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K12 Inc. (NYSE:LRN)

Q4 2008 Earnings Call

September 9, 2008 8:30 am ET

Executives

Keith Haas – IR

Ron Packard – CEO

John Baule – COO & CFO

Analysts

Sara Gubins – Merrill Lynch

Kelly Flynn – Credit Suisse

Suzi Stein – Morgan Stanley

Jeff Silber – BMO Capital Markets

Amy Junker – Robert W. Baird

[Charles Neun] – Neuberger

Operator

Good day ladies and gentlemen. Welcome to the fourth quarter and full year 2008 K12 Inc. earnings conference call. (Operator instructions) I would now like to turn the presentation over to your host for today's call Mr. Keith Haas, Vice President of Financial Planning and Investor Relations; please proceed, sir.

Keith Haas

Good morning and welcome to the K12 fourth quarter and full year 2008 earnings conference call. Before we begin the company would like to remind you that statements made during this conference call and that are not historical facts may be considered forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties that could cause actual events or results to differ materially from those expressed or implied.

In addition this conference call contains time sensitive information that reflects management's best analysis only as of the date of this live call. K12 does not undertake any obligation to publically update or revise any forward-looking statements. For further information concerning issues that could materially affect financial performance related to forward-looking statements, please refer to K12's Form 10-Q filings and other related company documents filed with the SEC on the Investor Relations section of our web site www.k12.com.

In addition to disclosing 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 yesterday, and is also posted on the Investor Relations section of our web site. This call is open to the public and is being webcast simultaneously on our web site, and will be available for replay there for 60 days.

With me on today's call are Ron Packard, Founder and Chief Executive Officer, and John Baule, Chief Operating Officer and Chief Financial Officer. Following our prepared remarks we will answer any questions you may have. I will now turn the call over to Ron Packard.

Ron Packard

Good morning and welcome to K12’s fiscal year 2008 earnings call. Obviously we are very pleased with our financial results for the year and also with our business development success. The concept of virtual education is becoming more accepted in the United States and around the globe which positions us well for continued growth.

As this market grows, K12 plans to expand its share by continuing to invest in educational quality, hiring great people with a passion for education and improving student recruitment. We ended the year with revenue of $226 million, an increase of 61% over last year and EBITDA of $25.6 million; more than double last year’s amount.

These results were fueled primarily by an increase in enrollments in existing states. As many of our customers originate from referrals, we believe our high customer satisfaction contributed to the strong same-state growth.

The fact that same-state growth remains strong bodes well for the future. We were also pleased that EBITDA more than doubled as our operating model begins to scale. We will continue to work hard as our business grows to focus on the cost side as well as the revenue side and improve our operating leverage.

In addition to existing state growth we continue to add new states. Not only is that important to K12 from a financial aspect but is also necessary for the fulfillment of our mission; to make our world class curriculum and instruction available to every child who wants access to it regardless of their location or economic status.

During the past six months, we have entered into long-term contracts to serve virtual public schools in four new states: Oregon, South Carolina, Indiana, and Hawaii. In Indiana, we are opening hybrid schools in Indianapolis and Muncie similar to the one we now operate in Chicago.

Our existing state-wide virtual school partner in Minnesota also recently added our high school program. Overall this brings us to 21 states in which we are able to serve public school students in K12- managed public schools.

We are pleased with the pace at which we have been able to open new states this year which is faster then we had contemplated six months ago. We hope this is the beginning of a trend as public virtual schools become more accepted and are seen as a positive educational choice for states as they provide good results for children and are a vale to the tax payer as they are generally funded at a lower per-pupil rate then the traditional brick-and-mortar public schools.

Beyond strong same-state performance and new states our growth was also aided by our high school expansion. We are now at the stage where almost all of the courses for our high school program are proprietary. This will create a more cohesive and relevant experience for a wider range of high school students.

Over the last year we continued to develop new proprietary courses for high school as well as replace licensed courses. As a result our high school catalogue has grown to over 160 semester courses; over three times the number that a four-year high school student would typically take.

This provides the virtual high school student with more flexibility and choice then a traditional high school. We recognize that high school consists of more than courses, towards that end we have added a number of tools and social activities that differentiate our offering and ultimately provide our high school students with a superior experience and education.

At the same time we are proceeding with our international expansion initiative. In January we opened the K12 International Academy; a fully accredited tuition-based online private school which serves students in the US and throughout the world.

We have already enrolled students from 18 different countries. This is a school that allows students from all over the world to access K12’s outstanding curriculum, systems and teaching practices. While we do not expect these international operations to have a material impact on our revenue in fiscal year 2009, we believe that we are planting a seed which will generate long-term growth.

With K12’s rapid growth and continued desire for innovation we sometimes have growing pains or initiate pilots that do not provide the desired results. Recently concerns were raised in internet blogs about our outsourcing and essay reviews to a corporation in India. K12 did initiate such a pilot but we have discontinued this teacher-assistance program and it is no longer offered at any of the virtual public schools we serve.

This essay review service was not outsourcing designed to replace teachers but an extra cost K12 incurred to allow students to have more frequent feedback on their essay drafts and thus become better writers.

Despite occasional glitches like this we will continue to innovate and experiment through various pilots as a means for improving the student learning experience.

Fast growth is often accompanied by some minor disruptions. The new state opening and rapid in-state growth have caused some issues in our material supply chain but those have either been remedied or being resolved. We have also experienced some system downtime in the first few days of school as we have absorbed the large increase in students.

We are looking forward to the coming year and extremely pleased with the large demand for our products and services. We expect revenues to exceed $300 million for the fiscal year 2009. This increase in revenue will be driven primarily by enrollment growth as per-pupil revenue will go up only slightly.

We are particularly happy to see that existing states continue to grow rapidly and are also pleased to be adding new states. We anticipate that operating margins will improve by 1% to 2% over the fiscal year 2008. While operating leverage is increasing faster than we anticipated and we could potentially expand margins more, we are not committing to do that at this point because we plan to invest in both student growth and educational quality which should help us see share.

The growth we are currently experiencing leads us to believe that we can continue to expand the business at high rates and we do not intend to miss this opportunity. We believe seizing this opportunity is the best way to build long-term shareholder value.

All children deserve an outstanding education and K12 intends to deliver it to as many students as possible.

To provide you with more color I will turn it over to John Baule to walk you through the fourth quarter and year end financial results.

John Baule

Thanks Ron, I’d like to spend a little time providing a wrap-up of the full year 2008 results, first though let me provide a few of the highlights for the fourth quarter.

Revenue for the fourth quarter was $56.5 million, an increase of 59% over the same quarter in 2007. From an earnings standpoint we had a loss from operations of $700,000 for the quarter largely attributable to increased selling costs to drive enrollments for the upcoming school year.

This compares with a loss of $4.2 million in the fourth quarter last year. EBITDA for the fourth quarter was positive $3 million, compared with a negative $1.4 million last year.

During the fourth quarter based on the determination that it was likely that the company would have sufficient future profitability to utilize our cumulative net operating losses, we reversed the valuation allowance that we were maintaining on our deferred tax assets. The result of this was a one-time tax benefit in the fourth quarter of $17.3 million.

As a result net income for the quarter on a GAAP basis was $17.1 million. Excluding this tax benefit we would have had a net loss for the fourth quarter of $200,000 and a net loss per share of $0.01.

Now let me turn to the full year results for fiscal 2008, in aggregate this was a stellar year for K12. For the year ended June 30, 2008 revenues increased by 61% to $226 million compared with $141 million in fiscal 2007.

This growth in revenues was driven by strong enrollment performance as well as an increase in the percentage of enrollments associated with managed schools to 82%, up from 76.9% in the prior year. Average enrollments for the year were 40,859, an increase of 51% over the previous year.

The growth in enrollments was the result of both growth in new states and continued growth in our existing states. For the year, enrollments in states where we have been operating for more than one year grew 40% over the prior year while new states opened in 2008 contributed 11% to the overall enrollment growth.

EBITDA for the full year more than doubled to $25.6 million from only $12.1 million in fiscal 2007. EBITDA margins increased from 8.6% in fiscal 2007 to 11.3% in fiscal 2008, a 270 basis point improvement.

Operating income increased to $13 million, up 176% compared with the prior year operating income of $4.7 million. As a percentage of revenues operating margins increased by 240 basis points to 5.8% of revenues. This increase was attributable to additional leverage gained on our corporate and product development infrastructure.

From a percentage of revenue standpoint we gained 540 basis points on the selling and administrative line of the P&L and 190 basis points on the product development line. These gains were offset by a 390 basis point increase in instructional costs and services as a percentage of revenues reflecting the higher per-student costs associated with our high school offerings which have not yet attained scale and also with the increase in percentage of enrollments associated with managed schools.

Net income for fiscal 2008 on a GAAP basis was $33.8 million. This figure includes a one-time tax benefit of $27 million related to the aforementioned reversal of the deferred tax asset valuation allowance. If you exclude that item net income would have been $6.3 million for fiscal 2008 compared with net income of $3.9 million in fiscal 2007.

Our book tax rate for the year was 46.6% and excluding the one-time tax benefit book taxes would have been $5.9 million. Diluted net income per share on a pro forma was $0.26. This assumes the conversion of preferred stock at the beginning of fiscal 2008 and excludes the one-time tax benefit. On a GAAP basis diluted net income per share was $1.10.

With regard to fiscal 2009, as most of you know we enroll the majority of our students in the first quarter of our fiscal year; the quarter which ends on September 30th. Accordingly we will provide annual revenue and earnings guidance for fiscal year 2009 when we report on our first quarter in November.

As Ron mentioned we expect revenues to at least exceed $300 million for the full year 2009. We also anticipate that operating margins will improve by 1% to 2% over fiscal 2008 as we balance our margin goals with the opportunity to drive additional revenues. And again, I will provide you with a more detailed outlook in November with regard to both revenues and earnings.

And with that I’ll turn it back over to Ron.

Ron Packard

Thank you John, in summary we have enjoyed our first year as a public company and we are looking forward to the upcoming year. I would like to thank all of the investors who believed in our mission and invested in K12.

We will continue to work hard, strive to deliver value and most importantly provide a great public educational choice to families in need. Now we will be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Sara Gubins – Merrill Lynch

Sara Gubins – Merrill Lynch

Could you talk a bit about your plans for marketing spend to drive enrollment in the fall and presumably beyond and also just about the seasonality of this?

Ron Packard

Well the seasonality of it—we start, the fourth quarter obviously has heavy marketing spend and as does the first as we’re recruiting for the fall school year, so all the spend for what this current year is primarily was included in the fourth quarter results that we just presented today. We continue to see large growth opportunities in our core business in existing states and we plan to take advantage of those opportunities by doing heavy student recruiting.

Sara Gubins – Merrill Lynch

Any update on what referral rates are like at this point?

Ron Packard

What I’ll say to that is referral rates have not decreased at all and we actually are seeing an uptick in the referral rates. So it’s still a significant source of student growth.

Sara Gubins – Merrill Lynch

You mentioned in your prepared remarks that there have been some issues in the material supply chain and some system downtime in the first couple of days of school, could you provide some more detail on that and also I think it was last first quarter where there was a gross margin hit because enrollment came in better than expected and so therefore you had to get materials more towards the last minute, was that an issue at all in this quarter, was that part of the problem with the supply chain?

Ron Packard

The large growth—when companies are growing at the rate that K12 is, when you’re trying to project growth, you’re not always perfect on that and there were some issues getting all of the customers or materials as fast as we would like to get them. Those have largely been resolved or are being resolved. We’re not expecting a major hit financially because of that.

The system downtime is something—you can bench test the system as much as possible but until you actually hit it with a heavy load, you don’t necessarily have all of the little glitches out. We believe those have also been resolved. We had about eight to 10 hours of downtime over the whole cumulative launch over the last three or four weeks so we’re not talking about a major issue but I want to make everybody aware of it.

John Baule

One thing I would say to the other question, if you were looking at the first quarter of last year, I differentiated the two situations because the first quarter of last year was more we didn’t have enough inventory to supply the big enrollment surge that we saw. This year we have the inventory, there’s so much going out, that it’s taking us longer to get them in the boxes and ship it out.

Sara Gubins – Merrill Lynch

I’m wondering if that impacts the revenue recognition for it during the first quarter, if some of that would kind of move into the second quarter.

John Baule

No I don’t think that’s going to have much impact at all because what we’re talking about is a few days around the start of school when all our schools start well before the end of the first quarter.

Sara Gubins – Merrill Lynch

Can you give us an update on how big high school enrollment is as a percentage of your total for the fourth quarter?

John Baule

For the year, I think it was approximately 14% of our enrollments were in high school.

Operator

Your next question comes from the line of Kelly Flynn – Credit Suisse

Kelly Flynn – Credit Suisse

On the $300 million minimum revenue target can you give us a sense; I recognize you don’t want to give a lot of detail, any sense of what the assumptions are for enrollments from new states versus same-state?

John Baule

I think all we factored in are the enrollments for the four new states that you--

Kelly Flynn – Credit Suisse

But if you look at the press releases and things that have been put out by either you guys or the states, it looks like about 2,000 students, is that right?

Ron Packard

I don’t think that’s far off. We’ll give a lot more clarity on that in the November call, but let me say this, same store sales growth was strong and obviously the bulk of that increase is being driven by that.

Kelly Flynn – Credit Suisse

Given the seasonality in the business would you be willing to give us any help with earnings guidance for the first quarter to avoid the huge range of estimates out there?

John Baule

I’m going to keep staying away from quarterly guidance because I’ve been saying all along, I really think thinking about our business on a full year basis is the way to do it and I know once I kind of start that on the quarters, it’s a slippery slope downward.

Kelly Flynn – Credit Suisse

On state funding you implied a bit of what you’re seeing in the guidance comments, could you get more specific on how the economy is impacting state funding levels and you’ve mentioned California and Florida in the past, could you give an update on those and on any other states where you might be seeing a significant change?

Ron Packard

I don’t think we’re seeing a significant change in anywhere other then Florida. I think some states with tight fiscal budgets you see a smaller increase then you would in normal years in terms of per-pupil funding we receive. Florida is a specific case where the school is actually a line item in the state budget and therefore more vulnerable shall we say, so Florida will have decreased revenue for the year relative to this past.

But because Florida is only 950 students and a very, very small part of K12’s overall revenue we don’t think the impact of what happens in Florida is going to be material to our overall results. The other states were just a little less then typical perhaps but nothing far from normal.

Kelly Flynn – Credit Suisse

Should we use the 40% tax rate in 2009?

John Baule

We’re going to give guidance on that when we do the first quarter because of the provision, but that seems—46.6% was the rate this year; I would think 40% would seem a little bit aggressive.

Operator

Your next question comes from the line of Suzi Stein – Morgan Stanley

Suzi Stein – Morgan Stanley

I just want to clarify on the high school development of curriculum, you gave some numbers, so you can talk on a percentage basis about how complete that is and how much more development you have to go on that end?

John Baule

I’ll just start off by saying last year we had said that approximately 60% of the courses we deliver via high school were proprietary with the remainder being licensed courses. This year we anticipate that the percentage of courses that are proprietary will be above 90%. So the core offering I think is fair to say is complete.

Ron Packard

That’s by course enrollments not by number of courses. High schools can continually have more and more electives and a lot of those that serve a small number of kids may never be K12 proprietary for that matter, but all of the courses that comprise the bulk of the actual student enrollments are already K12 proprietary as of this year.

Suzi Stein – Morgan Stanley

Looking ahead, what are you doing to manage your inventory and demand a little better for next year now that you have a couple of more years behind you of overwhelming demand, I guess it’s a high class problem to have, but what are you doing to manage that better?

John Baule

This year it wasn’t so much that—this year we solved the inventory problem; we had plenty of inventory. Our problem is shipping it out. What we did this year was we switched to a new logistics vendor to be able to scale up even faster. So I think we’re going to see a lot of productivity on that going forward.

Operator

Your next question comes from the line of Jeff Silber – BMO Capital Markets

Jeff Silber – BMO Capital Markets

On enrollment for the current fiscal year, fiscal year 2009, I know you’re not giving specific guidance right now, but in terms of the mix between managed schools and non-managed schools, should it be fairly comparable to what we saw in fiscal year 2008?

John Baule

I think it’s safe to say it’s definitely, its going to probably increase a little bit just because when we do add these fully managed schools they tend to grow much more rapidly.

Jeff Silber – BMO Capital Markets

And that will have the accompanying impact on gross margins, correct?

John Baule

Yes, that will have an impact on the margins.

Jeff Silber – BMO Capital Markets

And again I know you’re not giving specific quarterly guidance, but looking back to last quarter the implied guidance for 4Q 2008 revenues would have been down somewhat from the third quarter, that did not happen. Can you tell us why and also should we expect the same type of seasonality in terms of revenues for fiscal year 2009?

John Baule

I think the primary reason is that when we—that’s why I kind of say all the time that you’ve got to think about our business on a full year basis because our students are funded at an annual per enrollment funding level, and what happens is we make estimates during the quarter of the full year revenues and the full expenses of the schools that we operate and all those estimates get trued-up at the end of the year.

Sometimes they’ll balance off each other and you’ll come out exactly where we forecast and sometimes you’ll have been conservative a little more then you were non-conservative and you’ll end up where we are which is a little better revenue in the quarter then we’d expected.

Jeff Silber – BMO Capital Markets

On the system downtime issues, are there any funding issues related to that? What I mean by that do certain states require a certain number of minimum hours and because of this issue some of the funding may be at risk?

Ron Packard

No we don’t anticipate—again this downtime was very little. It’s basically a blip in the radar screen. But obviously we want to be up 100% of the time. To even have an hour to us is a lot. So but no, we don’t anticipate that.

Operator

Your next question comes from the line of Amy Junker – Robert W. Baird

Amy Junker – Robert W. Baird

If I could just touch again on the gross margin, for the full year as we think about that, as high school continues to ramp as a percentage of total revenue would you expect that to be down again year-over-year just as that grows and as managed schools ramp up as a percentage of the total? Should we expect continued contraction there or could we see some leverage in that line item?

John Baule

I think we’re going to give more detailed guidance on that for the year, at least with operating margins when we do the next quarter call. It’s hard to say at this point. I think what we’ve said all along is that we think over time our high school margins will improve and approximate our [K through eight] but whether that happens next year or longer term, we’re not sure yet.

Amy Junker – Robert W. Baird

On some of the states that you have caps in, Texas recently doubled its cap, what do you think is the potential for other states and I think you’re in maybe seven that have caps right now not including South Carolina and the newer states, but to move those caps up, are you seeing an increased willingness from the states to broaden those up?

Ron Packard

As I mentioned, its hard for me to comment on the likelihood of political processes happening and that’s why we don’t build any new states into our models, but I will say is we’re working very hard to try to continually expand those caps and I think the fact that the schools represent a good bargain to tax payers they offer a great choice for every single family in those states and is often the only policy change that a state can make that will actually give every family in that state a choice, we’re obviously optimistic enough to keep working at this and I believe over time we’ll have success there but its hard for me to predict exactly how much and when.

Amy Junker – Robert W. Baird

On the newer states that you’ve been approved in, South Carolina, Hawaii, Oregon, Indiana, those all have caps on them, can you share a little bit with how those typically ramp, I assume and I know it varies state by state, but I assume there’s some pent-up demand. Is it fair to say you typically reach those caps relatively quickly because of the demand that’s there?

Ron Packard

That’s a very safe assumption in the sense that we don’t have any, I believe, schools with caps [inaudible] have enrollment. We fill those up very quickly so there is pent up demand. There are large waiting lists in almost every place in which we have a cap. So the demand is not the issue. In fact having a large waiting list is helpful as we try to expand the cap.

Operator

Your next question is a follow-up from the line of Sara Gubins – Merrill Lynch

Sara Gubins – Merrill Lynch

When do you expect to pay cash taxes, what year?

John Baule

I couldn’t tell you that without giving you a forecast for the earnings, but its not next year.

Sara Gubins – Merrill Lynch

To the extent that you can talk about it, I’m wondering about you’re expectations or the potential impact of the Presidential elections on your operations and an ability to expand?

Ron Packard

Well our business expansion is driven a lot much more by local state politics then it is by national politics so we don’t have any opinion on the Presidential election and how it will affect our business. Most of our growth will come from existing state growth and we’re going to continue to drive that. I think this is not a partisan issue. Education should not be a partisan issue and we believe we can work successfully in any environment.

Operator

Your final question comes from the line of [Charles Neun] - Neuberger

[Charles Neun] - Neuberger

How have you changed your marketing strategy this year given the strength of the referrals and then can you give us an update on the school in Dubai?

Ron Packard

I don’t think we went through any change in marketing strategy, I think we’re getting constantly more and more sophisticated on how we employ the tactics, but essentially I think our strategy is essentially the same. We’re just getting better at is as we get more sophisticated which is I think true of every part of our business.

As we’ve mentioned the school in Dubai and the International Private Academy is—we’re very happy where it is. We don’t think it will be material this year, but we’re seeing student demand. I don’t think we’ve figured out the student recruiting completely. It’s kind of like our first year as we try to recruit globally, but we’re happy where we are. We’re seeing very satisfied families. We’re seeing demand.

So as the years come we think this eventually will become a strong business for us.

Operator

There are no additional questions at this time; I would like to turn it back over Ron Packard.

Ron Packard

As there are no more questions, I’d like to mention that we will be presenting at the BMO Back-To-School Education Conference tomorrow and I hope to see some of you there. Thanks again for your participation on the call today.

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Source: K12 Inc. F4Q08 (Qtr End 06/30/08) Earnings Call Transcript

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