Apollo Group Inc. Q2 2006 Earnings Conference Call Transcript (APOL)

Apollo Group (APOL)
Q2 2006 Earnings Conference Call
March 23, 2006, 11:00AM EST

Executives:

John Sperling, Acting Executive Chairman.
Brian Mueller, President.
Kenda Gonzales, CFO, Secretary and Treasurer.

Analysts:

Kelly Flynn, UBS
Kierstin Edwards, Bank Equity Partners
Howard Block, Bank of America Securities
Mark Arrosco, Piper Jaffray
Jeff Silver, Harris Nesbitt
Sara Gubin, Merrill Lynch
Corey Greendal, First Analysis
Jennifer Tsao, Bear Stearns
Chris Gutek, Morgan Stanley
Trey Cowan, Stanford Group
Bob Craig, Stifel Nicholas
Greg Capelli, Credit Suisse
Mark Hughes, Sun Trust

Operator:

At this time all participants are in a listen only mode. Later we will conduct a question and answer session and instructions will follow at that time. Please refrain from entering into the cue until those instructions are given. If anyone should require assistance during the call, please press * 0 on your touchtone phone. As a reminder, ladies and gentlemen, this conference is being recorded, today March 23, 2006 and may not be reproduced in whole or in part without permission from the company. There will be a replay of this call available through April 7th, 2006, beginning approximately 2 hours after we conclude today. The replay number is 1-800-642-1687 or 706-645-9291 internationally. The conference id for the replay is 6340488. Additionally, this call will be broadcast over the internet and can be accessed via the company’s website at www.apollogrp.edu. I’d also like to remind you that this conference call contains certain forward looking statements with respect to the future performance of the Apollo group that involve risks and uncertainties. Various factors could cause the actual results of the company to be materially different from any future results expressed or implied by such forward looking statements. These factors are discussed in the company’s 10k report filed with the SEC. I would now like to turn the call over to Dr. John Sperling, acting executive chairman of Apollo group. Dr. Sperling, please go ahead Sir.

Presentation:

John Sperling, Acting Executive Chairman.

Good morning everyone and welcome to the 2nd quarter results conference call for Apollo group. The results we’re going to report are pretty much in line with what we’ve given as guidance and to give you all the details on that I’m going to turn it over to Brain Mueller, our president.

Brian Mueller, President.

Thank you John. Good morning and thanks for your participation in the conference call this morning. As I have said very consistently during the past 3 weeks we are in a period of transition as a company. We are not pleased to report a 9.5% increase in student enrollment for the quarter. We are encouraged however by three things. There was a greater than 20% increase in online enrollments. We have the most scalable online program in the world and we are in the process of training our entire enrollment staff to sell in to the trend of more people wanting to do education online. We think that’s encouraging. Two, we underspent significantly in advertising as compared to the previous year. We are reversing that trend and the early results are positive. Thirdly, in spite of our revenue shortfall our operating margins excluding unusual expenses actually increased. The transition period that we’re going through is impacting our growth rate but is not having a significant impact on our margins. And, we expect that long term our historical margins will remain intact.

On the revenue side, I indicated three weeks ago that we had three factors that were negatively impacting our 2nd quarter performance. One, we had been taking for a while now a conservative approach to advertising. In the 2nd quarter of 2005 we actually spent $56.1 million and spent only $49.4 million in the 2nd quarter of 2006. We had to spend aggressively later in the quarter to even get it to the $49.4 million number. We have started to reverse that trend and March’s lead flow is strong, especially at the local campuses. Secondly, we had a $17 million shortfall in revenue in December because of the holiday schedule adjustments that were made and students deciding to take extended breaks. Many of those students came back in January and February, but not all of them returned. We will make the necessary adjustments next holiday season to avoid that happening again. Thirdly, the percent of Axia students as a percent of all students continues to rise, which slightly impacts revenue. We expect that process to start to reverse in the 4th quarter as we begin to transfer students into the University of Phoenix from Axia College.

On the expense side, enrollment counselor expense was up as a percent of revenue as we anticipate that our recent strength in lead flow will continue throughout the 2nd half. Bad debt levels are stabilizing and we expect them to go down in the 4th quarter of this year and the first quarter of this year.

Three weeks ago I said we would focus on topline growth in the 2nd half and would have three broad strategies. I want to give an update on those strategies. The first strategy involves building our core business. We want to invest at historical levels and slightly beyond in sales and promotion in our core business of 24-45 year old working adults. We expect that the downward trend in cost-per-lead will continue in the third quarter. The right pricing strategy of leads will begin to have an impact in the 4th quarter and we think a major impact in the next fiscal year.

We are hiring enrollment counselors in the Midwest in the southwest and in the northeast where lead flow is the strongest. The upgrade of our telephone systems and the completion of the technology necessary for full implementation of our qualifying center is on track and should be completed by august 1st.

All 2,400 online enrollment counselors are on the hot transfer system. We moved the southern California campus on the system 2 weeks ago. We will continue to roll it out in the western region in March and April and hope to finish the entire country by august 1st.

We are still waiting approval on the bachelor’s programs in psychology and communications. The master’s degrees in psychology and social work are still under development.

The S3 scheduling system for academic counselors continues to rollout throughout the country and a compensation plan to reward them for retention success is under consideration and I hope to talk more about that in the fourth quarter.

We are expanding our reach into the 18-24 year old market through Axia College. We believe our ability to be successful here is a key driver in our strategy to improve growth percentages. I indicated previously that we have four activities that we’re working on. One: Axia College will come under the university of phoenix by April 1st.

Secondly, we will have rolled out Axia to the western region in April and will be putting students into the program in May. We expect conversion rates to go up in California in the third and fourth quarters.

Thirdly we will begin advertising for Axia, directly specifically at the 18-24 year old market in May.

And fourth, we will continue to work with students nearing college graduation to transfer them to the Unviersity of Phoenix. We hope to have a large enough sample size in the fourth quarter to begin building models that we think will be good predictions for the future.

We continue to believe that our retention rate with Axia College students will exceed that of level one students put into the UOP program. The reasons are that 1) the 20 month path to graduation is something that’s considered achievable by those students, 2) younger students are comfortable with the technology, 3) being able to work and go to school at the same time is important for students in that age group and 4) the high levels of academic support we’re going to be giving those student, we think, will increase our retention rate and increase our graduation rate.

The advertising dot com partnership is going well. We are merging the technology systems, we’re building process flows and working with all our current vendors to transition them by May 1st. from May 1st until the end of August, we’ll be working to right-price leads and work towards improving significantly the quality of leads. The goal is to bring maximum efficiency to our internet spending by combining right-pricing with a total conversion to our qualifying center, to improve significantly the conversion rates of our enrollment counselors.

That is kind of a high level view of the quarter and I want to turn it over now to Kenda to give you some specific information about the financial results.

Kenda Gonzales, CFO, Secretary and Treasurer.

Thank you Brian. Revenue related to students enrolled in degree programs increased 12.6% for the 2nd quarter of fiscal 2006 to $526.7 million, compared to $467.6 million for the 2nd quarter of fiscal 2005. Ddiscounts for the quarter were $25.9 million or 4.3% of gross revenue. Instructional costs and services increased as a percentage of revenue in the quarter ended February 28, 2006, primarily as the result of an increase in bad debt expense. Selling and promotional costs decreased as a percentage of revenue in the quarter ended February 28, 2006, primarily as a result of a decrease in advertising.

University of Phoenix currently has 67 local campus locations of which 34 are less than five years old. Fifteen of these local campus locations are two years old or less, with thirteen of these locations not yet at a break-even for fiscal 2006.

Excluding the $26.5 million related to our former CEO’s separation agreement, general and administrative expense increased during the 2nd fiscal quarter of 2006 as a percentage of revenue due primarily to increased administrative space and depreciation costs due to the opening of the redundant data center. Our operating margin, excluding the amounts paid under the separation agreement and stock based compensation expense, increased to 28.3% for the 2nd quarter of fiscal 2006, compared to 27.6% for the 2nd quarter of fiscal 2005.

Turning to the balance sheet, cash and marketable securities were $433 million at February 28, 2006. Net receivables were $200.7 million, which equates to 30 days sales outstanding. At February 28, 2006 we had reserved 28.5 million dollars against our receivable balance, and during the 2nd quarter of fiscal 2006, we wrote off $17.3 million of student receivables.

Between February 28, 2005 and February 28, 2006, the current portion of deferred revenue increased 13.5% to $125.5 million and student deposits increased 3.4% to $261.1 million.

Cash flow from operations for the first six months of fiscal 2006 was $260.3 million, compared to $229.9 million for the first six months of fiscal 2005.

Capital expenditures net of the online, land and building transactions for the first half of fiscal 2006, were $15.4 million, compared to $43.9 million for the first half of fiscal 2005. During the 2nd quarter of fiscal 2006, we purchased 3,548,000 shares of APOL. At the end of the quarter, we had $140.1 million remaining of the amount authorized by our board of directors for stock buyback.

And with that I think we’re ready to turn it over for questions. Operator?

Operator:

Thank you. Ladies and gentlemen, at this time we will be opening the call for a question and answer session. Please press * then the number 1 on your touchtone phone if you would like to ask a question. If your question has been answered and you wish to withdraw your request, you may do so be pressing * then the number 2. If you are on a speaker phone, please pick up your telephone handset before entering your request. One moment please for the first question.

The first question comes from Kelly Flynn with UBS.

Kelly Flynn.

Thanks. Question for Brian. I appreciate that you don’t want to give guidance but I was hoping that you could just maybe give kind of broad guidance on where you thinking marketing spend could go, relative to where it’s been historically. I think you’ve made some comments recently about that at some conferences but maybe just clarify what levels you think were based on in the past and how much above that you might go. Thanks.

Brian Mueller, President.

What I have said at conferences in the last number of weeks is that our levels will be pretty close to historical levels and maybe slightly beyond that. But not significantly beyond that.

Kelly Flynn.

Okay. And then could I just add another one? I appreciate that you gave out online enrollment numbers this quarter. Can you tell us what it was for the first quarter? What the growth was?

Kenda Gonzales, CFO, Secretary and Treasurer.

I believe Kelly it was in the neighborhood of 30...let me look it up, I don’t want to misquote it. 34%? Yep, 34%.

Kelly Flynn.

Okay. Thanks a lot.

Operator:

The next question comes from Kierstin Edwards with Bank Equity Partners.

Kierstin Edwards.

Good morning. For the redundant data center that you mentioned, is that something that’s temporary? So we should assume that to go back to the 4% of revenue?

Kenda Gonzales, CFO, Secretary and Treasurer.

No. We built a redundant data center. It opened late in the fourth quarter of last year. So we began depreciating those assets late in the fourth quarter. So it wasn’t even the full fourth quarter last year. But that data center will be open permanently.

Kierstin Edwards.

Okay. And then along the same vein for the sales and promotional, you mentioned that the enrollment counselors’ wages were higher year over year. Is that something that should continue going forward?

Kenda Gonzales, CFO, Secretary and Treasurer.

There are two things. First of all, there was an adjustment in the enrollment advisor compensation during the first quarter of this year where we increased pay levels. So, obviously that will continue as well as additional hiring that we’ll be doing in that area.

Brian Mueller, President.

Yeah. As we said in the last number of weeks we’ll be watching lead flow carefully and matching up our enrollment counselor hiring with where we see the strongest lead flows. And, we expect them to be in the Northeast, the Southeast and the Midwest.

Kierstin Edwards.

Okay. Great.

Brian Mueller, President.

But it will be done in relationship to that lead flow so I don’t think that you can expect that as a percent of revenue, it to increase significantly.

Kierstin Edwards.

Okay, great. Thank you.

Operator:

Your next question comes from Howard Block with Bank of America Securities.

Howard Block.

Thank you operator. I wanted to get back to Kelly’s question quickly. When you say that the selling and promotion will be close to historical levels, does that mean the growth rate will be at historical levels? The margin will be at historical levels?

Brian Mueller, President.

The spend as a percent of revenue will be at historical levels.

Howard Block.

Okay, historical being, some sort of an average margin from 1994 to 2004? Or 2000 to 2004?

Kenda Gonzales, CFO, Secretary and Treasurer.

Howard, we’re not going to give guidance in that detail but, I would say that the last couple of years, selling and promotional spend around 21.5% of revenue in total. And we’ve been under that in the last four quarters.

Brian Mueller, President.

So if you averaged the last two years, you would be pretty close.

Howard Block.

Okay. And are you actually going to manage it that way? Because it would seem that you’re suggesting that a period of deficit spending…or there’s been a deficit in selling and promotion in the last three quarters. Do you feel you have to compensate first before you get to that new run rate?

Brian Mueller, President.

Yeah we want to make sure that the investments we’re making are in the right places and are getting the returns that we want. But we’re not far off from understanding that. And so, we will be moving there quickly.

Howard Block.

Okay. And on the sequential basis, the enrollment for Axia appears as though it only grew a few hundred students after several thousand in the prior quarter, sequentially. Can you elaborate on that?

Brian Mueller, President.

I would say that is the place where we have had the shortfall with regards to student growth. It’s the area of biggest opportunity for us and when we don’t spend where we should spend from an advertising standpoint, that is the biggest percentage of the leads that we don’t get and therefore the number of starts that we get is mostly impacted in that area. If you’re asking, is it the result of – have we had significant numbers of students either graduating, dropping or transferring into the University of Phoenix, none of those three things have happened. The retention rates of students are up as compared to students we’ve put into our UOP program and we have not yet started graduating them and sending them into UOP in big numbers. But, we expect to have a large sample size in quarter four.

Howard Block.

Okay, so the lower spending in the past three or four quarters in selling and promotion, it seems to suddenly have manifested in Axia in this quarter’s enrollment or the prior quarterly grew pretty handsomely on a sequential basis? Even with lower spending…

Kenda Gonzales, CFO, Secretary and Treasurer.

On a seuqneitl basis, but also the prior quarter had one of our heavier enrollment periods in August/September plus, you didn’t have the…we had just started it a year ago September, where we really started to get some traction last February quarter.

Brian Mueller, President.

Yeah, and you have to understand that the 2nd quarter historically is a quarter where we don’t do a well from a new sales standpoint because of the holiday season and the significant amount of time that we’re off and the inability to place advertising, to get advertising placement. As compared to, for example, the third quarter.

Howard Block.

Okay and if you’re going to reward…you’re going to elaborate, I guess, maybe at your analyst day but…if you’re going to reward your enrollment advisors for retention success, is it possible we could see them begin to focus more on quality rather than quantity?

Brian Mueller, President.

The comment I made is that we are considering rewarding our academic counselors. Those people that are currently responsible for retention; rewarding them and putting in place for them a performance matrix and a compensation plan that looks like the enrollment counselor’s compensation plan but for retention. We have noticed that there are significant differences in the performance rate of our academic counselors with regard to their ability to retain students, coach students, keep them in the program. And, there’s a lot of potential there, there’s a lot of money to be made there if we can apply the same things that we’ve learned to manage enrollment counselors, if we can manage academic counselors that same way. We think we can get some good gains. Its really the academic counselors we’ll have more of a focus on than the enrollment counselors.

Howard Block.

Very helpful, thank you both.

Operator:

Your next question comes from Gary Bixby with Lehman Brothers.

Gary Bixby.

Hi. A couple of questions. It looks like, given the fairly strong online growth, you can back into the fact that the campus enrollments actually fell a couple of percent. First of all, is that right? Second of all, can you give us some sense as to what’s going on there? Is it across the board or is there weakness in a certain geography? Any color would be helpful.

Brian Mueller, President.

Well, number one, the 20% growth rate or slightly above that in online is not as good as what we wanted. So I’m not saying that I’m satisfied with that. We have put the very top people that we have in that campus on the road. They’ve been on the road for over 2 months, really 2.5 months, training and preparing all of our ground campus infrastructure to be able to sell and service the online product. That has negatively impacted our growth rate in the 2nd quarter in online to some extent. With regards to ground campus growth, yes. It’s a couple of percentage points down, and we want to be giving you more information about that as we move forward. It’s not going to be something that you want to pay a lot of attention to in my opinion, in the future. Once we’ve got all 3,800 or so enrollment counselors throughout the company able to put a student into the online program, if that’s where they want to go, then that’s where we’ll put them. The student will stay at the campus from the standpoint of a student count perspective and from a revenue perspective and we’ll allocate our expenses appropriately so that the incentive of the local campus to keep growing in their local marketplace is there. But actually saying here is the enrollment growth in online and this is the enrolment growth on the ground, those numbers won’t be as significant as they were in the past. What we’re focusing on as a compnay is our capabilities of increasing or growing University of Phoenix students by marketplace, regardless of whether they choose to go on ground or online.

Gary Bixby.

Does that at some point…it seems like you’ve had a natural move where a lot of students realize that they prefer online, given the convenience. Does that at some point mean that you’re going to have to shrink the actual campus footprint or when leases come due, take on less space? I don’t’ know if at some point there’s a margin pressure if we continue to see falling campus-based enrollments when you (inaudible).

Brian Mueller, President.

Actually, from a marketing standpoint that’s a very good development. Because, number one online is our largest margin campus. So, putting more students in there is positive. Secondly, yes, it would enable us over time – especially in areas like California where space is every expensive – cut back on the total amount of space that is necessary. That’s going to help the margin as well. But, we will absolutely be investing in space, not to the same extent, but we’ll still be investing in space. We’ll start to utilize it in slightly different ways; computer labs, tutor centers, customer service support areas. And so, we will be having classrooms, we’ll be offering our core programs that we can build class size in there. Students will still be attending on ground in those programs. So, there will be classrooms but there will also be additional administrative space that we’ll put in place to offer services to students that currently we don’t offer.

So, the movement of students into the online program in a higher percentage is a positive thing, not a negative thing both on the top and bottom line.

Gary Bixby.

Okay. You said you’re going to start in a month and a half advertising separately for Axia. And, I assume that’s going to be advertising for a 2 year program. Do you think you’ll get nearly as many as you’re expecting to stay around and then continue on with University of Phoenix when you’re getting them in the front door with the advertising message of a 2 year program instead of coming through UOP leads, who wanted a four year program? And, in the case that not nearly as many of them stay around for the third and fourth year, how do you think about the investment in that student? It would seem like the return on the investment would be a fair amount lower, if you’ve got to spend a similar amount up front on advertising but yet you get 2 years of a lower revenue and lower profit from that student. I guess I’m wondering what you’re thinking.

Brian Mueller, President.

We don’t expect that to happen at all because we’re going to make sure that we brand Axia College and the messages that go out there…it’s a higher ed program, it’s not a vocational program, it’s not a technical program, it’s not a career education program. It’s not something that would involve us developing placement opportunities for students. So, we’re not going to advertise it, brand it or promote it from that standpoint. What we’re going to say is, it’s a program designed for students who want eventually to get a baccalaureate degree, but it’s going to be a nice way to transition into higher education for students who can’t or don’t want to commit to a state university for four years, a private four year college for four years, move away from home and do all those kind of things. It’s going to be promoted for student who have a part time job, they want to turn it into a full time job, they want to stay in their local community and this is a way to be able to go to school in a way that is affordable because title 4 costs will cover it but also in a way that there’s a foreseeable goal in place. As compared to what many working students who attend a community college have to see, which is five, six or seven years. We’re talking about 20 months and it’s completely online and it can be used as a way to transition into a baccalaureate degree. We don’t expect that to happen. It’s not vocational, it’s not technical, it’s not career ed.

Gary Bixby.

Great. Thanks a lot.

Operator:

Your next question comes from Mark Arrosco with Piper Jaffray.

Mark Arrosco.

Good morning. My first question is in regards to selling and promotion, yet again. You mentioned, Brian, that during the February quarter, toward the end of it perhaps, you actually increased selling and promotion and I thought you mentioned that you saw some positive impact. Could you give us a little more definition of what you saw once you turned the spigot on?

Brian Mueller, President.

Well, one of the things when we had two separate marketing departments that was a liability for us, was that each department and each side of the university was really held to specific goals. And so there was a conservative approach taken with regards to zip code areas that the ground side of our business would give to vendors in order to generate leads. In order to get the best return, they were keeping those zip code areas fairly confined, knowing that as you get a student closer to the local campus, your opportunity to start that student or convert that lead is higher. As we trained enrollment counselors to sell both the online and on ground product we got less restrictive about that and we started to expand those zip code areas and started to send to enrollment counselors leads that were further away from the local campus; knowing that we would have the online product to offer them. That helped in two ways. Number one as you expand the zip code areas you can pay less per lead and you can expand the number of leads you get; that’s where we’re seeing the greatest increase right now, especially in the newer areas of the country where we haven’t been for a longer period of time – the southeast, the Midwest and the northeast.

Mark Arrosco.

And in regards to these leads that you’ve talked about from other sources and other locations with the expanded zip code strategy, what type of conversion rates have you seen on those leads?

Brian Mueller, President.

We typically don’t release conversion rates but…the conversion rates as we’re able to evaluate it at this point are holding their own. Where we have trouble or more difficulty with conversion rate generating of leads and converting leads, is in marketplaces where we’ve been the longest; specifically California. And, that’s why we think that rolling our Axia College in the California markets will be helpful. I think it will help us generate more leads but I think it will help us significantly increase the conversion rates because a high percentage of their leads are level 1 leads.

Mark Arrosco.

Got it. The color is helpful. And on to bad debt expense. One of the things I was interested in learning is what you’re doing to actually turn the trend of bad debt expense that’s been up at elevated levels as of late, around. And, I think you mentioned by fourth quarter, perhaps early next year, we should expect that to turn but, any commentary around what you’re doing to turn that will be helpful.

Kenda Gonzales, CFO, Secretary and Treasurer.

Basically, Mark, when you look at it the bad debt expense came from one thing and that was the fact that as we rolled out Axia 18 months ago we were rolling it out very rapidly and we did not follow our normal process and got a little bit behind, in having students apply for financial aid prior to beginning their first night of class so that we knew that the financial aid money was going to come in. that really was not wholly rectified until late last summer. It has been, but we do take our bad debt reserve based on an aging of the receivable which is why we anticipate that it will run into the fourth quarter before we finally get that back under control. But it was a very specific event that caused that.

Brian Mueller, President.

And as you look back on that, had we made the decision to put Axia College under the University of Phoenix to begin with, we could have avoided that issue. Putting that entire organization together in a short period of time in order to get at that marketplace through Western international University, caused us to get – from an administrative standpoint – a little bit behind with regards to processing financial aid stuff with those new students. But I think the good news is that it’s a completely fixable problem. It’s not the result of huge percentages of Axia College students dropping as compared to students at other levels.

Mark Arrosco.

Okay and one last wrap up question. Could you review for us how many new campus openings you did in the first half of ’06 and then what your plan is in the second half and perhaps ’07 as well?

Kenda Gonzales, CFO, Secretary and Treasurer.

Our guidance is still intact at 7-9 new campuses. We opened 3 new campuses in the first quarter of fiscal ’06. We opened no campuses during the second quarter. Our anticipation is that we will open Northwest Indiana, Omaha and Harrisburg in the third quarter. Madison, WI is scheduled for late in the third/early in the fourth and then Connecticut is in the fourth quarter. And I think I missed one…Columbia, SC should be in the third quarter as well.

Mark Arrosco.

Thank you.

Operator:

Your next question comes from Jeff Silver with Harris Nesbitt.

Jeff Silver.

Thanks. Just a follow up to that. It looks like you opened up about six learning centers. Is that something we’re going to see going forward? More learning centers than full campuses?

Brian Mueller, President.

I don’t know that it will be different from what we’ve done in the past, although we’ll be opening up some of those learning centers as online only campuses. Which means we’ll put a sales staff out there and some support service but we won’t open a full-blown campus. We’ll have a physical presence in the community and we’ll be able to sell in that local community but we won’t have to make the investment of a huge classroom infrastructure and lots of administrative staff before we see significant revenues. So we think the time to profitability in those learning centers will be quicker than it’s been in the past.

Jeff Silver.

Okay. How about an update on your potential entrance into the New York market?

Kenda Gonzales, CFO, Secretary and Treasurer.

We still have our application in there. And, I know that they do have that moratorium; I’m not exactly clear on how that’s impacting our application although our application has been there for 8 years. That’s effectively a moratorium, isn’t it?

Jeff Silver.

I guess so. And just one follow up. Can you give us an update on the turnover of your enrollment counselors?

Brian Mueller, President.

It was down significantly in the first quarter and we’re maintaining that level in the second quarter. And, part of that is because of the new compensation plan. Part of that is because we are rolling out online and giving ground campus enrolment counselors a greater chance to be successful. And, we think thirdly, the implementation of the qualifying center where counselors don’t have to work through hundred of leads in order to get at students who are very interested, improves the quality of their job. So, we expect that downward trend in turnover to continue.

Jeff Silver.

Okay, great. Thank a lot.

Operator:

Your next question comes from Sara Gubin, with Merrill Lynch.

Sara Gubin.

Hi, thank you. First, can you talk a bit about how long you would expect improving lead flow to translate into better enrollment trends? How long that takes to cycles through the system? Particularly for University of Phoenix, given that it looks like UOP enrollment were down, year over year, in the quarter.

Brian Mueller, President.

It’s a 60-90 day cycle. And so the investments that we’re making now, I believe you’ll start to see toward the end of the third quarter and into the fourth quarter. That’s where we’ll start to gain some momentum; especially if we hold with our spend throughout the third quarter. The increase in leads is something that you’ll see through t he third quarter, but as we move into the fourth quarter and get good at right-pricing leads, you might see an actual decline in the number of leads, an increase in the cost per lead but also an increase in the conversion rate. As I’ve said earlier, the goal of the advertising dot come strategy is to move towards lowering cost per acquisition. We’ll continue to keep you updated on that.

Sara Gubin.

Is it fair to say that from an enrollment perspective that things are going to get worse in terms of growth before they get better?

Brian Mueller, President.

No. No.

Kenda Gonzales, CFO, Secretary and Treasurer.

But we’re not going to guide to that Sara, right now.

Sara Gubin.

Okay. Can you also talk a little about revenue-per-student trends and the impact that Axia may be having on this? And what you’re expecting in general in terms of revenue-per-student trends over the next couple of quarters?

Kenda Gonzales, CFO, Secretary and Treasurer.

Revenue per student has actually gone down, as you recognized, with the mixed shift towards the Axia students. It is a lower-priced program than the University of Phoenix program for the baccalaureate degree and the master’s degree. So we would anticipate that the revenue per student trends will continue to be flat to slightly negative over the next several quarters. We’ll start to see some improvement in those numbers as again we graduate students from Axia into the University of Phoenix.

Sara Gubin.

Okay. Then last question, when you mentioned rolling out Axia to the California market do you mean physically rolling it out, meaning having it on your on ground campuses?

Brian Mueller, President.

No, not initially. It’s going to be promoted and sold as a completely online program. Which we think it’s the right thing to do, given the characteristics of those students. What I meant is that we are training all of the enrollment counselors around the product so that if a level one student becomes a lead at one of those campuses, they’re able to offer them the opportunity to go into Axia College in an online environment. Then they would count the student there and recognize the revenue there and all of that.

Sara Gubin.

Okay. Thank you very much.

Operator:

Your next question comes from Corey Greendal with First Analysis.

Corey Greendal.

Hi, good morning. First question for Brian: could you give a little bit of insight on the extent to which the local campuses have autonomy over their S&P spend? Can they control their own hiring of their own admission reps, their own advertising? How do they spend that or how much is that determined centrally?

Brian Mueller, President.

In terms of the enrollment counselors, they’ve got…that is their responsibility. They just need to make sure that they are doing it in line with lead flow and with anticipated lead flow. So there’s a lot of communication there. But, we’re getting better at understanding that and so as we move forward we think we’ll get better at making sure that the number of enrollment counselors in a marketplace is very specific to what we are capable of from a lead generation standpoint. And, therefore make the whole process more efficient. On the advertising side, right now, the majority of our spend is on the internet. We have moved in that direction…we moved in that direction at the online campus many years ago. We became very much a leader and very successful from that standpoint. The ground campuses took on that strategy and we have now become very internet focused from the standpoint of our advertising strategy. If we can start to experience some success from the standpoint of right-pricing leads, increasing conversion rates, increasing retention rates and we start to get some traction here in the third and especially in the fourth quarter, it think what you’ll find is that we will move back into a period of time when we’re going to do more brand advertising. We’re going to provide more air support in an effort to increase the efficiency of our internet spend. But we’re not going to do that in the next number of months because we’ve got to focus on getting the enrollment trend back up.

Corey Greendal.

So I’m sorry. Is that to say that the spend is being more controlled at the local level than at the headquarters level?

Brian Mueller, President.

No. Right now it’s more controlled at the headquarters level. The majority of it is controlled there because we make the internet buy centrally. It’s a lot more efficient way to do it. But as we move forward if we can start to get some traction from an enrollment standpoint, we’ll turn some of that back over to the campuses to use local strategies from an air support standpoint that we think will be helpful.

Corey Greendal.

Okay. I understand. Thank. And just a quick follow up. Something that hasn’t been brought up for a while but, I was just wondering as you’re looking to grow your traction in the younger, not degree completion market, if domestic acquisitions are any higher on the priority list than they might have been in the past?

Brian Mueller, President.

No, I wouldn’t say that it’s gone up higher from a priority standpoint. There are things that we watch. And we evaluate things on a continuous basis. But I wouldn’t say it’s moved up from a priority standpoint.

Kenda Gonzales, CFO, Secretary and Treasurer.

And that evaluation and the way we do that hasn’t changed at all.

Corey Greendal.

So nothing?

Kenda Gonzales, CFO, Secretary and Treasurer.

No.

Corey Greendal.

Okay. Thanks very much.

Operator:

Your next question comes from Jennifer Tsao with Bear Stearns.

Jennifer Tsao.

Thanks. Brain, has the 60-90 day sales cycle changed at all? Has it always been 60-90 days? And Axia students versus University of Phoenix students, are they right in the middle of that, at the lower end…?

Brian Mueller, President.

We haven’t seen any difference in the time it takes to recruit an Axia student versus a UOP student. But remember, until we start being more aggressive about advertising specifically to an 18-24 year old marketplace, that’s probably to be expected. Right now, the students that are in Axia College are students that investigated initially about University of Phoenix; we put them there because we thought that we had a better tchance to retain them, which is true. We are not sure exactly what’s going to happen when we start to advertise more aggressively to 18-24 year old students, in terms of the time it takes to get them into the program. And so, it’s one of those things that’s a little bit of an unknown now and as we learn we’ll make whatver adjustments we need to.

Jennifer Tsao.

Thanks. And are you seeing any diminishing returns from increased marketing spending relative to previous years because of increased competition?

Brian Mueller, President.

No, and that’s the encouraging thing. We’ve only got a couple of months under our belt really, being a little bit more aggressive from an advertising standpoint. But, we haven’t seen any initial results that would say to us, we can’t get the return that we expect. Very honestly, the whole deal, the contract with advertising.com and that strategy is a strategy that we want to put ourselves in a position to get the lion’s share for a much larger percentage of the best leads that exist out there in the marketplace on a monthly basis. So…if we spent randomly and without strategy, I think maybe what you’re saying, that would be a risk. But, I don’t think that we’re doing that.

Jennifer Tsao.

Okay. Thank you.

Operator:

Your next question comes from Chris Gutek with Morgan Stanley.

Chris Gutek.

Thanks, good morning. Kenda, I’m a little confused on your comments earlier about the seasonality regarding enrollments. If I look back over the last several years, the company has always had sequential growth in enrollments. In fact,…

Kenda Gonzales, CFO, Secretary and Treasurer.

Chris, what I think I was referring to was just comparing the Axia. But, as far as not the sequential growth, that was the slowing in online.

Chris Gutek.

But in the last 3 years the highest sequential growth has always come in the fiscal second quarter. So, here we’ve actually seen a sequential decline in the fiscal second quarter. So, maybe could you just talk about the seasonality? Obviously your business model is less seasonal vs. some competitors. (inaudible) the second quarter has been seasonally strong, not seasonally weak.

Brian Mueller, President.

Seasonally, we have always reached an apex in the months of March and October.

Kenda Gonzales, CFO, Secretary and Treasurer.

Right, which wouldn’t be in the 2nd quarter.

Brian Mueller, President.

So from a total enrollment standpoint, and from a revenue standpoint, March and October have always been our strongest months and then we’ve gone into decline as we’ve moved toward the summer and moved toward the holiday season.

Kenda Gonzales, CFO, Secretary and Treasurer.

But I think that also, and this is something that’s important, University of Phoenix online has the same seasonal trends and has had the same seasonal trends as University of Phoenix. But, it was growing so rapidly that it was masking those trends, just because of the sheer volume. The trends were still there, but they weren’t as apparent because of the sheer volume in the growth of the acceptance in online education through that period.

Chris Gutek.

Right. Okay. Just to be clear though, the sequential growth has always been highest in the fiscal second quarter. So, I’ll just toss that out there. Secondly, if you look at the significant deceleration in sequential growth we’ve seen in the last couple of quarters, given the multi-year duration of the average educational program, that wouldn’t seem to be explained by a drop off in marketing spending over the last couple of months. It would seem to also indicate, potentially, a significant increase in attrition of students. Am I missing something there? Or, is it just a sharp drop off in new starts?

Brian Mueller, President.

No. it is really a sharp drop off, a fairly drop off in spending, in advertising at the end of the quarter – for really about five quarters in a row. And the accumulated effect of that has caused us to reach what we think is our low point, in this quarter.

Chris Gutek.

Okay. A couple of quick follow ups. So, Brian, you’d mentioned before you thought the operating margins longer term to hold at relatively near historic levels. What is the thinking on the gross margin? Obviously gross margin has been declining. Is that expected to continue or do you think that will stabilize soon?

Kenda Gonzales, CFO, Secretary and Treasurer.

Well the gross margin is declining because of the bad debt. And I think we’ve already made our comments on that.

Chris Gutek.

Okay. And then finally real quick, so the severance costs for Todd Nelson were a bit less than you previously told us to expect. And, it sounds like some of that flowed directly to shareholders’ equity?

Kenda Gonzales, CFO, Secretary and Treasurer.

Right, exactly.

Chris Gutek.

Why did that happen?

Kenda Gonzales, CFO, Secretary and Treasurer.

Why did that happen? Because of the accounting for stock options under FAZ123R.

Chris Gutek.

Okay. Great. Thanks.

Operator:

Your next question comes from Trey Cowan with Stanford Group.

Trey Cowan.

Thanks for taking the call. I guess I’m a little dense here, but maybe you call can help me out. Whenever you look at the advertising.com strategy, how has that relationship changed vs. what you were previously doing with advertising.com?

Brian Mueller, President.

Previously, advertising.com was one of our vendors and it was one of forty principal vendors and then there were thousands of affiliates under those forty, what we referred to as main partners. The relationship that we have with them now is that they’re an exclusive partner of ours in the edu space, which mean’s they’re not doing business with any other edu vendor. And, it means that all of our major partners and all of their affiliates in order to do business with us in the future, have to put their leads through advertising.com’s technology. This makes then, everything that they know about those leads, transparent to ad.com and to us. In the past those partners and the affiliates had all of the information. So, as we would negotiate lead costs and as we would negotiate lead amounts, we were doing it with very much a deficit of information; which made the whole process very inefficient on our end and made the process very manipulative on their end. Once all of the information, and we believe everybody will still want to do business with us because we have a large spend out there… once all those leads go through ad.com’s technology so we know where the lead originated, at what time of day or night, what the creative was, what the click-through rates and the conversion rates are on that property or with that key word, at that point we can begin working with vendors to right-price leads. And so, for a good vendor who has good properties with good messages, with good landing pages, with good conversion rates, we’ll actually increase our cost-per-lead with them and try to garner all the leads from that particular site, not just maybe 25% of them.

Trey Cowan.

Okay. And then if I’m looking backwards, can you sort of help me through what the strategy was as far as not spending as much in the third month of the quarter, in the last few quarters?

Brian Mueller, President.

The bottom line.

Trey Cowan.

Okay. And can I ask just one more question? If you’re looking out into the future, I believe you’re going to replace you’re open text system as far as your imaging that you do, as far as managing your student files and what not. Can you tell me what the timeframe is on that and what you expect to accomplish by changing out that system?

Kenda Gonzales, CFO, Secretary and Treasurer.

I don’t even k now about that.

Brian Mueller, President.

There are discussion around that. I don’t have the details.

Kenda Gonzales, CFO, Secretary and Treasurer.

I don’t think anything’s been finalized there.

Trey Cowan.

Thank you.

Operator:

Your next question comes from Bob Craig with Stifel Nicholas.

Bob Craig.

A couple of questions for you. And if you’ve said this and I missed it, I apologize. Have you received all requisite regulatory approvals to fold Axia into UOP?

Kenda Gonzales, CFO, Secretary and Treasurer.

Actually I believe that the state of Arizona is meeting today on the final one.

Bob Craig.

But that’s it? Everything else is all set?

Kenda Gonzales, CFO, Secretary and Treasurer.

I believe so, yeah.

Bob Craig.

Okay. And when you ramp up spending on the 18-24 year old market, you are going to do so under the name Axia College as opposed to just ultimately layering associate degrees under the University of Phoenix and maximizing the University of Phoenix brand name. is that correct?

Brian Mueller, President.

We will be promoting it as Axia College of the University of Phoenix. And so, University of Phoenix, that name will definitely be attached to Axia College but we do have separate promotional material. We have a separate website that we will be moving those students to that we think that they will better relate to.

Bob Craig.

Okay. So the current plan is to then definitely use and build the Axia brand name.

Brian Mueller, President.

Yes, we want to build the Axia brand name as part of the University of Phoenix.

Bob Craig.

Will there be any coming transitional period when you will essentially hold off enrolling or starting students into Axia under the western umbrella, vs. the University of Phoenix umbrella? Does that in any way, or will that in any way be part and parcel of hindering revenue growth in the third quarter?

Brian Mueller, President.

No.

Bob Craig.

Okay. One last question for you. As far as the enrollment advisor compensation expense increase of 21% year to year, can you give any indication of the breakdown essentially between wage growth vs. recruiter growth? I take it the majority would be wages as opposed to recruiters but…

Brian Mueller, President.

It is wages. Wages of recruiters as opposed to advertising, is that what you meant?

Bob Craig.

Exactly. Volume vs. price, in other words.

Brian Mueller, President.

I’m confused, I’m sorry.

Bob Craig.

The number of additional enrolment advisors vs. the wage growth and the compensation plan changes.

Brian Mueller, President.

Oh, thank you. It’s a combination of those. And, I don’t have the exact breakout of that, but it’s a combination. We’re definitely hiring more people in areas where we believe we have a lot of strength from a lead growth standpoint. But, a certain percentage also relates to the fact that we are, on average, paying enrollment counselors more than we did a year ago.

Bob Craig.

Okay, great. And then one last one. Have there been any other significant management changes, and/or are there any open positions that you’re currently looking to fill?

Kenda Gonzales, CFO, Secretary and Treasurer.

The only other management change was that as we brought the IT department together, significant management changes, as we brought the IT departments together we had a lot of duplication. And, Bob Carroll has left our organization and Jill Miltonhall has assumed the role of Vice President of information technology.

Bob Craig.

Okay, great. That’s helpful. Thanks.

Operator:

Your next question comes from Greg Capelli, with Credit Suisse.

Greg Capelli.

Two quick ones. Just thiking back about your comments Brian about the core and then the holiday issue. I’m wondering if you can give us a little bit more color, how much of the weak enrollments this quarter were due to attritions of students who didn’t come back after December vs. the weak new starts due to the advertising isseues. I guess originally you guys had a goal of around 15% and when I look at the shortfall vs. that…give us some idea of how much of that is attrition vs. new student related.

Brian Mueller, President.

A higher percentage of that would e as a result of new slaes vs. the attrition. Most of the attrition that happened was a one-time event in December. I don’t know exactly at this point what percentage of those students we didn’t get back at all, because we’re still trying to get some of them back. But the vast majority of them returned in January and February so, a little bit of the student shortfall has to do with that, but the biggest majority has to do with the lack of advertising leads and therefore new starts.

Greg Capelli.

Okay, that’s helpful. And then in terms of Axia and campuses, have you given any thought to just accelerating the rollout there across the country in terms of getting Axia in sooner? And if not, why not?

Brian Mueller, President.

Yes, we have. We moved much more aggressively in California where we think we have the biggest opportunity. Initially I said we were thinking about starting specific Axia advertising in the fourth quarter, June or July in preparation for august, but we’ve moved that up to May. And so you can expect, now that we have the whole online part of it done, we’ll get more aggressive with expanding that Axia College program throughout the country.

Greg Capelli.

Okay. Just one more quick one. When you think about that being an important period or quarter for you having a better understanding of the continuation rates of students from Axia to UOP, are we looking at a number north of 10,000-15,000 students that you’ll have in your database that will be used to do an analysis on that by the fourth quarter?

Brian Mueller, President.

No, it won’t be north of 10,000. it will be probably…I can’t tell you. But it won’t be at 10,000 or north of it, it will be under that.

Greg Capelli.

Okay. That’s helpful. Brian, is there any change in your thinking on share repurchases?

Kenda Gonzales, CFO, Secretary and Treasurer.

We have a board meeting tomorrow and will be discussing that with the board.

Greg Capelli.

Great. Thanks guys.

Operator:

Your next question comes from Howard Block with Bank of America Securities.

Howard Block.

Thank you operator. The question is Brian, what’s hard to reconcile is I guess your large and growing appetite for leads with your expectation of being able to right-price them. What gives you any confidence that you’re going to be able to right-price while you’re asking for more? Years ago, when you were building online success, you were virtually a monopoly, and now that’s no longer the case. I’m just wondering where you’re going to get that leverage form.

Brian Mueller, President.

That’s a good question and it’s a big reason why we did this. You can read lots of reports out there that typically people are expecting internet advertising space to go up between ten and fifteen percent next year. For a smaller player, that’s a significant problem. For a larger player that has an exclusive relationship with the largest internet network in the world and their ability to buy properties out 12-18 months, that puts us in an advantageous position. The fact that 20% of their business or less is in the edu space, allows them again to buy space out far in advance, as much as 12-18 months. And if we find that there are properties that are not good from an edu standpoint, they’re able to sell that to the other people that they do business with in different industries. So that was a big part of why we think that relationship puts us … number one, we’ve got the technology and so we can do all of the intelligence on the leads and have all of that intelligence and secondly it gives us an advantage from the standpoint of buying advertising space.

Howard Block.

Okay. So then I would guess if there is a little bit of limitation on the inventory and you’re getting some more exclusive on this is, bad news for the other buyers?

Brian Mueller, President.

I hope so.

Howard Block.

And then, again, on the web analytics piece that you’re excited about with advertising; isn’t it arguable that what their web analytics is really going to do is just rev and improve the quality of the leads, which they’re not necessarily generating exclusively; it’s just going to increase the information on the bad leads?

Brian Mueller, President.

Well, it helps tremendously from a couple of standpoints. Number one, once you find out where the good leads come from, you’re going to get some sense for how many good leads are available there. And if we want to temporarily increase the amount we’re willing to pay for those good leads to keep them out of the hands of our competition, we’ll actually be willing to do that. That’s part of the strategy. And so, that puts us in an advantageous position. But then separately, there are lots of leads out there, referred to as co-reg leads, which aren’t eh greatest leads and make the enrollment counselors’ jobs very inefficient. However, we will have one of the countries largest qualifying centers. And, because we’re running all those leads through that qualifying center, we will only be sending to enrollment counselors leads that we can hot transfer. Which means that we’ve gotten voice-to-voice contact with them. Does that mean we could go out there and purchase 100,000 co-reg leads in a month and pay $5 for them? It does because we’ll run them through the qualifying center and we’ll only transfer them to an enrolment counselor if we’ve made voice to voice contact and we know then that we’ve got a lead that might convert at 15-20%.

Howard Block.

Very helpful. Thank you.

Operator:

Your next question comes from Kelly Flynn with UBS.

Kelly Flynn.

Thanks for taking another one. Back to the margin issue. On Axia, can you talk about that issue, if you look out a year or so, where does the Axia gross margin shake out relative to the UOP gross margin? And, where does the operating margin shake out, relatively, as well? And then, maybe give a little detail on bad debt on a normalized basis for Axia students, relative to UOP. It would seem, given maybe the income profile of those students on average that it might be a little bit higher.

Kenda Gonzales, CFO, Secretary and Treasurer.

Let me take that part of it, the last part first. And that is, the income profile of those students. The way the Axia program is priced, as Brian mentioned earlier, allows the Title 4 funding to cover 100% of that tuition. So, frankly, we’re not lending to the students directly. So the income profile of those students really has no impact on our bad debt. As far as going out with what a normalized level would be, I would anticipate that we would return to close to historical UOP levels with the bad debt at Axia and at UOP so that those (inaudible). That’s really where it becomes a little bit tougher. The students will know in the fourth quarter how the students are going to behave. But if the students move on into the UOP baccalaureate program, we’re not going to have to pay to recruit that student to continue the program.

Brian Mueller, President.

Let me also say that if you look at it just from the standpoint of the operational margin and the UOP online, and I think I said this last conference call, we’ve done a number of studies but there’s no question that revenue per student per week goes down because of the lower tuition rate. But, if you take groups of students that started under the UOP model and those tuition rates and Axia College students under that model, the revenue per student per year is actually greater under the Axia model because the retention rate is higher. So, if you look, for example, because we’ve had Axia College at UOP online since ’04 September, if you look at the operating margin of UOP online, even though a huge percentage of those students are now in Axia College, there hasn’t been a degradation of that operating margin at the campus.

Kelly Flynn.

So what’s the answer on the gross margin? Do you think its going to be comparable and therefore that’s why the operating margin is? It sounds like that’s what you’re saying.

Brian Mueller, President.

I think yes. But, I think a big part of it has to do with what we eventually find out about the percentage of students that transfer into the UOP.

Kelly Flynn.

Okay. Fair enough. Thank you.

Operator:

Your next question comes from Mark Hughes with Sun Trust.

Mark Hughes.

Thank you very much. Could you give us a sense of what the absolute level of lead flow was year over year in the quarter? Your advertising costs were down a bit, but can you say anything about lead flow itself?

Brian Mueller, President.

We haven’t historically given that information in terms of lead flow. But we’ve made some gains on a cost per lead basis and so what you could ascertain from that is that the cost, we spent less but it didn’t all go to a direct level, the same percentage of leads. So there was a reduction in leads but not commensurate with the amount of money that we spent.

Mark Hughes.

Right. Then, could you talk about the productivity of the enrollment counselors. You suggested that the volume of counselors up year over year…how was their productivity in the quarter as lead volume was down, but they were up? Could you talk about that dynamic?

Brian Mueller, President.

There wasn’t a depreciation of their productivity but there wasn’t an acceleration of their productivity, and that’s what we’re looking for.

Mark Hughes.

Right. Now if you bump up the lead volume but there’s not an acceleration in productivity, is that going to lead to an acceleration in enrollments?

Brian Mueller, President.

If we bump up the spend and we don’t get the commensurate return, then that’s not going to be a good sign. But early indications are that it’s not going to happen. You’re right. There’s a limit, ultimately, to where this thing can go. I don’t have any idea as we sit here today, what that limit is. But, we haven’t seen at this point in time a negative response to that increased spend. And, very honestly, at some point if we’re successful in right-pricing leads, some of that increase in spend and therefore the increase in productivity that we hope to see, is going to be at the expense of some of our competition.

Mark Hughes.

Right. Presumably the enrollment counselors, there wasn’t any vital time during the quarter – they were all busy and as productive as possible?

Brian Mueller, President.

Yes.

Kenda Gonzales, CFO, Secretary and Treasurer.

Operator, we have time for just one more question. We’ve already gone about 10 minutes over. So the next question in the cue will be our last one.

Operator:

Your last question comes from Gary Bixby with Lehman Brothers.

Gary Bixby.

Hi guys. Just one follow up question. I understand the opportunity to track the larger addressable market by rolling out the reps at the campuses to sell Axia, but don’t you fear to a certain extent that there could be further make-shift issues like you’ve had in online? Like I don’t know if you realized after the fact or somehow it turned out that half the leads coming in the door were a better fit for Axia? So, couldn’t we have this continued pressure on your revenues and margins for several quarters more than it would if you didn’t sell it as aggressively on the campuses?

Brian Mueller, President.

That’s a good question. You’re right in asking that question. But remember that we’ve already taken the biggest hit. Our online campus is 60% of the UOP. The online campus has the highest tuition rate and the differential between that rate and the Axia College rate is the greatest and that’s your biggest risk. All level 1, level 2 students at Axia College online are in Axia College now. So, we’ve taken the biggest hit on that. As we roll it out now, we’ll be rolling it out campus by campus, so not all at the same time. And, we’ll be rolling it out to campuses whose tuition rates are closer to the Axis college tuition rates. So, the risk is not nearly as great because we’re rolling it out gradually and the tuition rates are closer, especially in the middle parts of the country.

Gary Bixby.

Okay. Thanks a lot.

Brian Mueller, President.

Thanks a lot everyone. See you next quarter.

Operator:

This concludes today’s conference call. Thank you for your participation. You may now disconnect.

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