K12's (LRN) CEO Stuart Udell on Q3 2016 Results - Earnings Call Transcript

| About: K12 Inc. (LRN)

K12 Inc. (NYSE:LRN)

Q3 2016 Earnings Conference Call

April 27, 2016 08:30 AM ET

Executives

Mike Kraft - VP of Finance

Nate Davis - Executive Chairman

Stuart Udell - CEO

James Rhyu - CFO

Analysts

Jeff Silber - BMO Capital Markets

Corey Greendale - First Analysis

Operator

Greetings, and welcome to the K12 Fiscal 2016 Third Quarter Earnings Results Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Mike Kraft, Vice President of Finance. Please go ahead sir.

Mike Kraft

Thank you and good morning. Welcome to K12's third quarter earnings call for fiscal year 2016. Before we begin, I would like to remind you that in addition to historical information, certain comments made during this conference call may be considered forward-looking statements, made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, and should be considered in conjunction with cautionary statements contained in our earnings release and the Company's periodic filings with the SEC. Forward-looking statements involve risks and uncertainties that may cause actual performance or results to differ materially from those expressed or implied by such statements. In addition, this conference call contains time sensitive information that reflects management’s best analysis only as of the day of this live call. K12 does not undertake any obligation to publicly update or revise any forward-looking statements. For further information concerning risks and uncertainties that could materially affect financial and operational performance and results, please refer to our reports filed with the SEC, including without limitation, cautionary statements made in K12's 2015 Annual Report on Form 10-K. These filings can be found on the Investor Relations section of our website at www.k12.com.

In addition to disclosing financial results in accordance with Generally Accepted Accounting Principles in the US or GAAP, we will discuss certain information that is considered non-GAAP financial information. A reconciliation of this non-GAAP financial information to the most closely comparable GAAP information was included in our earnings release and is also posted on our website. This call is open to the public and is being webcast. The call will be available for replay for 30 days. With me on today's call is Nate Davis, Executive Chairman, Stuart Udell, Chief Executive Officer and James Rhyu, Chief Financial Officer. Following our prepared remarks, we will answer any questions you may have.

I like to now turn the call over to Stuart Udell. Stuart?

Stuart Udell

Thank you Mike, good morning and thanks for joining us on the call today. Before reviewing the results for the quarter, I just want to share how delighted I am that I came to K12. My entire career is focused on providing instructional services to kids who need the most help. I have always been a champion of school choice and educational options for students. Now, after almost 3 months on the job, I'm even further convinced that there is no better platform to do this at scale and to make a difference with kids than in K12. I've spent the last 75 days visiting schools, attending school board meetings, listening to customers and talking with employees to quickly gain a deep understanding of the Company's operations, curriculum and talent. My takeaway is that the K12 team is more than just a leader in building create curriculum and technology; it’s a team of incredibly passionate and committed individuals including teachers, school administrators and support personnel who are on a mission. It’s those individuals that truly differentiate this organization and make us a true pioneer and leader in online and blended education.

Now turning to the results, revenue for the quarter was $221.3 million, a decline of 9.5% year over year. On a pro-forma basis excluding the impact of the Agora transition, revenue grew 3.1% from the third quarter of last year. Operating income for the quarter was $19.1 million versus $27.4 million in the prior year. Once again our revenue, operating income and capital expenditures were within the guidance we provided last quarter. Our forecast for the fourth quarter places our full-year expectations at or above our original guidance for the year. This underscores the strength of the K12 management team and our commitment to deliver on our financial objectives while remaining focused on our core mission to help deliver an outstanding education to students. Now today I want to cover four important topics; enrollment, academic results for our managed public schools, international operations and our institutional business.

First, enrollment results for the quarter. Average enrollments for managed programs in the third quarter were 104,640, an increase of about 1% versus our average enrollment in the second quarter of this year. This is the first time in the last three years were average enrollments actually increased from the second to third quarter. Most importantly this means that student retention I continuing to improve. To put this in perspective let's look at the figures for the last two years. From accounts date in fiscal year 2015 excluding the impact of Agora to accounts date in fiscal year 2016, enrollments declined by over 4, 000. However, by the end of the third quarter in fiscal year 2016, enrollments were the same as the end of the third quarter in 2015. In other words, in year in fiscal year 2016, we gained over 4,000 enrollments over fiscal year 2015’s end-year performance. Primarily, we believe this is due to the effectiveness of the programs we introduced to keep students engaged and to reduce withdrawals.

On a year-over-year basis, our retention has improved about 200 basis points. Over the last two years our retention has improved by 280 basis points. This is certainly not something that we were able to accomplish overnight. We believe this improvement in retention is a result of a fundamental shift in how we manage the entire student lifecycle. These programmatic changes began about two years ago and have now been rolled out to enough schools to make a measurable impact. Despite these positive indicators I believe we have a lot more work to do in this area.

Second, I want to share some results from newly available annual standardized test data from the 2014-15 school year. This year the majority of states changed the test they used to evaluate student progress. Of the states which administered a test and where K12 manages the school, 65% of the states switched to a different test making it extremely challenging to compare results year-over-year. Test scores for students taking the same test in consecutive years demonstrate that students in K12-managed schools improved by 2 points in reading in English language arts and 1.8 in math. These results reflect 12 schools across eight states.

Among our schools we had some very nice successes. For example, students at the Virginia Virtual Academy exceeded the average percent proficient state-wide in both math and ELA in grades IV, V and VI on the State Development Assessment scoring above the 80th percentile. Overall, I'm very proud of the work that our teachers, school administrators and the entire K12 team put into driving student outcome.

While we're excited about how far we've come, we appreciate that even more work is still need to be done to maximize student outcome. We will be publishing our annual academic report in the next few months which will provide a rigorous review of all assessment results on a school by school basis. Typically we would hope to issue this report earlier, but some -- many states changing their assessments have taken more time to normalize and understand the result.

Third, an update on our international operation. As we previously mentioned, from the financial point of view, we are focused equally on growth and long-term profitability. With that in mind, last year we took a hard look at our existing assets specifically in the United Kingdom and decided that the current framework for operating schools in the UK did not fit our business plan. Virtual schools and online curriculum are just not moving at the pace we like and operating brick and mortar schools is not our long-term goal.

As such, we have begun transitioning our schools in the UK to other trust consortia with the support of the Department for Education. At the end of the third fiscal quarter, three of our four schools in the UK have been transitioned or closed. The remaining school will be transitioned by the end of the fiscal year. Our future international efforts will focus on less of a physical footprint and more flexibility. We will keep you apprised of other developments as our international strategy moves forward.

And lastly, our institutional business. As you know, we believe school education is a growth business for us over the long run. Unfortunately revenues can be somewhat lumpy and this quarter's results are no exception. Since arriving at K12 a lot of my time has been spent with the institutional team and I have already enacted the changes including adding incremental sales resources and accelerating and refining the focus the company places on large accounts sales. While it’s still early in the process I believe we could begin to see some improvement in the near term. Obviously we are far from satisfied and we will continue to work with the team to drive growth in this business for the next year and beyond.

From a strategic standpoint, we continued to look for multiple strategic acquisitions and partnerships to expand our distribution, to enhance our product set and to improve our technology platform. In that regard, I am very pleased to announce today that last Thursday we closed our first acquisition that fits all of these criteria, LTS Education Systems. The value of the transaction was approximately $20 million in cash.

LTS Education Systems is a proven educational technology company that provides flexible learning solutions at 1500 school and after school sites. They serve more than 350,000 pre-case with 11th grade students in 37 states across the country. Their core product is Stride Academy which is a SaaS offering that blends instruction, assessments and games into a mobile field practice and test readiness solution. It is adaptive, it’s gamified, it’s engaging and it’s mobile, all of which we know works and it’s where we're heading as an organization.

Importantly, the solution has delivered positive efficacy results. In a 2014 independent study by the Public Affairs Research Council of Alabama, student test results in grades 3 through 8 were 10% to 14% higher in reading proficiency and 13% higher in math proficiency as a result of using Stride Academy to support learning and the results were strong across sub-groups indicating the product helped close the achievement gap.

From a strategic standpoint, this acquisition fits nicely with our institutional assets in many ways. First, the product filled the gap we have in skilled practice, assessment and test readiness across all core subject in reading, English language, arts, math, science and social study.

Second, the LTS customer base has very minimal state or client overlap with our current FuelEd customer base. Therefore, we will be able to take advantage of cross-sell opportunities with FuelEd solution set.

And lastly, this acquisition gives us an entrée into game-based products. Gamification of learning engages today’s students translating into engagement and persistent. And as we know, engagement and persistence are key to improving academic outcome. We believe that gamification and game-based learning will be important to both our future student success and our company growth.

Our team is excited about the prospects for this acquisition. While LTS is an already profitable company with $8 million in revenues at the onset, we believe the growth prospects for Stride Academy and the cross-sell potential for FuelEd’s product set will make this acquisition a strong growth driver for K12 in the future.

I want to again reiterate that I am very excited to be here and I look forward to supporting K12’s growth going forward. Thank you for your time this morning. I will now hand the call over to James. James?

James Rhyu

Thank you, Stuart, and good morning everybody. First a few words about our reported results. Revenue for the quarter declined 9.5% from the year ago quarter to $221.3 million. This quarter we posted an operating income of $19.1 million. This compares to $27.4 million in the third quarter of last year.

As in previous quarters, I’ll spend some time discussing revenue and enrollment on a pro forma basis, excluding the impact of Agora. We believe this approach will provide you with a clear picture of the underlying trends in our business.

Total company pro forma revenues increased 3.1%. Revenues from managed programs would have risen about 3.9% year-over-year. This is largely a result of 4.3% increase in revenue per enrolment. The revenue per enrollment trends relate to a combination of factors including school mix and improved funding environment in some states.

Average enrollments would have declined slightly from the year-ago quarter. As Stuart mentioned, our ending quarter enrollments actually were about the same as third quarter of fiscal 2015. That means that while we started fiscal 2016 approximately 4,000 [ph] below we started fiscal 2015, we have now closed that gap. The investments we have been making for the last few years are beginning to pay-off an improved student retention and average student enrollment.

For non-managed programs, excluding the impact of Agora, revenues would have been $13.1 million. Non-managed program enrollments grew just under 1%. That was more than offset by 4.7% decline in revenue per enrollment. Revenue per enrollment decline were largely due to mix.

Institutional software and services, which includes software, technology, professional and other educational services sold by our FuelEd team, posted revenues of $10.6 million in the quarter. This is a year-over-year decline of 2.8%. While we did see modest decline in fees revenue this quarter, we continue to believe in the opportunities in the institutional market. The LTS acquisition is just the first step in a set of targeted investments to expand our product set and distribution capabilities. As we previously mentioned, our investments in areas like peak product ELO and other products should gain traction over number of sales cycles.

Revenue for our Private Pay and other businesses was about $11.7 million, an increase of 5.4% over the prior year. As Stuart already reviewed, we are pivoting away from our UK operations. On a year-to-date basis, we recorded approximately $9 million of revenue for the UK, while we will see a decline in Private Pay and other revenues for the fourth quarter as a result of the shift. The impact of operating income will not be material. You should also note that we have already accounted for this change in our fourth quarter guidance.

Third quarter gross margins remain flat at 39.1% compared to prior year. On a full year basis, we anticipate gross margin to be roughly flat. Selling, administrative and other expenses were $64.9 million in the quarter, that is flat from a year-ago period and consistent with our focus to manage costs tightly.

Product development expenses were $2.6 million, which is mostly flat from the year-ago quarter. Operating income for the quarter was $19.1 million compared to $27.4 million in the prior year. The reduction in operating income is largely due to the transition from the Agora contract.

Now, let’s turn to some other items. We ended the quarter with cash and cash equivalents of $199.5 million, a $28.2 million increase from the prior quarter. Our cash balance has increased approximately $57 million versus the year ago period and it’s higher than our beginning of the year cash balance. Cash on hand now represents approximately $5 a share of value.

DSOs have improved by 12 days on a year-over-year basis, with improvements across all business units. These improvements continue to be as a result of strong emphasis we are placing on accounts receivable management. While there may be some exceptions, in general, we’re clearly seeing more discipline in this area.

CapEx, as we have historically defined it, which includes curriculum and software development, computers, and infrastructure, was $45.3 million year-to-date versus $57.4 million in the previous year. We also had approximately $2.5 million in computer related equipment that falls under our capital lease program, but we expensed so it is not part of our CapEx number I just mentioned. The $12.1 million year-to-date decline versus last year was a result of lower spending on property and equipment as well as student computers.

Our tax rate for the quarter was 28% versus 39% in the year ago quarter. We get the benefit of certain losses [Technical Difficulty] as well as our international operations, which lowered our tax rate this quarter. We’ll be able to take that benefit for the full year and are therefore updating guidance for the full year tax rate to a range of 34% to 36%.

Now, turning to our expectations for the fourth quarter, we expect revenue of $205 million to $215 million, operating income of between $5 million and $9 million, capital expenditures of $22 million to $27 million. On a full year basis, this outlook equates to the following [Technical Difficulty]. In all cases, we anticipate full year results that meets or beat our original full year guidance expectations. Revenue in the range of $856 million to $866 million, operating income of between $18 million and $22 million, capital expenditures of $70 million to $75 million and as I just said, the tax rate in the range of 34% to 36%.

Thank you for your time and now I’ll hand the call back over to Stuart.

Stuart Udell

Thank you, James. Kevin, we’re ready for any questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question today is coming from Jeff Silber of BMO Capital Markets. Please proceed with your question.

Jeff Silber

Thank you so much and congratulations on the quarter. I’m just curious compared to your initial guidance, where the areas of upside were, both in the third quarter and in the current quarter based on your guidance?

Stuart Udell

I mean, predominantly, Jeff, we’ve been seeing a good environment for mix and rate on our managed school side. And that by the way has a lot to do with the way our retention programs did actually work as well, because our retention programs obviously feed into as you know the way that the funding office works, sort of pro rata throughout the year. So, that retention lift if you will does feed into improved revenue in many schools, not all schools, because there are some that have a different type of funding environment where it gets funded on the account date, but as they sort of over the year shifted to more pro rata during the course of the year, that retention does provide it. That’s probably the primary driver of this.

Jeff Silber

Okay. And then switching gears to the LTS acquisition, obviously, there is a number of companies out there that do this, I’m just curious why LTS, why not some of the other companies and what do you think the impact on core will be on your business both from a revenue and margin perspective?

Stuart Udell

Well, LTS, as I mentioned, has a number of things that we thought were really important for us moving forward. It helps us with skills practice, the assessment and test readiness across all subject areas, not just reading English language, arts and math, which is common in many products, but also science and social studies and it also covers grades pre-K through 11. So it helps fill in some gaps for us at the lower level. We think it is a product that is extensible across all of our areas. We of course will distribute the product through dual education, but we think there is a private pay optionality around it and it’s a tool that we can use in our managed public schools to improve performance. So we love the fact that it’s extensive throughout the business. We also see gamification as something that is really well done in this product, as an example we see usage in some districts up to 35% to 44% at home product, so it’s a product that’s so engaging that kids are using it in free time not just in school in some cases there is a lot that we love about it, as we mentioned earlier, it’s you know not particularly material at this time but we think it’s something that will tie to a lot of our future efforts around SaaS-based products around gamify products and around adaptively.

Nate Davis

Jeff this is Nate, I don’t – Stuart gave you all the operational reasons and strategic reasons I’d add one thing and then some financial reasons. Anytime you want to do these transactions, you’re right there are many companies out there but not all of them are executable, somebody who can buy a reasonable price and be current period accretive meaning as soon as we buy it, we are not taking on an in period loss, so ongoing losses from operations. So that’s the other reason why this is attractive because it gave us all of the things Stuart mentioned at a very reasonable price and it was executable in a short period of time and we don’t have to start taking immediate losses from operations that’s using money.

Jeff Silber

Okay. I appreciate that color. And just one more question, I know it’s still a bit early to talk about next year but can you highlight some of the states from the managed school perspective, where you may be seeing either expansions or new programs?

Nate Davis

This is Nate speaking. First of all, I think there is probably only two or three states where we see some risk and you guys already know about Tennessee and a few like that but we are expanding into new schools particularly in the area of career radius, we have four schools that have agreed to do a school where a career academy gets started. In addition to that, as we have mentioned before, Alabama is a state where they opened up the law last year but we really didn’t understand what the funding would be, what the rates and the procedures would be, so this year we understand that, we know that the rates are going to be and we’re going to start expanding in Alabama. So we think that that’s an opportunity to expand as well. The academy, the career academy in Wisconsin and in fact it’s already taking enrollments, we also see a new opportunity in Michigan, there is a new school that will starting there that focuses on dual credit and aero college, so it’s really a high-end school there. And then we have an opportunity in Indiana as well. Those schools were all what I will call relatively small but will offer expansion opportunities and then our normal schools will all be focusing on growing enrollments because their retention is so much better, we have a better opportunity to grow. So that's where we see opportunities.

Operator

Thank you. [Operator Instructions] Our next question today is coming from Corey Greendale from First Analysis.

Corey Greendale

First question, Stuart in doing some quick Googling here I see that you worked with LTS when you were at Catapult so that’s maybe that’s a good springboard to asking just kind of how you see the landscape as if -- presumably, you thought it was a good product from your work there as given your background of the industry, are there several other things that you’ve worked with or familiar with do you think in the interesting acquisition target, you think this was sort of a one-off or what’s your perspective?

Stuart Udell

Well yes, certainly one of things that was attractive is that you know I had some personal track record with LTS, I saw it used successfully in schools and we’ve been able – its certainly always more attractive when we know a product works well and not just from a usability perspective but from an implementation perspective with schools. So it truly is SaaS-based, there is not a huge service component around it and it’s easily deployable which are things that we certainly like. Regarding other opportunities, this is certainly the type of deal we like, we’re looking at opportunities frankly of all sizes, but the key is in size, it’s really strategic fit, and the key is also you know we’re also looking – we’ll make sure that that anything we close on is right within our environment whether its next month or a year or two from now, timing and size are really not important, it’s strategic fit, so this again is something we love because it was such an easy snap in to fuel education but we could also use it across other aspects of our business and those are the types of deals I think we’ll continue to love most as Nate also indicated it is immediately accretive and we like that too.

Corey Greendale

And then, I have a few kind of scattered questions, first of all the data that you share on the schools were they use the same test this year from last year, was the improvement – are you comparing last year’s fifth grade to this year’s fifth grade or is it the same group of students last year to this year?

James Rhyu

It would be last year's fifth grade to this year’s fifth grade. The student cohort itself obviously has some changes as some students come into cohort, some go out, you can’t compare exactly student to student, it’s really grade to grade.

Stuart Udell

I will add Corey that we do have other data sets that compare same student to same student, so for instance we have some data in Texas that shows exceptional gains on the same student basis from school year ’13, ’14 to ’14 to ‘15 so we try to look at both when possible.

Corey Greendale

Then on the managed program, I think James I think you said that revenue for enrollment was down due to mix, is that a phenomenon you start to persist in Q4 and into 2017?

James Rhyu

No, the mix for us is always a sort of a little bit of a balancing act because as you know we work with the boards and they really determine sort of if there is enrollment cap levels or what the [indiscernible] things like that. So I don't think that that's a trend that you’re going to see going forward, it's sort of the way the mix panned out this year and again there is a piece of that retention component that we talked about earlier that influences that as well.

Corey Greendale

Okay. I will keep working my questions around, so maybe for Nate or Stuart, whoever wants to take this, is there any update you could provide on the Ohio renewal?

Stuart Udell

Yeah, the Chairman of the Ohio board and myself have met a number of times already. They are very interested in starting the negotiation; as you know the contract expires June 17. I think all indications are that we have very good relationship and they love our head of school, as I do. She does a fantastic job. The school’s academics are strong. The one thing that I think they like us to do is they like us to be more aggressive on the PR front. They are certainly pleased that we are doing a great job and they like to see more people know more about that. I think overall we have a very good relationship and the computations are all about [indiscernible]

Corey Greendale

Okay. And then just a couple more quick ones on the - what’s going on with your UK schools, is there a meaningful revenue impact to that or can you quantify that?

James Rhyu

The revenue year-to-date was about $9 million, so that’s sort of good annualized number to use, so next year we won’t have that – it’s more of sort of Q4 trajectory continues on migrating the school over to a different trust, that would all go away next year.

Corey Greendale

Just like 12 million annualized.

James Rhyu

Well, what would happen is depending on the timing of Q4, what would happen probably is we will pick up a little bit in Q4 and we will give you some indication in Q4, because we are not sure about the exact timing, but assuming it didn’t happen till the end of Q4, yes it will be 12 million, but depending on the timing of it happening during Q4 might be a little bit less than that actually.

Corey Greendale

Okay. And what’s the margin on that?

James Rhyu

And so that was and part of the reason I think Stuart in his comments mentioned really it’s breakeven to slightly loss-making right now. So really it won’t impact bottom line results for next year at all.

Corey Greendale

Okay. And any material impact on CapEx?

James Rhyu

No.

Corey Greendale

Okay. And then last quick one I had was on the institutional, I guess it was listed in the segment breakout of institutional software and services that had been kind of modest growth, it was down a little bit this quarter. Anything you would highlight as the reason for that whether that turns around?

James Rhyu

Yeah, I mean it’s still a little bit lumpy. I mean if you look back a few years, each of past few years we’ve had a little bit of bumpiness and actually last fiscal year was at least lumpy year but historically it’s always been a little bit lumpy. I think we will continue to see some lumpiness going forward in that I think next quarter and going next year it will also be a little bit bumpy. So I think as Stuart mentioned in the prospects we think given some of the products we’ve invested in, LTS, some of the synergies we will gain from those things, we do think the prospects are good, but there is some lumpiness that we will continue to see.

Corey Greendale

Okay, just one last one on LTS. Do you think that as more products that will go through your existing sales force or does LTS bring meaningful sales force as well?

James Rhyu

Yeah, really both, Corey. So they bring some really exceptional sales resources some folks who have been quite successful in terms of their track records who know how to execute and close large account sales. That said we're very excited about the opportunity to distribute that product through our existing channel as well and we are starting that cross-pollination and fertilization immediately.

Nate Davis

Cory, this is Nate. I want to add one thing to the question on institutional software, and that is that we’ve had an effort to try to get the sales force to sell at a little largest sales cycle, average sales cycle. We need to do that and as far as the larger accounts sales cycle is a little longer and as James this mentioned, it’s more lumpy. If you look at last year you would have seen quarters where we were down and you would see big increases in a quarter. You will see some of that same thing happen this year where we've got big sales that happen, but when they do happen, they come through. So overall for the year we are pretty comfortable we are going to see good growth, but it comes because if we try to grow larger accounts, the sales cycles take a little while and takes a while for that one to pop through. It happened to us last year, we think it will happen some this year, okay.

Corey Greendale

Very helpful. Thank you.

Operator

[Operator Instructions] We’ve reached the end of our question-and-answer session. I’d like to turn the floor back over to management for any further closing comment.

Stuart Udell

Thank you very much for joining us. We do look forward to joining you again in the coming quarter. Have a good quarter.

Operator

Thank you. That does conclude today’s teleconference. You may disconnect your line at this time and have a wonderful day. We thank you for your participation today.

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