Stride Inc (LRN) 2011 Q2 法說會逐字稿

Good day, ladies and gentlemen. And welcome to the second quarter 2011 K12 earnings conference call. My name is Latasha, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question and answer session towards the end of the conference. (Operator Instructions). I would now turn the call over to Mr. Keith Haas. Please proceed.

Thank you. Good morning, and welcome to the K12 second quarter 2011 earnings conference call. Before we begin, the Company would like to remind you that statements made during this conference call and that are not historic 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 publicly update or revise any forward-looking statements. For further information concerning issues that could materially affect the financial performance related to forward-looking statements, please refer to our Form 10-Q and 10-K filings with the SEC. These filings can be found on the Investor Relations section of our website, www.K12.com.

In addition to disclosing results in according to the 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 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 simultaneously on our website, and will be available for replay there for 60 days.

With me on today's call is Ron Packard, Founder and CEO, and Harry Hawks, Chief Financial Officer. Following our prepared remarks, we will answer any questions you may have. I will now turn the call over to Ron.

Thank you. Welcome to our second quarter 2011 earnings call. This was an exciting quarter for K12 marked by strong revenue growth, and the closing of our acquisition of American Education Corporation. This acquisition and the others completed in the past year have given K12 scale in two adjacent businesses, institutional sales and private schools, both of which leverage K12's core assets and skills. K12 now serves over 170,000 students, the equivalent of almost 100,000 full time students, and delivers more than 1 million courses annually.

Last February, we announced that we were embarking on a disciplined acquisition strategy. Since then, we have completed the acquisition of KC Distance Learning,American Education Corporation, and Cardean Learning now Capital Education. Our strategic plan also contained international expansion, and thus, we recently made investment in Web International English, added another international private school and entered into numerous international partnerships and associations.

Beyond those transactions we formed a joint venture with Middlebury College, that combines our online curriculum development and distribution expertise with Middlebury's world-class foreign language instruction, we have also now partnered with Blackboard, to sell college remediation courses to our nation's universities and community colleges. We believe the strategic acquisitions and partnerships now in place have created a foundation that will accelerate future growth.

Our current focus is on successfully integrating the businesses as quickly as possible, and developing the infrastructure necessary to support our high growth rate. We need to complete this process while also taking advantage of extraordinary opportunities in our core business. After a sharp increase in our expenses in the first quarter, primarily due to one-time events and M&A activities, our expenses have significantly declined in the second quarter as we said they would in the last call. We incurred approximately $2 million of integration one-time expenses from acquisitions in the past quarter, down from $5 million in the first quarter, and we expect the third quarter integration and acquisition expenses to be even lower.

In the past quarter we also incurred some start-up losses, as we introduced innovative models of individualized education, such as flex schools and classroom pilot programs. The effect of the acquisition expenses and start-up losses was $3.6 million inEBITDA, down from $6.7 million effect to EBITDA in the first quarter.

Turning to our second quarter results, which now include a full quarter of KCDL revenue, our financial performance was strong. Quarterly revenue was $129 million, up 38% from the second quarter of last year. Excluding the KCDL and AEC acquisitions, our organic revenue growth rate was 26% for the quarter. Revenue was higher in part because we have experienced robust end year enrollment. Enrollment in the second quarter this year was 81,083, compared to enrollment of 67,354 in the second quarter of last year.

Additionally, EBITDA was $24.3 million, up 19% from the same quarter last year. Organic EBITDA which excludes acquired company revenue, as well as M&A start-up losses and other one-time integration expenses was $25.4 million. This continued healthy performance in our core business is indicative of both the robust demand for K12's products and services, and management's ability to operate the core business while expanding into adjacent markets.

Public virtual schools will be our core business for the foreseeable future. This business still accounts for approximately 83% of our revenue, and we expect both revenue and income to grow rapidly as the business scales. Our enrollment in end year retention numbers are also approving. Increased efficiency achieved with scale has helped us to offset decreased per pupil funding in multiple states. We are still however, anticipating per pupil funding in several states for the 2012 school year. And we will keep working to reduce our cost structure as a percentage of revenue to offset this. However, as recently reported in The Wall Street Journal, we are encouraged that state tax revenue increased in the past quarter at the fastest rate in five years, due to increasing corporate profits, the stock market recovery, and the reduction in the unemployment rate.

I am energized by the current business development environment as it relates to K12. Expansion opportunities have increased dramatically because of the November elections, the wider acceptance of online education, and the growing recognition that it is more efficient to educate students with our individualized education model, at a lower cost to tax payers. The savings to taxpayers in K12 managed schools are enormous. If every child in the country were in a K12 school, taxpayers would save hundreds of billions of dollars annually.

Since I founded K12 ten years ago, I have never seen an environment with so many opportunities. As a result of this, we are recruiting new staff just to be able to pursue these opportunities. We recently announced a new virtual academy in Louisiana that is now starting to accept enrollments for the next school year. This is the earliest we have ever received approval to open a new school. We are actively working to open schools in other states, and to remove our enrollment caps in existing states. Removing some or all of these caps will significantly improve our growth rates for years to come.

The institutional business and private school business are now generating meaningful revenue for K12. At an annualized rate, the combined revenue now totals over $70 million, which is 14% of K12's revenue. We expect both of these business lines to expand rapidly in both revenue and profitability. The institutional business is now are our second largest business, with approximately $55 million in revenue on an annualized rate. The pipeline of school direct contracts is promising, and the integration of the K12 and KCL institutional sales forces and distribution channels is under way. We have also made the cost cuts at KCDL that we had planned, so from that standpoint our acquisition targets have already been achieved.

Our institutional business will only improve with the addition of American Education Corporation, an acquisition we closed on December 1st. Beyond its A-plus online curriculum, AEC gives us a value-added distributor network. We believe that we now have a product line that is the best in the industry, and we are excited to be able to offer customers a full range of products and services at varying price points.

Our private school business is also rapidly expanding. We are very pleased with the 92% increase in our private school enrollments, which are now drawn from 60 countries, including the US. We are also proud to partner with George Washington University, to offer the George Washington University Online High School, which recently began accepting enrollments. This will be a premier online private high school, that will feature college-preparatory academic programs in a highly personalized and flexible learning model. We now operate three separate private schools at different price points, which allows us to meet the needs of a broad spectrum of students.

Additionally, we closed our $10 million cash investment for 20% of the Chinese education company, Web International English, in early January. Our investment will be used to fund expansion initiatives. Web has already opened new learning centers since we made our investment, bringing its total to 72 centers serving over 35,000 students in 47 cities throughout mainland China. We believe that web has enormous potential, and will be a significant part of our future,particularly if we exercise our option to purchase the rest of the Company.

Finally, our nascent businesses are showing great promise. I would like to highlight capital education in Middlebury Interactive languages. With the addition of Capital Education, K12 now offers a high-quality comprehensive online curriculum and learning platform, for colleges with over 700 courses to choose from. We are actively pursuing partnership agreements to provide content and learning systems to not-for-profit colleges, who want to offer an online education option. We have already completed one contract with Sierra Nevada College, and we have several others in the pipeline.

After going through its start-up phase, the Middlebury Interactive joint venture is executing on its strategic plan. It recently released beta courses in French 1 and Spanish 1, is developing a new learning management system, and will be operating foreign language instruction camps in five additional sites this summer, bringing the total to eight. On last quarter's call, I mentioned some of the investments we have been making in our infrastructure to support future growth, and I am pleased to report that our implementation of Oracle financials is on time and on budget. This system will result in more efficient financial prophesies and improved management information. I expect that the system will be live by the time of our next call.

To summarize, we had a terrific quarter with significant increase in organic revenue and profitability in our core business. Our one-time M&A expenses declined, and are expected to continue to decline in the third quarter. The virtual school business development environment is extraordinary. Our institutional private school businesses are now significant high growth businesses, our investment in China is expected to yield excellent results, and our commitment to innovation and education is stronger than ever, as we pursue our manifest destiny of making a K12 education available to every child.

Turning to the outlook for fiscal year 2011, we are increasing our revenue guidance to a range between $515 million and $520 million. We are now guiding to EBITDA in excess of $72 million. If we back out losses from early stage businesses and one-time transaction related expenses, EBITDA would exceed $87 million.

Now I will turn the call over to our CFO Harry Hawks, who will provide more detail about our financial results.

Good morning, and thank you, Ron. Given Ron's comprehensive comments and the detail we provided in our press release, I will make a few key observations, and then get directly to your questions. But first, it is incumbent upon me to reemphasize the lead story, which was included in Ron's comment, and that is during the period, we had healthy organic growth in our core business. We are successfully integrating our recently completed acquisitions and we are executing successfully against several new strategic initiatives, which we discussed with you in some detail. My next few comments are really more targeted or perhaps technical.

We are working our way through the various transaction-related expenses, merger integration costs, one-time only expenses, things such as that which we discussed with you in some detail on the last call, and we are, indeed realizing sequential quarter-over-quarter deceleration of those kinds of expenses, and a quarter or two out from now, we would expect those to be de minimis. Start-up costs of the new initiatives, while a temporary burden on our operating income, EBITDA, and net income, are in fact, creating significant asset value that is not presently reflected in those numbers. So we are actually pleased with the value that we are creating for the owners of the Company in these new initiatives. And in subsequent periods, we would look to see a contribution to the financial and operating results of the Company.

I am pleased to report that notwithstanding the rather significant acquisition and investment activity, the financial health, flexibility and liquidity in the Company remains quite good. Leverage is quite low, liquidity is high. We have got excellent working capital position, including cash. So financially, the Company is in terrific shape in that respect.

As Ron mentioned to you, we have provided updated guidance, including increases to the outlook for revenue EBITDA, operating income, and the like. We also include an updated outlook for capital expenditures and capital leases, noncash compensation, interest expense, and income, taxes, and the like. Basically, everything other than EPS. It is annual guidance. And while we do not give quarterly guidance, I think it is probably helpful to mention to the audience that there is seasonality in our results, and so for the remainder of the year, we would expect to see the normal seasonal pattern in Q3 and Q4. And if you look in the past several years, Q4 generally speaking, is the lowest revenue quarter of the year. So while we haven't given quarterly guidance, expect the normal seasonal pattern for the next two quarters.

And then last comment, after our last quarterly call with you, we believe we have communicated with probably over 90%, perhaps even approaching 100% of the ownership of this Company, as well as a number of prospective new investors. And while the overwhelming emphasis of all of those conversations was indeed strategic, and the competitive environment and things like that, I did want to point out that much of the detail and increasing amount of transparency you are seeing in our press releases and other communication with you, is in response to comments and suggestions we have received from you. So this is, I guess, my opportunity to thank you for that input. We will continue to try to be responsive to your suggestions and request for additional transparency.

At the same time, we are working very, very hard to fully integrate all of these transactions. And so at some point, we won't be able to provide too much detail on for example, a KCDL or American Education because they are fully integrated into the Company. However, we will work with you as best we can to help you understand how we are executing against all of these new initiatives, that is a fair question, and we will continue to work with you on that.

On that note, we will pause and open the call up to your questions, please.

(Operator Instructions). Your first question comes from the line of Suzi Stein with Morgan Stanley. Please proceed.

Hi. I was wondering if you could talk a little more about school district sale, and where you are in terms of building out your sales force and just how quickly you will monetize this business. I'm not sure if you're willing to give this out, but how much of that is in your plan for this year?

Well as you know, a lot of that, the sales usually lag. So we are currently selling now for the next school year and the summer. But the hiring of the salespeople which we are expanding is going on as we speak. So what ends up happening you is end up hiring salespeople this year that you won't get revenue from until next year. So this year we are adding about ten more salespeople, and plus when you add the Aventa people, I think our sales force would have grown by about 16 people from last year to this year.

We also with American Education Corp, we are now able to sell through a very large network of resellers that has been developed over time, and we believe that being able to take the American Education Corp products through our sales force, and take some of our products through the resellers, that we are going to get pretty significant synergies out of that transaction. So with the sales force and this reseller network, we now cover a pretty broad spectrum of American schools, and we believe the institutional sales business will grow faster than even our core business, and maybe significantly faster. We are seeing a lot of traction and the pipeline is pretty robust, and we have to see what closes out of that pipeline. But we are pretty optimistic about what the growth rate will be for the institutional sales.

Okay. And then on the guidance, the difference between last quarter on the revenue number of $500 million to this quarter is $515 million or $520 million, is that just American education? Is that the only difference thee? Was there any change in the underlying number?

The underlying number has improved. We said in excess of $500 million last time, and now we are saying $515 million to $520 million. Not all of that increase is solely American education related. There is some additional improvement, if you will, in the outlook for the core business, as well.

Remember we only include half a year of AEC approximately.

Right.

Got it. And then just one more. Can you maybe give some more detail with the relationship with Blackboard, what you are doing there?

Yes. I am happy to. In fact, we just met with Blackboard. We are pretty excited about that. The relationship is going well. We have already got the courses ready to be delivered. And Blackboard brought into an event a lot of their customers, and many are now signing up for pilots. So what we expect to see in the fourth quarter is a series of pilots of the program with customers of Blackboard brought in, and then a full-out launch of it for next year.

But the response has been fantastic. I mean there is very strong interest in doing this, because I think we're able to do it, to do the delivery of courses better, and at a much better price point than a lot of colleges can. It is something a lot of them don't want to deal with. I am getting pretty optimistic that this is going to be very successful.

Okay. Great. Thank you.

Thank you.

Your next question comes from the line of Jeff Silber with BMO Capital. Please proceed.

Thanks so much. I wanted to shift base and talk a little bit about the political environment out there specifically at the State Houses. We had a number of new Governors. A lot of states have Republicans in charge of both Houses of Representatives. Are you seeing a change in mind-set I know it is a little early, either in the existing states that you are in, or in some potential new states?

Yes, we are. And I have never seen it like this in ten years. It is almost like someone flipped the switch overnight. And so many states now are considering either allowing us to open public virtual schools that weren't even six months ago, but also states where we have capped, we are hearing many people saying to us is the opposite, we want more people in these schools, not less.

So we are already seeing legislation start to move in several places. We are seeing caps start to come off. I am getting calls to ask why we have caps and how they can help us. So like I said, we're actually building up more staff and business development because there are more opportunities than we can actually cover to both add new states and remove caps. We are sitting here now and we never had a new state as early as Louisiana, and there are several more in the queue that we never can be sure these will happen, but I have never seen it as likely to happen as it is right now. And I have never been more excited than I am about the probabilities of new states, and also cap removal.

That is great to hear. And on cap removals, can you just remind us where the major caps are?

It is where they aren't. Texas obviously is large. There are structural issues in Florida that are limiting our growth, so not a cap per se. We have caps in Wisconsin and other structural issues there that are limiting it. Arkansas. We have it in Oregon. And there, it is in Chicago. So there are a bunch. If the caps were removed, it would accelerate our growth rate for years to come. And we believe many of them will be if not completely removed, significantly increased

Okay. Great. And Harry, this one is for you. You mentioned in terms of the guidance for the rest of the year to expect, I guess, the normal seasonality. In prior years, the Company has generated at an operating loss in the fourth quarter. Is that something that we should expect again this year?

Well, once again, I want to stop short of giving quarterly guidance, or if you will, backing into it, if you will. But let me answer you in the spirit of trying to be responsive, let me say this year's seasonality will be reflective of prior years' seasonality. So let me sort of stop there. But I think that is responsive in a different way to your question.

Okay. Fair enough. I will jump back in the queue. Thanks.

You bet. Thank you.

Your next question comes from the line of Amy Junker with Robert Baird. Please proceed.

Thanks. Good morning, guys. Harry let me start with you. I am hoping could you share with us how much revenue KCDL and AEC each contributed to the quarter? Can you split those out for us, so we can get a little sense of that?

Let me answer your question a different way, because one of the things we want to try to not do is get in the habit of giving revenue results or individual results for the acquisitions, because we are trying to assimilate those into the Company. And at some point, this will just sort of blend in. However in an effort to be responsive to your question, let me come at it a different way.

Of the revenue growth that we have for the quarter, and you can sort of back into some of these numbers, we have said that of the 38% revenue growth, 26% of the growth for the quarter was from the core business. And so just using kind of simple math backing into what growth and revenue came from the new stuff, well then, it is kind of 12% of that revenue growth in the quarter came from the new stuff. The new stuff will be largely KCDL with a smaller contribution from AEC. And that is about as close as I can come. But I think that is at least partially meeting you halfway in being responsive to your question.

Well the reason I was asking is just, and I won't ask this every quarter but because AEC just closed in December and I am guessing was not in people's estimates, I am just trying to gauge the beat that you had, how much of that was actually just due to the addition of AEC, versus outperformance either in KCDL or the core business?So if there is a way to answer that without --?

I can answer that. If AEC were zero for the quarter, because remember, it is a business that because we have talked about both AEC and KCDL at the time we acquired them, giving a relative dimension of their annualized revenue. And as you will recall from some of the prior press releases and prior calls, AEC is probably half the size of KCDL, and we incorporated results of only one month. So let me once again try to triangular ate on this, and I apologize for not giving you the specific number because we are just trying not to do that. But to come back it your question, once you do that math, you can quickly conclude that the contribution from AEC for the quarter was quite small.

Okay. That is helpful. Thank you.

You bet.

Another question that, Harry, you may not want to answer but I will ask it anyway and we will see what we get.

Go ahead and try.

of your non-core businesses, can you help us understand, perhaps, which businesses are kind of running above your current margin profile and which are below?And you don't need to necessarily give us specifics. And what I am really trying to get at, and perhaps, more importantly is where is the opportunity where some of those can improve or go up?

I think Ron and I will tag team on that. But let me add one sort of qualitative comment on the front end. When we use the word core business, we are trying to talk to you about what we had last year that, so you can kind of understand last year's business, and then all of the stuff we have added onto it. The new stuff we're doing I wouldn't call it non-core,we call it very strategic. One clarification. It is important stuff to us. I wouldn't call it non-core business. Okay.

And then the other part of my response is that a number of these new launches, and we put aside the acquisitions. A number of the new launches, where we are creating something from scratch with a de minimis amount of capital investment, what the investment is we are funding the start-up costs. So it has got a current period negative effect on expenses are higher. But because there is little revenue contribution to go with it just yet, the contribution to EBITDA and operating income is negative.

So the margin, if you will, on that stuff is negative. However, the reason we are doing these things is because we are incredibly excited about them, and think they are high margin, high growth businesses. So in subsequent periods, certainly subsequent years for sure, we are looking at those businesses not only having a positive contribution to EBITDA, but a positive contribution to consolidated margin of the Company. Now let me bounce pass it over to Ron, because I think he wanted to add some color to that, as well.

Yes. No, a couple of things. When you look at the private school business, the gross margins and things should be probably a little bit higher because there are a lot of costs that are imposed on the schools by government regulations, and the private schools will be able to while operating maybe even more services in some cases, there are a lot of things they don't have to do. So it should be similar or slightly better. The institutional business may also be better. But it is important to realize that these businesses are leveraging often an enormous amount of corporate costs and curriculum development and system development, that are already in our cost structure for the core business. So it is a tough question to answer. It depends on what margins you are talking about. But we are able to do these businesses with minimal investment in systems and curriculum. And that is what makes them such a natural expansion for us.

Right. So for example, AEC, just to reemphasize one of the compelling strategic rationales for doing the deal is that distribution network they have, is a magnificent opportunity for us to put our product and services into an incredibly larger sales and distribution network, which we believe materially expands the core business, if you will, of K12's addressable market. Okay. So as you know, we have been selling very hard into the virtual online school marketplace. A lot of these new initiatives expand that addressable market into virtually all public school districts in the country. And so the addressable market expansion for us is dramatic over the course of the next few years.

Great. That was very helpful. Thank you.

You bet.

Your next question comes from the line of Sara Gubins with Bank of America. Please proceed.

Yes. Good morning. Ron, talk about your outlook on funding for 2012, you mentioned that you think it may be down in some key states?

We certainly think that states, as I said, states are facing large budget gaps. They are looking to close them in a lot of cases education funding will take a hit. So we expect several states to see the funding go down. There are some others that won't go down and will be flat, and there are probably several that will be up a little bit.

I expect overall that we have been seeing it the last taw or three years, and we will see another year of it. I am encouraged to see tax revenues go up so much, what I am hoping by 2013 the revenue is caught up, and we won't have to see the big budget gaps and cuts. Fortunately for us, our business is scaling and the marginal student is obviously better than the average, so we are able to continually improve our cost structure to more than make up for these funding cuts. I would never have thought ten years ago you would ever see an environment where you would have three or four years straight of cuts, but I think that is what we are in as a total portfolio across the states.

Do you have any sense of the magnitude of the cuts we will see in 2012 versus 2011?

I am guessing they will be similar to what we have seen in the past year or two. It is hard to tell because obviously I will be able to answer that a lot better in three months, as the states are all in session figuring that out. And it is hard to tell where the budget gap closures, and how real the budget gaps are. At least in terms of magnitude. So it is a little early to answer that question. It is just hard.

And we have to take that number and balance it by the number of kids we have in each state. You are seeing Governors like Governor Brown in California saying that we aren't going it take it out of K12 funding, they will just hold that, and it will come from somewhere else. It is very hard to tell at this stage. But my general outlook when I look at the gaps the states are saying they have, and it is not clear how much of them they have taken into account where their tax revenues are increasing. But generally it is hard, you have to believe they are going to be down.

Okay. And then just an update on potential areas for further cost cutting?

Well again, we are integrating all of these things so the efficiencies come there, we are leveraging overhead, both in the schools and in corporate more efficiently. We have learned a lot of things about how we recruit students, the call center, that we believe are going to deliver increased efficiencies in both of those areas in the coming year, so I think there is plenty of opportunity for us to continually fine-tune our cost structure to makeup for that difference.

But let me also add to that, Ron, that of the cost of delivery of an education to the students we serve, a portion is variable with the increase in enrollment, and those costs are such as teachers, for example. But there are other costs in the cost of delivery of that education that are very scalable. And the monies we spend on curriculum, learning platforms, content management systems, and a variety of other things. So not all of the cost of delivery of an education are variable with a growth in enrollment. So one of the things that helps us fight back against a per pupil funding cut is as the enrollment goes up, not all of the cost structure goes up with it. So that it is indeed an offset in that particular kind of scenario.

Okay. Thank you.

Thank you.

Your next question comes from the line of Gary Bisbee with Barclays Capital. Please proceed.

Hi. Good morning.

Good morning.

You mentioned I think the thought process in near term of trying to integrate and make more efficient all of the partnerships and acquisitions you have done in the last year. But are you getting closer to what you would say your vision of the right mix of assets for the business will be, or would it be reasonable to expect a continued pace of some level of additional M&A and partnerships, as we look forward over the next, say, two or three years?

I think we are now in the businesses in the meaningful way that we planned to be in. So I don't see going far off field and adding another strategic business. When I look at, I have a virtual public school business, I have the institutional, the district sales, I have the private school business, and a significant entry into China. I think those are where we wanted to be, and we are there.

But I could easily see smaller follow-on acquisitions and particularly in the institutional business that add more product to that we think is good. We are looking obviously for technology-based products that can go into that channel. So there may be add-ons to that come along. But I think the pieces are in place to allow us to grow at the rate we want to grow for the next decade.

And then I guess the follow-up to that, you talked about some areas where you will rationalize costs. Are there infrastructure investments other than the Oracle system you mentioned, like I guess I am thinking people, more layers of management, are there areas that you are having to increase spending to be ready to handle all of this growth that you are looking at?

Well, when you are growing at the rate we are growing, you are constantly hiring people. There is no way around that. Though our labor productivity continues to go up. As we grow we are actually getting more labor productivity, as measured by revenue over labor as opposed to less, but what we are building out is business line management, right? I mean one of the reasons you want scale is so you can afford it put in the right person to run private schools, to run institutional, so that you have the business line to drive that business forward. So I think there is a layer of business line management that comes with this. And that is a good thing, not a bad thing. And one of the reasons you do the acquisitions is to get the scale, so you can justify putting that kind of caliber of person into these, or people into those lines.

And then can you give an update on some of the various bricks and mortar-type, or hybrid pilot programs that you talked about last year at your Investor Day?

Sure. We can. The hybrids, we continue to do well. We have a whole series of partnerships. In various states now we have individual sites that are, and we think it is increasing utilization, and it increases retention. So we literally have tens of these in the various schools running hybrid facilities.

These standalone hybrids which are more mandatory attendance that we have are all full in capacity, and we are looking to expand the capacity either through more sites or more of them. The full-time Select School in San Francisco, we think we have got the academic model now pretty well refined, and we are looking to add a couple more of those next year. So these are works in progress but the academic results we are very happy with and the student demand for these we are very happy with. So we think they are going to be significant parts but we pilot them only into a couple because we have to optimize the model academically, but also economically. But we are pretty pleased with where they are, literally every hybrid is full, and the standalone hybrids, and they are making AYP, so they are a pretty good solution to where this country is going to go I think educationally.

Okay. Great. And just one last one. In the press release, it looked like the Chinese business had 10,000 fewer students than what you said in your last press release. Is that seasonality, or are they struggling for some reason? Thanks.

That is really a correction from the prior number. There are 35,000 kids in that program right now.

So that business is far from struggling

Okay. Great. Thank you.

Quite to the contrary, it is actually growing quite nicely.

I think it is the different between FTE and how you count the students. We will clarify that.

Great. Thanks.

Your next question comes from the line of Frank Mcevoy with Craig Hallum. Please proceed.

Hi. Good morning, guys.

Good morning.

Good morning.

I have a few questions some are kind of follow-ups to some of the other ones that have already been asked. With respect to the legislative outlook on easing some of these enrollment caps, you made some very nice positive comments. Should we expect to see some new legislation that might affect the next school year, maybe give you some lift?

Yes. And there are already some that have been introduced, and I don't want to get into specifics on the states, because I don't talk about any of that until it actually happens. But there is legislation if you look carefully you would find that has already been introduced.

Very good. And in terms of there has been talk obviously there are tight budgets on, and average per pupil funding will be down. Can you give me a sense of like overall what that percentage decrease might be, looks like it will be for this year we are in right now?

It is a little early for me to answer that question. Sessions are just beginning and I think states are getting a handle on their budget. What is causing a lot of it is the Federal stimulus money is going down or disappearing in a lot of cases, and that is being offset by increased state tax revenue. Where that ends out I would much rather comment on that in May or June, since it doesn't affect us until next year. I will have a much clearer picture in three or four months.

Okay. But in terms of the institutional business, does the tight budgets does that make schools more receptive to your online curriculum?

There is no doubt about that. How everyone would look at it, online delivery is a much more efficient way of doing it. So I think how schools, how districts provide summer schools, they are looking at online, making individual courses they are looking online. So I think it encourages districts to move kids online off, and I think the fact that we are able to offer almost every price point in that and we can do it all the way from just offering courseware, to the complete solution, with teachers that actually take on a complete virtual school for the district. That portfolio allows it. I think it increases demand, it doesn't decrease it.

Thank you very much.

Thank you.

Your next question comes from the line of Giri Krishnan with Credit Suisse. Please proceed.

Hi, thanks. I have a couple of quick questions. Ron building up of earlier questions on state budgets, are we still on pace, and I know last quarter you suggested a decline of 1% to 2% for the year, have you heard anything that would suggest the declines might be less?

No. I am sticking with that. We haven't seen a change in the picture for this year's funding yet. So it looks similar to what we thought it was a couple of months ago.

Okay. And just quickly on guidance maybe for Harry, on both as we look at the instructional expense and the SG&A line, I know there are a lot of one-time costs involved. But is that a way for us to think about modeling these on a percentage revenue basis for the next couple of quarters, things that we should keep in mind?

Let's see. I think obviously we haven't given the, we have three line items of expense. We didn't give detailed guidance and as to each, the components of those three line items. We went straight from revenue to EBITDA and operating income. And obviously the only difference between EBITDA and operating income is depreciation and amortization and we have given that guidance. So I am trying to figure out a way to be responsive here. I probably need to kind of beg off trying to give you a percent of revenue kind of framework for modeling SG&A and instructional expenses, and things like that. Other than to say this.

If you take a look at the first quarter press release and 10-Q, and put it side by side with the second quarter press release and 10-Q, you will see that the instructional costs relatively flat picked up a little bit,a million or two, something like that. But you see SG&A down probably $15 million or so. And so as you think about the kind of EBITDA guidance, and frankly what we are talking about is how do you spread this over the next two quarters, I would kind of just suggest maybe look at the second quarter numbers, and the seasonality that you see in prior years, and you can kind of come pretty close to a good split between those numbers.

But as it relates to the transaction and one-time only expenses as a component of those costs, we have given annual guidance and we have also given you some kind of year-to-date numbers. And so you kind of see how much we are thinking we are going to incur for the remainder of the year. So I guess without directly answering your question, trying to help you get there through some of the information that we have already provided. Because I try not to give new guidance on the call that we hadn't specifically given in the press release. However in the spirit of trying to be helpful, see if I can get you where you want to be, through referencing stuff that is available. So I apologize for not directly answering your question, but tried to help you get there another way.

Okay. Alright. Fair enough. Thank you.

You bet.

I would now like to turn the call over to Ron Packard for closing remarks.

Thanks everybody, and there will be several Investor Conferences in the coming weeks, and we look forward to seeing many of you.

Thank you. Have a good day.