K12 Inc Quarterly Report
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OPERATOR: Good day, ladies and gentlemen, welcome to the Q2 2013 K12 Inc. earnings conference call. My name is Sonya and I will be your operator for today. At this point, all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator instructions). As a reminder, this call is being recorded for replay purposes. I would like to turn the call over to Christie Parker, Vice President, Investor Relations. Please proceed.
CHRISTINA PARKER, IR, K12 INC.: Thank you and good morning. Welcome to K12’s second quarter fiscal 2013 earnings conference call.
Before we begin, the Company would like to remind you statements made during this conference call that are not historical facts may be considered forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties that could cause actual events or results to differ materially from those expressed or implied. In addition, this conference call contains time-sensitive information that reflects management’s best analysis only as of the day of this live call. K12 does not undertake any obligation to publicly update or revise any forward-looking statements.
For further information concerning issues that could materially affect financial performance related to forward-looking statements, please refer to our filings with the SEC. These filings can be found on the investor relations section of our website at www.K12.com.
In addition to disclosing results in accordance with Generally Accepted Accounting Principles in the US, or GAAP, we will discuss a certain information that is considered non-GAAP financial information. A reconciliation of this non-GAAP financial information to the most closely comparable GAAP information was included in our earnings release and is also posted on our website. This call is open to the public and is being webcast. The call will be available for replay on our website for 60 days.
With me on today’s call is Nate Davis, Executive Chairman; Ron Packard, Founder and Chief Executive Officer; Tim Murray, President and Chief Operating Officer; and Harry Hawks, our Chief Financial Officer. Following our prepared remarks, we will answer any questions you may have. I would now like to turn the call over to Nate.
NATE DAVIS, EXECUTIVE CHAIRMAN, K12 INC.: Good morning, everyone, and thank you for joining us today. First I would like to congratulate all of our employees, our school board partners and especially the teachers for a great performance during this past quarter. I am truly proud to be working with such professionals, who are all dedicated to producing great student outcomes and a high-quality education.
I would like to start today by answering a question that many of you have asked me as I’ve gotten to know you. What is my vision for this business as a new member of the K12 management team? The answer to that question starts with the recognition that K12 and individualized online earning are both at a critical stage of their growth. Individualized learning is increasingly achieving mainstream acceptance. But like any disruptive industry, it’s facing a series of challenges.
As the industry leader, K12 needs to both continue to lay the groundwork for greater adoption of individualized online learning and to lead the way in addressing the rising challenges facing our industry. As we grow the business, I see our mission as broader than just simply operating virtual charter schools. Our vertical product set is really about empowering individualized learning. From our Pre-K learning curriculum to making multiple products available to school districts, on to just managing schools, K12 is all about bringing this individualized learning capability and technique to all educators and students. We have developed the most comprehensive online curriculum available and we have learned a tremendous amount about how to successfully operate our products and to advise schools on how to operate our products.
We are learning not only how to sell the product, but how to be good consultants to these school districts on how to operate the products. My vision is that we will continue to sell more products, whether inside the managed services contracts or as a stand-alone implementation, selling by course.
The key to our success is a great curriculum with teachers and administrators who can help schools use our curriculum. At the same time, we need to sharpen our focus on executing with excellence, excellence in academically delivering, excellence in operational delivery and excellence in our financials. And our speakers today are aligned with these three areas. Ron Packard, our CEO, will discuss academic excellence and the state and local opportunities before us. Our new management structure has been designed specifically to free this visionary leader to continue to grow this sector and the Company’s reach, including laying the legislative and regulatory groundwork for greater acceptance, while providing leadership on improving academic performance.
Tim Murray, our President and Chief Operating Officer, will then discuss how we are achieving operational excellence.
And finally, Harry Hawks, our Chief Financial Officer, will then discuss our financial results.
So let’s get started with a report from our CEO and the founder of K12, Ron Packard. Ron?
RON PACKARD, CEO, FOUNDER, K12 INC.: Good morning. When I reflect back on the 12 years since I founded K12, I am more enthusiastic than ever about the potential to benefit children who need more choices. As we continue to lead the transformation to individualized learning and educational liberty, we are not simply building a business, we are changing lives and giving opportunities to those children who previously had no opportunity. Our goal remains the same, which is to make available to every child an opportunity for a high-quality individualized education, regardless of geographic location or economic circumstances.
As we have grown and the Internet has become more ubiquitous, virtual schools have seen a significant increase in the growth in the number of academically at-risk students. We welcome the opportunity to serve these children and are rapidly making adjustments to every part of the delivery system to better serve these children as well as the students who come to us at grade level or advanced.
One of the great things about the culture here at K12 is the speed at which we are able to change what we do. We are excited about our new Chief Academic Officer, Margie Jorgensen, who comes to us with an extensive background in assessment and instructional practices. Her objective is simple — to analyze all of the data that K12 has and to work with the management team of K12 to improve every aspect of our instruction, including but not limited to curriculum, teaching practices and information systems.
One of her very first projects is to analyze the current industry model for measurement and then work to ensure that they adequately and fairly major virtual schools while ensuring students master everything they need to master not only for state tests, but also for what is required for an excellent education.
Additionally, K12 has formed an education advisory committee of outside experts which will meet regularly with K12 management and provide their guidance on continuing to improve our educational delivery. On February 7, we will release our academic report, which addresses how we measure the academic performance of students in K12 Managed Public Schools and provides detailed information why and how we use the Scantron assessment method to measure academic performance of these individual schools.
We hope that many of you will join us on Thursday at our academic and product day where you will have an opportunity to meet Margie in person as well as other K12 management, see demos of new products, meet K12 students, talk with K12 teachers and ask any questions you may have regarding K12 products or academics.
Two of the great advantages of technology-based education is that it scales and evolves rapidly. To that end, K12 will be moving towards multiple programs and often multiple schools in every state. More specifically, we will have multiple learning pathways with separate programs that focus on academically average students, gifted students and college prep students. And we can envision a world with many more options in the near future. These programs will differ in curriculum, teacher utilization and teaching culture, the intervention model and the engagement model as well as the course library and the focus of the school. We are moving towards every student having an individualized learning plan, thus enabling more individualized attention, ensuring we are meeting the needs of every student and family’s unique goals for their child.
K12 continues their new charters and expanded access to our high-quality learning options. Renewals were recently announced in Indiana and Virginia. We continue to work on a renewal plan for the Colorado Virtual Academy. K12 also currently serves students in Colorado through an Insight program and through several district programs.
Over the past decade we have dealt with dozens of efforts to reduce reimbursement for virtual schools, such as current proposals that are currently out there in a few states. It’s surprising that states would look to cut funding for one of their most efficient options. With regard to these efforts to reduce virtual funding, it is important not to overreact and remember that they rarely end up in the form they are initially proposed. Often, nothing changes because virtual schools are already such a great value to taxpayers.
In fact, we are optimistic for the first time in five years about states’ budgets, which now appear to have stabilized and are actually increasing in some states. The removal of this powerful head wind should allow us to deliver even more innovation and value for our students. We are proud that we have been able to grow and succeed throughout this period in spite of these powerful head winds, and we continue to invest in curriculum, systems and people so that we can better serve students.
It is worth noting this is the model that not only helps the many students that are not being served (inaudible) today, but is a benefit to society and a more cost-effective option for taxpayers as well. Based on NCS data, these schools often receive 30% or 40% less funding than traditional schools in the same state. A recent Cato report would suggest that it might even be less than this.
With regard to Web, we have extended our option to purchase no less than 51% of Web to February 28, 2013. And as a result, we now have the option to purchase all remaining equity interest in Web between now and June 30, 2015, in one or two transactions. We have no current intentions to assume majority operating or management control of Web; rather, we are exploring partnerships with firms who have extensive investment experience in Asia and would assume much of the management oversight responsibilities. As things progress, we will continue to update you.
We also continue to explore adding new states and expanding or eliminating enrollment caps in existing states. As most of you know by now, this process takes place over the next 6 to 8 months and is often difficult to predict. What I can say at this moment, however, is the environment at this time looks as favorable as it has in past years.
In the 2014 school year, we’re looking at the addition of four charters in Florida and a substantial cap expansion in Michigan which increases from 1000 to 10,000 students. I plan on spending a considerable amount of time in the coming year on these efforts, even more so than in past years.
K12 has obviously added significantly to its management and operations team over the past year. We are now exceeding the goal I stated a year ago of growing EBITDA at twice the rate of CapEx, as EBITDA grew at 32% and CapEx grew at 10% during the first six months of fiscal year 2013. Additionally, our margins have grown more than 100 basis points.
Now I will turn it over to Tim to talk about what we are doing to achieve that objective.
TIM MURRAY, PRESIDENT & COO, K12 INC.: Thanks, Ron, and good morning. For our second-quarter results, we continue to take actions to improve our financial, operational and academic performance. Harry will elaborate in more detail on our financial performance in a moment, but let me comment on couple of highlights.
Revenue of $206 million grew 23.7% compared to the prior-year period. Operating income of $16.3 million grew 129.6%. Looking at volumes, average enrollments in our Managed Public Schools grew 13.6% as compared to revenue growth of 26.2% for those schools, consistent with our plan for the year to favor higher funding states, improve our revenue capture rates and carry fewer unfunded students. We also benefited from rate improvements in some states.
Total enrollments and semester course enrollments in our International and Private Pay Schools grew 10.9% and 1.5%, respectively.
Revenue in Institutional sales grew 8.6%. When I look at our operational metrics for this team, I continue to see a growing pipeline, greater sales productivity than last year and a growing backlog.
While we signed roughly 650 contracts in the first two quarters, we are not closing deals as we expected and they are getting pushed out. Our product mix of sold product continues to shift toward annual subscription leases — licenses, which over time will reduce the lumpiness in our revenues.
Adding to the press release comments that product development expense is down, let me further note that product development expenditures are down as a percent revenue on a year-over-year basis. If we look internally at the cash outlay for a project and its expected returns without regard to how the capitalization works, we leave the cap rate to the accountants to figure out.
Operationally, our internally tracked retention rate in our Managed Public Schools was comparable to the prior-year period. Our cost per acquisition was also comparable to the prior-year quarter. In the quarter, we optimized our owned media to include site search, increased our social media integration and increased the capture of organic interests on our sites. We further optimized our SCO in paid digital media. All these actions increased Web traffic and leads.
Further, we implemented click-to-call functionality on our mobile advertising pages, driving higher call volumes to our enrollment center, where we typically see conversion rates that are generally double that of Web forms.
We continue to make progress in improving the student experience with K12. For the quarter our student facing systems’ availability averaged in excess of 99.9% and we continue to work with key vendors to drive their availability up in recognition of our 7-by-24 operations. And better systems performance has reduced overall customer service call volumes some 30% compared to the second quarter of 2012, representing a 37% reduction on a per-student base.
In addition, those who do call us are benefiting from improved IVR capabilities to allow for more effective self-service. Improved customer service is translating into lower costs.
Turning to operating leverage, our approach is two-pronged, acting on near-term opportunities as well as unit cost initiatives that will help us to scale more efficiently as we grow. In our last call, I noted one area of focus was on procurement and logistics. In the quarter, we implemented a vendor change for computer refurbishment which will reduce our unit costs and also yield savings due to synergies in logistics and distribution of the computers. Our materials and computer cost as a percent of revenue are down compared to prior year. Our largest supply contracts will come up for renewal over the course of this and next quarter, providing an opportunity to leverage our buying power.
Further, we consolidated all outbound freight shipment, some 400,000 parcels last year, to a single vendor. In the quarter, we also put in place a revised procurement policy that will enable further automation of our purchasing with greater controls through the use of purchasing cards.
Shifting to academics and instructional execution, our product development team released two school electives in this quarter, anthropology and forensic science, as well as 15 advanced placement exam reviews in the quarter. We began piloting our Pre-K program with very positive feedback. We also released a number of applications for mobile platforms with distribution through iTunes, Google Play and the Amazon app store, bringing us to 16 mobile apps in total with over 600,000 downloads to date.
We have a number of efforts underway to improve our measurement, managing and coaching and instructional performance. Achieving improved academic outcomes remains job one for all of us in every area of the organization. Those who were able to attend our academic and product day will get a sense for this.
Two specific areas of focus on are teacher training and compliance. A big part of academic excellence is the ongoing professional development and training courses we deliver via K12training.com to approximately 6300 teachers and school leaders across the K12-managed schools. That includes more than 300 proprietary trading modules created and offered to our staff.
Since July, we have held 73 orientation sessions for nearly 1500 new teachers and staff members. We offer quality online teaching, K12’s own version of certifying teachers in accordance with iNACOL’s standards for quality online teaching and have completed 36 sessions for this school year. And we have held 23 face-to-face and 158 virtual professional development sessions since we started the school year on instructional planning and improving academic achievement.
Our focus on compliance is to provide our schools and our auditors better tools to collect and analyze data more efficiently, increasing productivity and accuracy. In the quarter, we implemented a new school analytics system, entire processes that increase the efficiency of our reporting to states and boards. We estimate these will contribute several million dollars to our bottom line this year by improving revenue capture.
Overall, we have significant traction in reengineering policies and processes, creating a identified enterprise systems architecture and focusing on our unit cost improvements in our business. These are the actions that will enable us over time to achieve scale efficiencies. Our ongoing challenge is to accelerate these efforts.
And now over to Harry Hawks, our CFO.
HARRY HAWKS, EVP, CFO, K12 INC.: Thank you, Tim. Good morning to everyone participating in our call and webcast and a special K12 welcome to those of you joining us again on Thursday for academic day.
This morning, we are reporting second-quarter results that are in line with our previously communicated plans for fiscal 2013 and, in particular, our second-quarter guidance provided in November 9 — revenue of $206 million, an increase of $39.5 million or 23.7%; EBITDA of $32.5 million, an increase of $10.7 million or 49.1%; operating income of $6.3 million, a $9.2 million increase, or nearly 130%; net income of $9.5 million, a $5.3 million increase or 126%; and EPS of $0.24, a $0.13 increase, or 118%.
In addition, this morning we are providing our third-quarter outlook for revenue of $210 million to $220 million and for EBITDA of $28 million to $32 million. Based upon our reported results for six months ended December 31 and our outlook for Q3, we are also generally reaffirming our full-year guidance for fiscal 2013, previously given on October 17, with the following updates. The updated fiscal 2013 revenue guidance is $840 million to $860 million. We estimate depreciation and amortization will be $64 million to $67 million. We have reduced our estimated full-year tax provision to 41% to 42%. Previous guidance of EBITDA and operating income is unchanged at $107 million to $115 million for EBITDA and $45 million to $50 million for operating income.
Based upon our comparison of our EBITDA outlook to consensus estimates, we observe that while our full-year guidance appears in line with posted numbers, we believe Q4 will likely be stronger than estimates indicate. Therefore, Q3 appears to be slightly overweighted.
In anticipation of some of your question, let me address a few topics that frequently come up in our ongoing dialogue with many of you.
Accounts receivable — given some concerns last year about the prospect for slow pay in a few states, we were asked about accounts receivable aging and collection. Our Q2 balance of $223 million represents a reduction in DSO of approximately a week. A 14% increase in AR balance compared to one year ago was well below a 24% increase in three-month revenue and 18% increase in six-month revenue. Incremental buildup in accounts receivable this year equals about 40% of incremental revenue, while a year ago it equaled 57%, and an improvement in cash collections.
Next, cash flow — cash from operations for the six months year to date was a positive $32.1 million compared to the same period a year ago as negative $19.5 million and two years ago was $7.1 million.
Cash — as a direct result of the foregoing, we know that net cash at 12/31 was $9 million higher than cash at 12/31 a year ago, notwithstanding our ongoing investments in curriculum, software and infrastructure.
Seasonality — while we are very encouraged with our solid and (technical difficulty) not necessarily indicative of longer-term trends. A complete business cycle for us spans an entire school year.
Next, depreciation and amortization — as you know, from fiscal 2010 to fiscal 2012, depreciation and amortization more than doubled from about $26 million to about $58 million, largely a result of acquisition-related purchase accounting. This year, our depreciation and amortization expense through six months is $31.9 million, representing a 15% increase over the same period last year, down from a 42% increase over the year before that. Our updated guidance for the year of $64 million to $67 million would, at the midpoint of the range, represent about an 11% increase over last year, clearly indicating its growth is slowing down.
Furthermore, we believe that our stated goal of slowing the rate of growth of capital expenditures will contribute to a further slowing of growth in depreciation and amortization relative to other metrics. Of course, I should point out, we always consider investing in strategic opportunities with compelling ROI characteristics.
In case you are wondering, capital expenditures plus capitalized leases, which is the way we think about CapEx, for the six months year to date totals $45 million, which is a 10% increase over the comparable number for the prior year.
Next, tax provision — our year-to-date provision of 43.3% is higher than statutory rates and higher than our updated annual guidance of 41% to 42%. So it can be expected that the next two quarters will not only be less than the full-year provision, but less than the Q2 provision of 41.8%.
Lastly, EPS — I’m sure you have already noticed. But to be sure, we are reporting year-to-date EPS of $0.36 after reporting Q1 EPS of $0.11 and Q2 of $0.24. The extra penny is due to rounding of the quarterly results and is not a typo.
Certainly, I have not preempted all your questions, so now would be a good time for Nate, Ron, Tim and I to respond to your questions and comments. Nate, back to you.
NATE DAVIS: Thank you, Harry. Operator, at this time we would like to open the call to questions. This is Nate Davis speaking. I will direct the questions to the appropriate person on the management team, so the call is now open for questions.
Questions and Answers
OPERATOR: (Operator instructions) Jeff Meuler.
JEFF MEULER, ANALYST, ROBERT W. BAIRD & COMPANY, INC.: Good morning, first, I appreciate all the extra detail under the new call format. I guess first question on revenue — I know you guys don’t give revenue guidance by segment, but given that I guess revenue was near the lower end of your guidance range this quarter and you are reducing the top end of the full-year guidance range, could you talk about what business line drove the reduction and the top end for the full year?
NATE DAVIS: Yes. Tim, why don’t you take that?
TIM MURRAY: Thanks, Nate; Jeff, thanks for the question. I think the area where we have obviously seen some weakness is in the area of the institutional segment. As we noted last quarter, that business is a products, software and service business selling into school districts nationwide. As such, revenues tend to be somewhat lumpy.
As we continue to lead with subscription-based offers and take fewer deals as perpetual licenses, we think some of that lumpiness will increase. As I noted in my comments, while we have closed over 650 sales in the first half of the year, there is no question we are seeing softness in that segment. Our close rates are below expectations, we are seeing purchase decisions being pushed out.
The funnel is growing; the issue is our ability to close that business in periods. So fortunately, given the size of that segment relative to the overall business, we think that’s manageable. But that’s the one segment where we see some weakness in the top-line revenue growth.
JEFF MEULER: Okay, thanks for that. And what is driving instructional costs growing materially faster than enrollment growth? Is it increased investment in instruction, or is it mix between states, teacher utilization? If you could discuss that, please.
TIM MURRAY: Jeff, Tim again. I think it really comes down to a couple of things. It’s mostly teacher costs, as you imagine. And specifically, we on-boarded teachers earlier in some schools coming into this year with the expectation that that would improve the quality of the initial experience with those schools and have a positive impact on academic outcomes.
So earlier on-boarding and a little higher staffing in some of our schools is really the drivers of the instructional cost increase.
JEFF MEULER: Okay, and then just finally, a question on full-year guidance. You’re maintaining your EBITDA guidance while increasing your EBITDA guidance, but it looks like your EBIT guidance is unchanged. If you could address that discrepancy, please.
NATE DAVIS: Jeff, Harry is going to handle that question.
HARRY HAWKS: Let me make sure I understand your question. Our EBITDA guidance for the year remains —
JEFF MEULER: Right, but you took up your D&A guidance, so it seems that your EBIT guidance would come down, but it’s unchanged.
HARRY HAWKS: Right. Well, we have not — we stand by the EBIT — or, excuse me — the operating income guidance, and our estimate of EBITDA in terms of the guidance, if you will, is pretty much still in line with our original expectations internally. So I guess I’m just saying that, internally, the budget numbers that we have are still in line. So we just sharpened up our annual guidance.
JEFF MEULER: But wouldn’t the math suggest that if you’re maintaining your EBITDA guidance and increasing your D&A guidance that your EBIT guidance should be reduced to reflect the increased D&A?
HARRY HAWKS: Well, our expectations internally, of course, were at a point within the range, and so our internal expectations remain within the range.
NATE DAVIS: This is Nate speaking. When you look at the math, of course the math would work that way. But what we are suggesting is we don’t give specific EBIT without D&A guidance.
So I think the real issue here is that, yes, you should see operating income have a slight change. In other words, you will see a mix change between the operating income and the depreciation and amortization. All we are doing is refining how much of it happens in earnings and not from — earnings from operations, and how much of it happens in depreciation. Now that’s just an exchange that we are signaling.
JEFF MEULER: Okay, thank you.
OPERATOR: Kelly Metzler. (Operator instructions) Suzi Stein.
SUZI STEIN, ANALYST, MORGAN STANLEY: Can you provide an update on Colorado and Pennsylvania, given some of the issues that you have had in those two states?
NATE DAVIS: Yes. Ron, you can handle that.
RON PACKARD: Hi, Suzi. So Colorado is going through a new renewal process, as I think everybody is aware of. And we will have, I believe, the meeting on February 6 that will look at the renewal of COVA. And then, if that does not succeed, it would go to a state board for appeal.
We also, as I mentioned, have another school in Colorado for students in grades 6 through 12. So that process is moving forward and it’s hard for me to speculate on the outcomes of any of those board meetings, and I wouldn’t like to do it at this time.
With regard to Pennsylvania, there was a bill that was introduced that would look at the funding of virtual schools. We have seen several bills like that in Pennsylvania over the years. This one will move its way through the process, and it’s tough to comment much more than that, other than it’s a legislative process and it’s always difficult to predict outcome of that. Because of the way that bill was worded, it’s even impossible to predict the exact effect on funding that would occur if that bill were passed, because it has a lot of calculations districts would have to do.
But again, we have seen lots of these over the 13 years since I’ve been doing this, at least. And we believe virtual schools are already a significant discount to what taxpayers pay for education and delivering a great value.
SUZI STEIN: Okay, and then I just had two questions about how you reported. So it looks like there was some reclassification of expenses between instructional and SG&A. Could you maybe just address what the change was there?
And then, also, it looks like there was some kind of a restatement in enrollments in the International and Private Pay business. Could you maybe address that as well?
HARRY HAWKS: This is Harry; I’ll take the first part of your question. We had a previously disclosed re-class where basically we consolidated some enrollment expenses from instructional costs and SG&A to one place, which was in SG&A. So the comparable periods are apples to apples, so — and what you are seeing in the press release and in that line item is — those are apples-to-apples comparisons.
NATE DAVIS: This is Nate speaking. I am not sure of your second question, but if I got it right, I think you are just seeing on the chart the difference from International and Private Pay business line to — we just changed the name to schools. But I think that’s all you are seeing, but maybe I’m missing your question.
SUZI STEIN: Okay, I will follow up after the call on that. Thank you.
OPERATOR: Kelly Flynn.
KELLY FLYNN, ANALYST, CREDIT SUISSE: I have a couple of questions. The first question just follows up on what Nate said at the beginning of the call. I think you made it clear, Nate, you intend to focus a lot on products. I just want to understand, would you characterize this as a strategic shift to focus more on products going forward, or do you feel like this is the same strategy you guys have had for the last couple of years?
And then maybe you could just indicate, as you look five years out, how do you hope ideally that the revenue mix will look between Managed Schools, products and other?
NATE DAVIS: What I was signaling was that when most folks look at K12, what they see is that the Institutional Business is our only products part of the business. But in fact, within the Managed Schools, there’s a significant amount of revenue that comes from selling products. So it’s not just that we sell our service of managing the school; we also sell the products to the school, the curriculum. And I was highlighting the fact that we are going to continue to enhance that product as it’s sold inside the managed services contract.
And as a matter of fact, I think one of the upsides in Managed Services contracts that many schools are going to be looking at tools, like remediation tools, extra math tools, things like that, that will continue to allow us to sell more products. So some of our product sales will not just be coming from the Institutional line of business, it will also be coming from within the Managed Schools area. So that’s the primary change.
I also signaled that we have something pilot that is preschool, Pre-K. And the reason we do that is because we think there’s an opportunity there to sell more products in that category as well. Again, that’s brand-new. It has not officially been launched. It’s something we are in pilot with and we are actually going to show it in the academic day.
So we are focused on developing more and more products because we think that’s a way of getting more revenue, and it’s not just in the Institutional Business.
KELLY FLYNN: Okay, and could I just ask a follow-up on the institutional comments? I think you indicated a couple of times that that was weaker than expected. I’m unclear on why that was the case. Can you just talk a bit about what’s going on there and why that doesn’t have — why you are not seeing the same thing in other parts of your business?
TIM MURRAY: Kelly, it’s Tim. From an operating perspective we always assume, first of all, that the issue is an execution issue on our part. So we are working hard, obviously, at sales execution, the quality of the experience we are providing those customers, etc. So that’s the first point.
As we do inspect deeper on that, and I’ve spent some time out in the marketplace with our customers as well, there is a lot of uncertainty on the part of the districts right now as budgets are being contemplated for the coming year and they are dealing with the levels of funding that is coming from the federal government or state governments as well as grant funding. And if you are reading the trade press, you are seeing more and more articles about that these days.
So what we are seeing and hearing from customers directly as well as our sales people, it’s just that that uncertainty is translating into some delaying of purchase decisions. The opportunity in our sales funnel is clearly there, so we don’t see any diminishment of opportunity. We are just seeing a delay in closing decisions.
KELLY FLYNN: Okay, thank you.
OPERATOR: Jerry Herman.
JERRY HERMAN, ANALYST, STIFEL NICOLAUS: Tim, you had talked about marketing and customer service efficiencies, and also some opportunities with regard to some contracts coming up here. Could you maybe quantify in some way what those savings might be?
TIM MURRAY: Yes and no; I certainly can. On this call, I don’t think I want to get into the practice of picking out small line items or even big line items that we would provide guidance on. But as you look at areas like our materials costs, that is a largest segment of our income statement. As you look at marketing and enrollment costs, those are large segments of our income statement. So we are clearly focused on where the dollars are, and we’re focused on what we can do to improve unit cost efficiencies. So, whether it’s in areas such as unit cost of materials per student, unit costs of computers per student; we are watching those with the intent of reducing the ratio of those costs to revenue, and we are seeing favorable improvement on a year-over-year basis on those line items. But I would leave it to Harry as we roll that up to articulate on those line items that we do disclose how he will be able to see those flow through the income statement to the bottom line.
I know that’s not a completely responsive question, but that’s the way we are looking at those expenses. That’s the way we are managing those, and we are seeing, at that more microscopic level, progress on a year-over-year basis.
JERRY HERMAN: Okay, great. You guys have talked recently more about serving the different types of students. Can you maybe spend a minute just to give some clarity on what you’re thinking about there in terms of servicing at risk, advanced and college prep students with regard to the model, brand name, etc.?
RON PACKARD: Sure, I will be happy to do that. So, as I mentioned, we have seen a change in the student mix, where we have a lot more of — when I describe at risk, I mean students that are coming several years behind grade level. So the kind of schools that serve those kids might be a little different in the sense that the curriculum you give may be different. But also, even the teachers — there are certain kinds of teachers that love nothing better than doing interventions with kids that are three years behind grade level. There are other teachers who want to work with highly-gifted students.
So the idea is, whether it’s separate schools, or it’s programs within a school to create these higher school culture, the curriculum, the teachers; hire teachers who want to work with those types of kids, want to do those types of interventions. And that way, we can really fine-tune all the services and the offerings to those students, and it also includes how you recruit students for the various schools.
So really, what K12 technology is about is driving an individualized education for every child so they can be whatever they want to be in life. And so we are continually working to refine that to be even more and more individualized.
So that’s what we are speaking about. And it could be programs within a school. In fact, I know there’s going to be multiple programs within schools; there already are. But it could also be separate schools with different brand names as well.
JERRY HERMAN: Okay, great. And then just one last question, if I might, for Nate. Nate, in the press release, you specifically mentioned driving increasing returns on investment capitals and profitable growth of the business. Now that you have been able to be more actively involved, your full-year guidance suggests that the operating margin of this business this year would be like 5.5%. How do you think about that level in the long run? How do you think about an acceptable level of profitability or returns in this business?
NATE DAVIS: Well, first of all, we start by looking at what we think the market opportunity is and what are the margins in that particular segment. So, as Tim talked about the Institutional Business, the business of selling stand-alone products to schools is a higher-margin product, but the business is growing a little bit slower. So I think that’s going to hurt margins in the near-term. But long term, we think that’s a great opportunity for us, and so we should see better margins.
And then, as Ron talked about, he has seen a great environment for rates right now in the Managed School business as well. So I think that over the long run, we should see a slight improvement, but I don’t see a heavy slope of improvement there. I see a modest slope of improvement in those markets.
When you see the margins modestly improve for Managed Services and long-term move more significantly in the Institutional area, we should see good margin improvement. That tells us that we are going to get a better return. Now, there’s other things you can do, obviously, to affect your return on invested capital, so we are looking at all kinds of options there.
But just looking at the core of the business itself, we think improving the margins is the greatest thing we can do to help deliver better returns. We have got to take more of the dollar that comes in as revenue and drop it down to the bottom line. So improving our cost structure, make sure that we get under rate capture; and then, lastly, talk about improving the sales of the Institutional Business, because that’s a very profitable products business for us.
All of those things drop something to the operating income line and make us have a better return on investment.
JERRY HERMAN: Great, thanks, I’ll turn it over.
OPERATOR: T. Urdan.
TRACE URDAN, ANALYST, WELLS FARGO SECURITIES, LLC: T. Urdan — I like that. I wanted to ask about the special ed dollars. This is an issue that has come up in the context of COVA, and then it also seems to be one of the areas of reform that the Pennsylvania legislation might concern itself with. Can you talk about how much revenue you derive from, I guess, it’s Title I, special ed dollars? And then maybe talk about how much additional incremental expense you incur servicing those particular students, and maybe how many of those students you’re currently serving and what the rate of growth of those students has been over the last few years.
NATE DAVIS: I’ll ask Ron to talk about that some. I don’t know that we track the dollars exactly to that category, but you can talk broadly about that.
RON PACKARD: Yes, So, Trace, that’s a good question. So over the years, and you will see this in the academic days, the special ed population at the virtual schools has been increasing, in some cases quite significantly, to where now it’s much above the average. And how that gets funded varies a lot by state to state. We have looked at it from time to time and we have looked at it holistically across the country, at least in the times that I’ve seen us look at it. We generally are losing money on special needs kids, meaning it costs more to serve them than we actually do get — receive for them. There may be exceptions to that for certain types of special needs or certain states, but generally across the board, like other school districts, it’s generally a money-losing venture. But it’s okay because we are helping the kids. That’s what matters to us.
I would also just point out that we deliver the same special ed services that are required by their IEP that a district would. So we’re no different than a large school district. These children have IEP’s. We have an extensive network of providers that we contract with throughout states to provide what is required on our IEP’s. So we serve them the way the district would, and consequently what our results are financially are not that different.
I would also mention — there are certain types of special needs we have seen tremendous results with, things like ADD and high functional autism, where we have parents that have told us that it has completely transformed their child.
So with regard to that, we view it a valuable part of what we do. And these children want our services and help, and we are here to provide them.
NATE DAVIS: And remember — Trace, this is Nate speaking — and remember that the definition of special education is so broad, from visually impaired to hearing impaired to physically impaired to some other way, all the way to just learning difficulties, a child you would see walking down the street that’s no different than any other but simply have some learning difficulties. When you categorize all of those together, I have seen schools in some of our stats that say we are as high as 30% on some schools in terms of disability, and then down as low as 5%. It really depends on the state that we are in; it varies. But that’s the range.
TRACE URDAN: But if I could just ask a follow-up, because it seems as though there’s sort of a criticism that is being levied that suggests that you guys are making disproportionate profits. So I just want to understand. While you guys are insisting his that’s not the case, that in fact you are incurring more in expense then you are receiving in additional dollars related to those children, would you expect to be able to present that data, for example, in Pennsylvania as they start to go through this process with the legislation?
RON PACKARD: What I would expect, Trace, is that nationally what I said is true the last time we looked at it. There may be isolated instances where that is not the truth, but we are clearly providing everything required in the IEP. It’s an important part of what we do and we will treat it case by case, if necessary.
TRACE URDAN: Okay, all right, thank you.
OPERATOR: Kelly Metzler.
KELLY METZLER, ANALYST, BOFA MERRILL LYNCH: This is Kelly Metzler for Sara Gubins. I was wondering if you could talk about the seasonality in the International pay business. I’m just wondering, on a dollar basis, is there any potential to see a pickup in the second half?
HARRY HAWKS: Good morning, Kelly. It’s possible because of the change in some of the mix of activity there. We have had some increase in full-time students. We’ve had a higher growth in some of our higher cost, higher price point offerings. Obviously, there are some private school offerings within that group. So it’s possible to see some pickup in the back half of the year, but not material. Of course, it’s not a particularly large percentage of our Company, so on a consolidated basis, I wouldn’t want you to have a take-away that it’s material. However, the trend lines right now are positive.
KELLY METZLER: Right, okay, thanks. And you gave some of your long-term cost initiatives. Can you talk about some of the near-term cost plans and expectations for the second half and into 2014?
NATE DAVIS: Tim, why don’t you tackle that.
TIM MURRAY: Yes, thanks, Kelly. I think, as I noted last call and implied in this call, we continue to focus on opportunities to impact unit cost on supplies and materials. We continue to look at ways to prevent calls coming into our customer service center by dealing with the root causes of those. We continue to implement steps, such as improved IVR technologies, to allow our customers to self-service themselves as able, which in turn reduces our cost. We continue to look at staffing models across our schools, both for the purposes of ensuring we have the right skill set and the right resource levels to meet demand, but also to make sure that labor costs are being managed effectively.
So those are the big items. We are experimenting wherever we can with marketing tactics to be able to find more effective and more efficient marketing tactics, whether that is in our owned media, our paid media. And importantly, we are increasing our emphasis on social media to improve the return on earned media, if you will, to reduce our cost of acquisition on the marketing side.
So those are some of the things that we are very, very focused on at this point in time.
KELLY METZLER: Okay, that’s helpful. If I can just squeeze in a last one — for fiscal year 2013, you raised your D&A guidance, but lowered CapEx guidance. I was just wondering if you could provide some color on that. Thank you.
HARRY HAWKS: The lowered CapEx guidance is, we are in fact, indeed, trying to manage that and be very disciplined about how we spend money. And as we pointed out, the trend lines there suggest that it is growing slower than either revenue or CapEx — excuse me — EBITDA.
And, as I pointed out in my comments, we remain open, however, of course, compelling opportunities with a great ROI — we will consider those investments as they come along. As it relates to depreciation, yes — I wouldn’t consider a material change. The actual point estimates internally that we are managing to is maybe a $2 million swing. And as we look at the updated guidance on depreciation and amortization, clearly we had a point within the range that we were managing to in the earlier guidance, and we have a point that we now are estimating in the current guidance. And the differential between those two points is, I would submit, immaterial, as in a couple of million bucks, and it doesn’t change the range of operating income estimates that we have provided.
So it’s just — I think that’s all it is. Does that answer your question?
KELLY METZLER: It does, thanks.
RON PACKARD: This is Ron Packard. I just wanted to add on that. Those of you who were at investor day a year ago, we talked about, in addition to EBITDA growth, we were going to move more towards an EBITDA minus CapEx measure in how we measure ourselves. And I think the reduction in CapEx combined with EBITDA growth is exactly what we were talking about.
HARRY HAWKS: Right, and you are seeing it in cash balances going up.
OPERATOR: Jeff Meuler.
JEFF MEULER: This is a follow-up to — I think it was Kelly’s question. But you talked about the ability to sell more product in the Managed School business. How much of the per-pupil funding that the nonprofits get that you contract with are you capturing? Just wondering how much opportunity there is to move that up. And are they buying other products from other providers right out and you think you have an opportunity to gain share there? Is that how we should think about it?
NATE DAVIS: No, I don’t think it’s a share gain — this is Nate speaking, Jeff. I don’t think it’s a share gain issue. I think, in terms of others who are buying products in the same school, I actually think it’s an additional services opportunity for students that are in the programs. So we’ve got students that are in the programs that need — I’m going to pick on one example — may need more remediation. And as our software is able to better recognize that a student is struggling in a particular area, they may go off-line into a specialized remediation program, and that’s a service that we can sell. We have developed some of that ourselves, as well as we can buy some remediation capabilities from others and sell that.
Ron has talked about in the past this trial that we have been doing with math labs. And it’s something that we have not ruled out, but it’s something we tried. As we learn more about it, I think that’s another program we can take and pour back into the schools that we are already in and sell them some particular math programs that help students do better at math.
So it’s those kinds of programs that we continue to develop that are course-specific, topic-specific, remediation-specific, that we can sell back into the same school that we are in. And that’s where I think the opportunity is.
JEFF MEULER: I guess maybe, if I could ask it in a little bit different way, where does the funding come from that? Are they currently spending funding on an alternative product, or do you have to go out and negotiate with the state to get increased per-people funding in exchange for those higher services?
NATE DAVIS: It happens in two places. In some schools, as they — they can apply for particular grants, they can apply for additional funding for the next year. And in some schools, they actually want to trial these opportunities. And when they trial the opportunity, they can go back the next year and say we think this is working and we would like to roll it out to more students. Then, they can ask for additional funding.
So some of the schools do have a surplus that they run, and they have the flexibility at that point with that surplus to change their teacher ratios or buy additional products. And we think that’s an opportunity for us.
JEFF MEULER: Okay, thank you.
OPERATOR: Paul Condra.
PAUL CONDRA, ANALYST, BMO CAPITAL MARKETS: I wondered if you could talk a little bit about the revenue per student. I know you spoke about the mix last quarter improving, but I wondered if you could talk specifically about which components seem to be driving that this time around.
NATE DAVIS: Harry, why don’t you start off, and Tim can add in.
HARRY HAWKS: Okay, so Tim and I will tag-team on this one. A couple of things — growth in certain states, in certain programs — we can influence that. So in other words, a state mix, a high school to K-to-8 mix, and one of the things that we have pointed out previously is better. We call it capture, or it’s the inverse of reducing the amount of unfunded students that we have.
Those of you that went to the investor day in Chicago earlier this year — excuse me — earlier in 2012 will recall that we pointed out at that time we had almost 7000 students that we were teaching that we were not getting paid for. We are on pace right now to cut that number about in half for this year. And, frankly, that does make a big difference for us. And so some of the funding, some of the capture, some of the mix — those are all the things that have resulted in what you observe from the press release is just taking the enrollment number and dividing it into the revenue number.
Of course, we manage it on a much more granular, individualized basis. But those are the key drivers. But let me bounce over to Tim, to elaborate.
TIM MURRAY: Thanks, Harry, I think you hit the key ones, and this was as we rolled out our initial plan for this year. We explained that it was a conscious strategy to try to focus on marketing to states that had a higher funding rate. We have invested in some of the systems and the tools and the processes to effect the revenue capture rates, as Harry mentioned.
If we look outside of Managed Schools, as one of the earlier questions also called that, we have also seen in the Private Pay and International segment a shift toward more full-time students versus part-time students, which has been beneficial; and also, a shift in some cases toward higher-priced products that we are selling as opposed to lower-priced products. So mix is a big driver here and then, of course, the things that we don’t control completely. We have seen some rate changes in some of those states that has contributed to the increased revenue per student.
PAUL CONDRA: That’s great; that’s really helpful. How comfortable are you feeling with the state funding? You said stabilization, a little bit of increases in some states. Are you optimistic about that, or is this something that — I don’t know; if you could just give me a little more detail about that?
RON PACKARD: Well, it’s hard to give more detail than that because these kind of things are determined over the next 6 to 9 months on what the funding per child will be going forward. What I said was that state budgets aren’t under the same pressure they have been for the past five years, and normally that would translate into increased education funding, which is good for every sector of our business.
So that will be decided over the next nine months, but you guys read the Wall Street Journal as well as I do. You can see the state budgets — even California is looking at a surplus. So when you look at it from that way, obviously the environment is much better than it had been the past five years.
PAUL CONDRA: I was hoping you were getting your news somewhere else, but alright, thank you.
NATE DAVIS: Thanks, Paul.
OPERATOR: Thank you, there are no further questions. I would now like to hand the call over to Nate Davis for closing remarks.
NATE DAVIS: Well, I would like to thank everybody for being on the call today. As I mentioned at the very beginning, I always like to thank especially the teachers, the school boards, the school administrators, both what you guys would think of as principals and superintendents, for the great work that went on this quarter. Our results are reflective of people who are dedicated to providing great individualized education and good student outcomes. And that will remain our key focus. Thank you for your time today and I look forward to seeing some of you in the next few days.
OPERATOR: Thank you for your participation into today’s conference. This concludes the presentation. You may now disconnect. Good day.
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