we think there's opportunity to grow FlexPath in both directions.

Operator

We have no further questions in queue. I would like to turn our call back over to Mr. Gilligan.

J. Kevin Gilligan

Okay. Thanks, Ryan. So I appreciate everyone joining us today. Hopefully, our comments were helpful to improving your understanding of I think the very strong momentum that we have, and we look forward to sharing our progress next quarter. If you have any additional questions, I would ask that you contact Heide Erickson. Again, thanks, everybody, and have a great day.

Operator

This concludes today's conference call. You may now disconnect.

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Source: Capella Education's (CPLA) CEO Kevin Gilligan on Q2 2014 Results - Earnings Call Transcript
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