Stride Inc (LRN) 2013 Q3 法說會逐字稿

Good day ladies and gentlemen, and welcome to the Q3, 2013, K12 Inc, earnings conference call. My name is Catherine and I will be your operator for today. At this time 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 Christina Parker, Vice President of Investor Relations, please proceed ma'am.

Thank you and good morning. Welcome to K12 third quarter, fiscal 2013 earnings conference call. Before we begin the Company would like to remind you, that statements made during this conference call that are not historical fact 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 risk 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 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 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, Chief Financial Officer. Following our prepared remarks, we will answer any questions you may have. I would now like turn the call over to Nate.

Good morning. Thank you for joining us today. Since joined the executive team I've gained a deep respect and an understanding of our strengths and our challenges as a Company leading the transformation to online education solutions, for students in pre-K through high school. As the industry leader, K12 often takes the brunt of assaults for online education, as our integrity and our effectiveness is sometimes questioned. This is to be expected. But I'm very proud of our employees their resolve, and all that we accomplish, even in the face of these challenges. This quarter highlighted two important examples of the real truth about K12, and what we stand for, and what we believe in.

In early March we announced that after reviewing more than one million pages of discovery, the lead plaintiff in a class-action lawsuit against the Company voluntarily and permanently dismissed the claims it made about the academic performance and educational quality of K12 managed schools. A very powerful vindication of the Company. And just last week, the draft reported the Florida Department of Education's Office of Inspector General, conclusively established that the primary allegations made by Seminole County Public Schools, were unsubstantiated. K12 did not implement a system to intentionally avoid Florida's teacher certification requirements. The draft report found only a few record keeping and reporting errors. But we've already improved and implemented changes in our student data management system, and teacher training procedures to make improvements. In spite of these headwinds, the demand for educational choice is growing, and K12 continues to meet and exceed its financial targets. Increasing operating income, cash flow, and operating margins.

I'm very pleased with our third-quarter financial results, and excited about our performance as we believe we are on track to continually improve in our operational academic and financial results. Tim, Ron and Harry will discuss these topics in further detail shortly. The drive and effectiveness of our team, is truly inspirational. As you may be aware, half of the states where K12 manages public schools, are capped. Meaning that there are limits on the number of students who are able to enroll in school. This is a tremendous market opportunity, and we anticipate as the caps are expanded or completely eliminated, we have the potential in the next three to five years to help at least 50% more students than we currently serve today. While we have example, in Michigan the cap this school year is 1,000 students. Although we may have 6,000 students on a wait list.

Next school year that cap of 1,000, increases to 10,000, this is one of the reasons why our business develop efforts are so important, and are a key part of our business. Ron will discuss all of our business development updates in areas like this, a bit later in the call, but I did want to mention some exciting news in Florida as well. Last Thursday the Palm Beach School Board and the Florida Virtual Academy at Palm Beach completed a contract negotiation for the opening of a new charter school for the 2013, 2014 school year. In addition, the Florida Department of Education, recently certified K12's Florida operations for another three years.

Now like to turn the call over to Tim Murray, our President and Chief Operating Officer, who will discuss how we are working to improve our operational performance.

Thanks Nate, good morning. Our third-quarter results reflect continued progress to improve our financial and operational performance. As we strive to increase both academic excellence, as well as operational excellence. Revenue of $218 million grew 22.3%, compared to the prior-year period. Operating income of $19.4 million grew 67.2% year-over-year, reflecting EBITDA margin improvement and deceleration of DNA growth rate, as forecasted. Operating income margin increase from 6.5% to 8.9%, for the quarter on a year-over-year basis, and from 7.9% on a sequential basis.

SG&A as a percent of revenue dropped from 34% to 32.5% on a year-over-year basis. And marketing costs increased 8.3% year-over-year but were down as a percent of revenue, versus prior year. Turning to our school results, average student enrollments in our managed public schools grew 12.2% during the three month period, or 13.1% for the nine months, as compared to revenue growth of 26% or again 23.1% for nine months for those same schools. As we have said previously, this aligns with our stated plan to focus on higher funding states, improve revenue capture rates, and reduce the number of unfunded enrollments. We also benefited from rate and mix changes in the quarter. In our international and private pay schools revenue increased 9.5% with total semester course enrollments growing by 8.3%. While student enrollments decreased by 10.5%, the mix shifted to more full-time students in the higher-priced Academy School and the George Washington University Online School.

Looking at our marketing and enrollment performance, our internally tracked in-year withdrawal rate for our Managed Public Schools was down 1.4%, compared to the prior year quarter. Our cost per acquisition was down 2.6% compared to the prior year quarter. Aided by the implementation of further SCO improvements, and more robust display advertising, auditing, and attribution analytics to strengthen our market science, and improve efficiency and yield. We also began testing in a variety of ways to better respond to our families, including extended weekday and weekend hours, and click to chat. These actions are all indicative of our efforts to drive greater operational excellence in our marketing efforts.

In our B-to-B market, revenue and institutional sales again fell below our expectations, decreasing year-over-year by 3.2%. While this is a small part of our business today, it involves selling into a very fragmented and nascent market, we recognize the importance of expanding our addressable market to be able to serve all students. Our success depends on providing our customers the benefits of a more integrated experience, across the digital assets they use in the traditional school environment. Our value proposition is to simplify the district's adoption and management of digital curriculum and solutions. Sales momentum continues to increase, we have entered into approximately 1,000 contracts during the first three quarters of this fiscal year, compared to 700 in the prior year, an increase of 43%. Our average deal size is down year-over-year, reflecting the shift of product mix and some pricing pressure.

Our posture on pricing is one of patience and caution, we will protect our base but not chase the premium and free ware competitors who are trying to buy share. On a year-to-date basis, perpetual license sales are down, though we have replaced more than half of that revenue decline with annual license sales. We expect the majority of our future perpetual license sales to be catalog up-sells to our installed base of perpetual license customers, rather than new perpetual license customers.

As noted last quarter, we continue to seek districts dealing with funding and budget uncertainty, causing them to delay purchase decisions. We do not expect this to improve during the current quarter. And operationally in the quarter we completed the transition of our Aventa customer base, to a monthly billing cycle. This is important for two reasons, it improves transparency and visibility of revenues, and second, it's a necessary prerequisite to moving down the road to an integrated bill across our multiple products.

Our commitment to improving the student experience with K12 was demonstrated again during the third quarter, where our student facing systems averaged 99.9% availability. As noted last quarter, improved systems performance, a concerted effort to impact call drivers, and customer self help capabilities have reduced overall customer service call volumes 30%, compared to the third quarter of 2012, representing a 36% reduction on a per student basis. Last quarter I noted procurement and logistics is one focus area to improve operating leverage. Our materials and computer costs as a percent of revenue are down 18% compared to the prior quarter, reflecting unit cost improvements, as well as mix and timing differences.

In third quarter we also added a second materials distribution center in the western US to compliment our facility in the East. In short order, the facility will more than pay for itself and reduce shipping costs, while also benefiting Western customers with shorter transit times. In accordance with GAAP, we capitalized some of our software and curriculum development expenditures, considering all of these expenditures on a cash basis, they have decreased on a year-over-year basis 14% and 4%, or three and nine months respectively. Our product development team delivered three new mobile apps in the quarter. Two of them in HTML5, and three apps were extended to other platforms such as Android. We now have 19 mobile apps with over 700,000 downloads to date. We delivered some 14 advanced placement exam review courses, and completed six core courses and nine state customizations across the K12, Aventa, and A-plus portfolios for delivery next school year.

We also have some exciting news to share regarding our pre-K program, embarK12. It was a winner of the 2013 Parent's Choice Award and was named a 2013 finalists for the Cool Tool Award, by EdTech Digest, as well as the 2013 Golden Lamp Award. Overall, I'm very pleased with the trends that I observed over the last 12 months, as return, profitability, and efficiency ratios are all showing improvement. These developments are tangible proof that the changes we are implementing, including re-engineered policies and processes, a unified systems enterprise architecture approach, and unit cost improvements in our business are starting to pay off. Our efforts to improve operational performance are ongoing, and we view this positive data is simply a step in the right direction.

Now I'd like to turn the call over to Ron Packard, our Founder and CEO.

Thanks Tim. Good morning. As we indicated at Academic Day, we are continually working to improve academic performance, and our goal remains the same, to make available to every child an opportunity for a high-quality, individualized education, regardless of geographic location, or economic circumstances. By doing this, we create a world were all children can pursue their dreams. We recently convened an academic team at K12 that focused on improving our academic results. The team created an exciting plan and that plan is being operationalized as we speak. These changes should make our strong results in the scan-tron tests, even stronger and should also improve our performance on state tests. We are looking forward to the Common Core Assessments, which we believe will be an improvement over most of the current state assessment systems, and allow us to optimize for one assessment instead of standards.

We are moving purposely, and rapidly, to meet the needs of our customers, as most of them transition to the Common Core State Standards and Assessments. In addition to preparing for Common Core, we are continuing to offer more engaging, more rigorous, and more impactful instruction, as well as increasing the personalization of education, so that we can enable all students to be college and career ready. To accomplish this individualization, we are moving towards individual learning plans for every student in our schools, and are particularly focused on high school, where we believe these individualized plans will have a big impact. We are now building ubiquitous individualized learning plans into our national instruction model, so that every child's education is individualized. In reality, technology is enabling individualization of education, in ways that would have been possible just a few years ago.

In addition to an individualized plan for every child, we are also upgrading the quality of our embedded assessments so that teachers will be able to measure mastery more easily, and therefore help students learn more effectively and efficiently. I am happy with the additional time I now have to devote to academics, and facilitating the delivery of individualized education. I also now have additional time to spend on business development, which I am enjoying. We are on track to have one of the best business development years in our history. As many of you know, our growth rate can be significantly increased by new schools, and expansion of enrollment and caps in cap states.

For the upcoming fall, we have already secured cap expansion of 12,800 additional enrollment slots. This is dramatically larger than anything we have ever experienced previously, and amounts to 10% of this year's full-time enrollment in managed schools. Furthermore, we believe there is a strong possibility of additional cap expansion. While there is no guarantee that we will fill all of these slots, the pent up demand, referral network, and existing school infrastructure, make these slots easier to fill than slots for students in new states. With regard to new states, we anticipate New Jersey will open this fall, and we are still working on additional states. If we add more states, or experience additional cap expansion, this will impact our marketing spend in the fourth quarter of fiscal 2013 and drive even higher growth for fiscal 2014.

Additionally, six new charter applications have been approved. K12 currently has a signed management contract in place with each of these charter schools and all charter contracts are either completed or we are currently assisting the nonprofit boards in negotiating the charter contracts with the applicable school district. Of particular note is the addition of four new charters in Florida, which greatly increases our adjustable market in Florida. Some of these counties have as many students as a small state. Additionally, we've added new charters is South Carolina and Kansas.

In addition to this unprecedented cap expansion, we continue to renew charters, and add additional charters in existing states. Since the beginning of this fiscal year, almost two dozen charter and, or management renewals have been announced. With regard to the Colorado Virtual Academy, negotiations to finalize our services agreement are ongoing, and the deadline for reaching an agreement has been extended to May 31. In Virginia, one of our district partners voted to not renew the school after voting one month earlier to renew it. Obviously this surprised us, we are currently in advanced discussions with several school districts, and hope to find a solution for most if not all of the 300 students in Carroll County's program.

In addition to the new state and cap expansion, our results are also affected quite significantly by per people funding, which has been a strong headwind for most of the past five years. We are optimistic about the state funding levels for next year, as we now expect that several states will have a higher funding level than this past year. Multiple states increasing funding is not something we have seen often in recent years. If these increases hold for this upcoming Fall, that would be two consecutive years of rate increases. It is nice to see the negative trend we have fought for the past five years, appear to be reversing.

We should also mention that there is pending legislation that could result in lower funding in Pennsylvania, it is too early to predict the outcome of this legislation, but I will say it is a mystery to me why anyone would want to reduce the funding for the most efficient educational option. With this unprecedented cap expansion, the prospects have increased for pupil funding, the continued mainstream of online education, the new state pipeline, and the improvements to our offering, we are looking forward to strong Fall enrollment, and a great 2013, 2014 school year. Now I will turn it over to Harry, to discuss our financial results for the quarter.

Thank you Ron. Good morning to everyone participating in our earnings call and webcast. This morning, for the third fiscal quarter ended March 31, we are reporting revenue of $218 million, an increase of $39.8 million or 22.3%. EBITDA of $35.6 million an increase of $9.4 million or 35.9%. Operating income of $19.4 million, a $7.8 million increase or 67.2%. Net income attributable to common of $12 million, a $5 million increase, or 71.4%. EPS of $0.31 a $0.13 increase or 72%. For the nine months year-to-date period ended March 31, we are reporting revenue of $645.1 million, an increase of $107 million, or nearly 20%. EBITDA of $92.5 million an increase of over $23 million or more than 33%. Operating income of $44.3 million, more than a $17 million increase or nearly 65%. Net income attributable to common of $25.8 million, a $10.1 million increase or more than 64%. An EPS of $0.66, a $0.25 increase or 61%.

Based upon our reported results for nine months ended March 31 and our outlook for our fourth-quarter, we are also updating our full year guidance for fiscal '13, which we last updated on February 5 in connection with our second-quarter earnings release. As follows -- revenue range of $840 million to $850 million, indicating year-over-year growth of between 18.6% to 20%, as compared to the revenue last year of $708.4 million; EBITDA in the range of $108 million to $112 million, indicating year-over-year growth of 24.1% to 28.7%, as compared to $87 million last year; depreciation and amortization expense estimated at $65 million, indicating year-over-year growth of 12% as compared to $58 million last year; operating income in a range of $43 million to $47 million, indicating year-over-year growth from 48.3% to 62%, as compared to $29 million last year. The estimated full-year tax provision of 41% to 42% is unchanged from the guidance we gave on February 5.

We would also like to address three questions you may have on your mind regarding our outlook. Number one, why did Q3 turn out better than we thought on February 5? First, enrollment and retention in our core business were better than our internal forecast for the period. Number two, funding and rate realization in our core business were better than our internal forecast as well. Number three, our gross margin was 200 basis points better than we thought on February 5. The foregoing however was offset by revenues that were below our expectations in our other businesses.

Second question you may have, why is the implicit fourth-quarter outlook somewhat below what we thought on February 5? Some revenue we thought that would hit in Q4 was actually realized in Q3. A portion of the funding increases in our core business that were indicated some time ago, and then subsequently included in our forecast, have been delayed to a future period. Although as noted by Ron, this year has seen the realization a significant improvements in the funding environment. We see continued weakness in our institutional business, potentially resulting in flat year-over-year performance for this group. Internal and private pay while growing, is expected to be below our internal expectations, and additional expenses are expected in the fourth-quarter associated with management changes and additions.

Third question you may have, why did we reduce the full-year revenue outlook to the lower half of our previous range? Simply it was the factors above. Particularly though, the weakness in institutional, and a delay in certain funding increases. However, the underlying fundamentals in the core business remain strong, specifically enrollment, retention, funding environment and revenue capture.

Let me move on to a few topics that frequently come up between our calls and our ongoing dialogue with many of you, first is accounts receivable. Given some concerns last year about the prospect for slow pay in a few states, we are frequently asked about our accounts receivable aging and collection. Our third-quarter balance of $234.6 million, represents a reduction, and they say -- days sales outstanding are aging if you will, of several days. A 14% increase in the balance as compared to one year ago, was actually well below the 22% increase in revenue in the quarter a 19.9% increase in nine month revenue. And we have had an improvement in cash collections.

Next point, cash flow if you will, cash flow from operations on a GAAP Statement of Cash Flows for the nine months year-to-date was a positive $59.2 million, compared to negative $13.5 million one year ago, and $27 million two years ago. Cash balance, as a direct result of the foregoing, we note that net cash at March 31, was $33 million higher than the cash balance at March 31, a year ago, notwithstanding our ongoing investment in curriculum, software, and infrastructure. Also a reminder about seasonality, while we are very encouraged with our solid and improving liquidity, our results are seasonal and one quarter is not necessarily indicative of longer-term trends. A complete business cycle for us, spans the entire school year.

Point on depreciation and amortization, as you know, from fiscal '10 through fiscal '12, depreciation and amortization more than doubled from about $26 million to $58 million-about, largely as a result of acquisition related purchase accounting. This year our DNA expense through nine months is $48.2 million, presenting a 14% increase over the same period last year, which is down from the 39% increase that we recognized a year ago. Our updated guidance for the year of $65 million, would represent about a 12% increase over last year, so therefore, the growth in depreciation and amortization is clearly slowing down.

Lastly, on capital expenditures, our stated goal of slowing the rate of growth of capture expenditures continues to be demonstrated. Capital expenditures plus capitalized leases, which by the way is the way we think about CapEx, for the nine months year-to-date total $61.4 million, which is a 5.1% increase over the comparable number for the prior year, which compares to our EBITDA growth of 33.5%, through nine months year-to-date. Of course we will always consider investing in strategic opportunities with compelling return on investment characteristics. Certainly we have not addressed all of your questions, so now would be a good time for Nate, Ron Tim and me to respond to your question and comments. However, before doing so, let me turn it back over to Nate.

Thank you Harry. Before I turn the call over to questions I want to congratulate all of our employees, as well as the management team for a very solid quarter. I'm very proud of what we have accomplished. I'd also like to sincerely thank Harry for his dedication and hard work over the last three years. Harry's been a key member of the senior management team during a period of rapid and substantial growth, and he's made a significant contribution to the Company during his tenure. Harry's commitment to K12 is continuing and ongoing, he has demonstrated that by his willingness to serve as a consultant, to ensure a smooth transition to our new CFO James Rhyu. We wish Harry every success in the future endeavors that he is going to take on. And we're thankful for all that he's done to help make K12 what it is today.

Operator, at this time we would like to open the call to questions.

(Operator Instructions)

Sara Gubins.

Hello. Thanks. Good morning. This is Kelly Metzler for Sara. Average revenue per student was up nicely again this quarter, I know there is many factors that go into it, but what were the largest drivers? And then how should we think about it in fiscal '14 in terms of maybe unfunded students and the per pupil funding that you talked about?

Certainly. This is Harry. Thanks for the question.

You will note the revenue increase for this quarter was actually significantly greater than the enrollment increase, clear sign that of the revenue increase that we had, perhaps just shy of half of it is due to volume or increased enrollment. Therefore, the other half is due to, as referenced in Ron's comments and mine, we actually had a positive funding environment resulting in increased funding in a number of states, as well as increased capture. As you know we have made a real effort this year to reduce the amount of, if you will, unfunded students. I think that is responsive to your question.

Great. Thanks. And I know it is a small part of the business, but in terms of international and private pay, enrollment was down year-over-year, while course enrollment was up. What is the bigger driver of revenue? Is it courses or enrollment? Thank you.

It's actually something else. The private school businesses has very different price points. If you look at what the price points are in [IS Byrne] versus I Academy, versus Keystone, they're significant. So, enrollment shift to the higher-priced options, makes probably the biggest different in terms of what the revenue is relative to enrollment. So it's really -- was driven by relatively higher growth in the higher-priced options.

Thank you.

[Torry Greendale].

Thanks for all the color on moving pieces between Q3 and Q4. There was one I was just hoping for some elaboration on. You mentioned it sounded like funding increases were a positive in Q3 and a negative in Q4, can you just elaborate on that?

It is not a negative in Q4 in an absolute sense, only in a -- in our forecast we got less funding increase than we had -- than had been indicated by the state and districts where we work. It just got delayed to a future period. In the quarter, there actually will be realization of funding increases, just not as much as we had -- had expected.

Okay. And in the institutional business, I am curious how you are responding to the market weakness? Are you in lock down mode and cost cutting mode, or is it more investing and approach to market by adding salespeople?

As you can imagine, we've adjusted our expenses in accordance with our revenue outlook throughout the year, but we are still very bullish on the opportunity here. We are in a transition year on a number of basis, as we think about products transitioning from perpetual sales to annual license sales (technical difficulties) our annual license sales, so we are continuing to stay focused on investing in those sales and product development.

(technical difficulties)Okay, a question for Ron. As you've been pretty clear about the what is happening in Florida and for the most part it seems like your position has been borne out. Increasingly, you see headlines in one state that references issues in other states, it seems like there's more national publicity going on. Can you just talk about your approach to the market and making sure that people get the perspective on K12, that you think they ought to be getting and how that might be changing as there's more national headlines?

Well I think what you are saying is right in that, one thing seems to happens in one state seems to get picked up in other states. Our approach is, hopefully that things -- what we said is being borne out, and I think our beginning with the academic annual report and the academic that we had in the Academic Day is a good way of communicating what we do. So I think what we're trying to do is be much more proactive about the academic truth about K12, what we offer students, and we're going to be continuing, I think, escalate our communication of those positive aspects of K12.

It seems to be, the truth seems to be getting known by the people that matter as the fact that students are continuing to come to us at high rates, and as I mentioned this business development year is pretty much close to unprecedented. So, we're going to be more proactive. I've been doing this for 13 years, extremely proud of the employees at K12.

Everyone at K12 shares that passion for educating children, and we are doing society an incredible value for it, in terms of making in the grade education available for everybody. And also using technology to drive that personalized education. So I think it's continuing to get known, and that is why we are having the business development success. And we are going to keep doing it, because what we do is a great thing for kids. And you'll see more research coming out of academic institutions with regard to K12 and our work, and we are just going to keep pushing out the truth.

Torry this is Nate Davis, I would also, comment that we are very much grassroots communication organization, as well. So we have newsletters and communications that go to all of the parents, that go to all of the teacher organizations, that go to all of the -- our Boards of Education to make sure that they understand and put in context all of the news they hear, whether it is positive or negative. And we get positive news, we get negative news, but we try to make sure they are all getting a communication directly from us about the things we're doing, and the truth and the facts about some of these accusations that come out sometimes.

Thank you.

Jeff Silber.

Thanks so much just a follow-up on that last question. Obviously, with your Company being the largest in the space, you tend to attract more attention, whether it's positive or negative. But I'm just wondering are there others in the industry that you're working with to help combat the negative publicity?

We have conversations, but obviously for antitrust reasons we can not, we can only go so far. The industry association is small, and really is not well funded to be able to make a big difference. We have conversations with connections about some industry trends. But overall we know this is a battle that we may have to fight largely by ourselves, and so we are out communicating. Now, rather than just people inside the industry though, the people who are our allies, are many of the Boards of Education that work with us, our partners -- because they are our partners and many of them are substantial business leaders in their community. In addition to that, there are a number of State Senators who understand our products and services, and who also are good advocates for us. So, our reach and our communication and our teamwork goes beyond just the industry players, it goes outside the industry.

I also was going to say, we are now seeing serious interest from very high quality education schools, with regard to online education and really becoming experts and doing research in that field. I also think we're benefiting a lot from now we are seeing the nation's most selective colleges, with moves to a lot online. I think the mainstream of online education has been greatly accelerated over the past several years by what is happening with Stanford and MIT and Harvard all going online. And really everybody -- I do not hear everybody saying it is not a credible education option anymore.

Alright that's great to hear. You had mentioned in your prepared remarks about increases in caps for next year, I think it was about close to 13,000. Besides Michigan, can you just give us some color on the other states where caps are increasing?

I'd rather not get into the individual states. That is why did it as a total. But I will say this, that number is from three different states, and I expect more to happen.

Okay. Great. Thank you so much.

Jerry Herman.

Just wanted to pursue the fourth-quarter a little bit in the hopes that you may be able to disaggregate some of these fourth-quarter inputs. You mentioned timing issues on funding, as item A. The management changes were also mentioned. Ron, you mentioned a marketing spend increase potentially in the fourth quarter, which I would like to get some color on. And then, talk if you will about the Institutional and Private Pay business, or Private School business, in terms of what it is doing to operating performance? Dilutive or that negative year-over-year swing perhaps? Some color on that?

I'll start with the marketing spend and the correlation. With the way our Business works is, we end up spending a lot of money in the fourth-quarter recruiting students for the next year, so we incur a lot of expenses that have no revenue impact on this fiscal year. When we go through our guidance and modeling at the beginning of the year, we expect a certain amount of new states and cap expansion.

Obviously this year has exceeded our expectations. And if we have additional cap expansion or an additional new state, it would be beyond what we had ever anticipated, so we would incur significantly higher marketing expense -- higher marketing expense in the fourth-quarter than we had originally planned. So, that's what I mean by that. And if it is a new state there is also hiring and building up the staff for that state in the fourth-quarter would already begin, depending on when we get approval for that state. Ironically our success in the business development year, adversely affects our fourth-quarter expenses.

Regarding your other question about Q4. We have just -- I think you mentioned or you had a question about the timing of funding. We have through the course of the year, communications with states, school districts, et cetera where we establish budgets, and forecasts, and as it turns out a couple of the states where we were actually informed us of a delay in some of that. So we still have a very positive story to tell about the core business. But just some of the funding increases we had expected for Q4 had just been pushed into the future. Notwithstanding, we are enjoying a very good funding year. So, that is basically the comment there. And, I think, Tim you want to comment on institutional?

Jerry to the third part of your question relative to impact of international and private pay and institutional in the fourth-quarter. As you know, we do not really comment on the profitability of those segments per se, so I don't want to go there. But to the point of what do we expect the impact to be in Q4? We are effectively extrapolating current performance for both of those segments into the Q4.

Back to institutional for just a second, there are two real reasons for the shortfall. One is at the beginning of the year we filled fewer seats in our highest revenue per student product, in other words, a full-time student for the year. And then second the impact of this transition away from perpetual licenses. If we look at the health of that business, on a more relevant metric, how is the growth rate in recurring revenues? We see mid-teen performance there. So, we are comfortable with that going forward.

And Jerry, Nate Davis speaking here. Just to put them in priority order for you, the largest issue of course is the delay in the student reimbursement rate that Harry talked about. The second most important, because you wanted some color on that, was the institutional business, and third would have been the international private pay. But the first two are really the cause of us looking at a different set of numbers in the fourth-quarter.

But also I would mention this is actually good news. Because only operational myths or concern for the next quarter is in a revenue stream that accounts for less than 10% of our business, institutional. So, that means we're in good shape in managed schools, it's performing as we expected, matter-of-fact better than we expected. That remains our focus for the next few years. So, we're actually pretty proud that we have no concerns in the managed schools area, it is really just some work we have to do in the Institutional business.

And then, if I can follow with a sort of a qualitative question. You guys have spent a lot on systems and controls, the architecture and also I guess people in the financial area. Harry, maybe it is an opportunity for you to sort of describe where you are at relative to where you need to be? And Nate you may also want to comment?

Okay. Let me start Harry. You want to start?

Go ahead.

Let me tell you where, I think, we are in the systems area, and I think we are now at a stage where the finance team is about staffed where we need it to be. I think it is a strong team. I think that most of the support functions in the organization, the general and administrative costs, those organizations are not going to see growth, but I will tell you that I believe that we will see some shifting from the money we have spent on curriculum development, and put a little bit more of that in the infrastructure of our systems, both internal business systems as well as learning systems. We want to upgrade those some from the past. I don't think it is the dramatic overall increase, but a slight shift in the expenses there. So, I think we still have more work to do in the infrastructure systems to bring them up to where we want to be for the future.

And I will just follow with a couple of comments after Nate. Yes, over the past couple of years, we have significantly increased the headcount in the finance group. We have some growth related needs for the next fiscal year, but the rate of growth of headcount and finance will decelerate, because we are approaching the level of staffing that is appropriate for the Company. On a go-forward basis a couple of targeted hires are needed to go into next year.

So from a personnel point of view, we are in pretty good shape and trending in the right direction. Financial systems point of view, the effort today is shifting where it's most value added, which is the timeliness and quality of actionable information that Nate and Tim and Ron can use to manage the Business. And if you will, sort of in the business intelligence area, it was not that long ago when it was mostly focused on debits and credits and accounting, bit now the emphasis is on quality and timeliness of actionable information. So, I will --.

To the extent that you were asking about Oracle, I don't know if you were but I will just make it clear, Oracle is now fully implemented in the finance part of our Business. We continue to see some enhancements we may do, but we are using it, we're largely through that implementation. So when you saw the increase in expense because of Oracle we are through that part of it, that it's about finance.

We are now beginning to use it for the business information systems as Harry mentioned, we put several customer data and student data -- data repositories up on Oracle and it allows us to pull data more accurately and faster across more of the organization. That is the infrastructure part that I mentioned we are going to be spending some more time on but it's largely done for finance. Did I answer your question?

Yes guys. Thanks very much. I will turn it over.

Trace Urdan.

Ron, I know that is came as a surprise, but I wondered if you can unpack the Virginia decision a little bit for us? And decipher some of the reasons that they offered for not wanting to participate? Specifically the thing that surprised me, was that I always understood that situations like that where a district is sponsoring you but has fewer students enrolled in the school was actually sort of a financial benefit to them, because they would essentially get some amount of overhead per student that was incremental and additive to the funds that they have in the district, can you help us understand what is going on there? And if there are any implications that we might read from that decision?

Yes I am happy to, first I would not read any implications from that decision. It was a very unusual circumstance, I am not sure that the reasons have been clearly articulated to us. I will say that was a school board with just about an entire if not entire new membership, so the entire membership of the school board had changed, and it also has a new superintendent. So you literally were dealing with a completely different set of people, operating in the school, there are some unique things to Virginia that make it a little different to operate here.

I'm really happy that we have had interest from many other districts now in taking on the program. So I would expect that we will be able to serve most of those kids, but I would not read anything from this, it was a very unusual circumstance. And while districts do get an oversight fee in certain cases, I'd like to believe the main motivation for doing it with most districts is they want to serve and help as many children as possible get a great education. But there is nothing to read in from this, it was a surprise to us, and again I'm not sure we know the reasons.

Okay. It seemed like there might have been an illusion in their press release, and I know this has come up in the case of Pennsylvania where there is some confusion or concern over the application of federal funds in the context of your running virtual schools. And when you have addressed this in the past, you have suggested that on the contrary, you actually feel like you not only do not make more money from the application of Title I funds, but you might make less money from the application of Title I funds. And I wonder if you have been able to make any progress in terms of making a quantitative case in that respect? It feels like to the points that were raised earlier about national criticisms, you know, coming up, it seems like this is an issue that is emerging. I am wondering if you have a more pointed response to it?

As I think I have told you before Trace, with Federal funds and Title I funds are designed to spend a very specific way to help a certain type of at risk child, and we spend the money on extra programs for those children. I don't think there's really much of issue with Title I. It allows us to do what regular schools, or what I would say brick and mortar schools to do, which is apply additional resources to students who are at risk.

I think again, it cannot be said enough, that we are often operating on 60% or less of the funds per child that a brick and mortar school gets, and delivering a great education. I think we can do a lot more for these at-risk children if we could get to closer to funding parity, because I have some fantastic ideas on how you can actually engage students who are not fully engaged, is one of the more significant issues that we face. And I think even with close to the same funding we can do dramatic things to improve that student engagement.

I'm not questioning any of that Ron, it just feels like this issue continues to surface. I'm wondering if there's some more definitive way that you guys have to address it? Or do you think my read on that is wrong and it's not emerging as an area of criticism?

I do not think we have seen it emerge as a significant area.

Okay. Fair enough.

Federal funding at least.

Thank you.

Jeff Meuler.

Sorry to revisit this, but just want to make sure that I have it right. On the Q3, Q4 funding, it sounds like Q3, part of the upside was driven by funding being better than your expectations. But that is not being pulled forward from Q4, that is kind of separate states or separate issues. And then with Q4 it is just pushback. It's not lost but you still expect to realize a similar amount to your prior expectations it is just timing that you expect to realize it in 2014 instead of Q4. Is that all correct?

I think the way you just said it is pretty much in line with our message.

That is correct.

Perfect. And then Ron, obviously kudos on the business development year to you and the team. It sounds like there is still some more opportunities that could be live for next school year. At what point of the year or summer should we think about business development being locked in for next school year? Where if you are going to get a new state or you are going to get a cap increase, are they kind of in place by July? Or how should we think about the timing of that?

For the most part, they're usually in place by July, I would expect the additional cap expansion we're expecting to be in place by July. With new states, it has happened in the past where we actually got final notification as late as the end of August and could open a school. That is not ideal and we -- it creates a rapid engagement here like you've never seen before. But at the end of the day, I would expect by -- certainly by early August everything is ramped down.

Okay. And then any change in terms of marketing, messaging or in terms of how you operationally go after enrolling new students and doing re-registrations for next school year? I ask that in the context of the Moyler family advertising from K12 seems to be focused more on the quality of the education this year than I remember last year. So just any change in marketing message or operations around that process?

Yes, you can expect to see a shift in balance from less national advertising to more localized advertising and more localized tactics. We are finding for some of the schools and some of the geographies, that more grassroots activities can be very beneficial in terms of bringing new students into the schools at a lower costs. So there will be some shift in balance, but not a major change.

Okay. Thanks guys. Congratulations on the quarter. Harry, best of luck.

(Operator Instructions)

Alex Paris.

This is Joe Jansen filling in for Alex Paris. Just one last question there with caps expansions being a big driver here in future years, maybe you could just put some color around it? I was curious. Use Michigan as an example. In terms of enrollment growth ramped up expectations, how typical -- Michigan is going for 1,000 to 10,000. It sounds like there are 6,000 students on a waiting list. Are you at 60%, 70% capacity typically in year one when these caps get lifted, and then by year two, you are pretty much maxed out again? How does that work?

Usually and historically when we receive cap expansions we've actually generally gone to 100% the first year. However, we have never experienced anything as large as Michigan where you're going from 1,000 to 10,000. So, I think being at 60% or 70% may actually be a reasonable estimate. We do not know, because it really is an unprecedented amount of growth in a single year. But we would anticipate that, obviously, Michigan is a big enough state that we could get to that 10,000 in Year Two. But generally we only fill them up right away because we have not had -- we're usually looking at about 2,000, 3,000 kids at most. Not 9,000.

Okay, and then also, what was driving retention rate higher in the quarter?

We have put a concerted effort in the schools themselves to engage with families and students to address the issues that they've identified that could have caused a student to leave in the past. It is just stronger touch points, more touch points and more focus on it quite frankly.

Are we seeing a behavioral shift? My understanding was, students were running to you from something. And then typically parents would go to K12, get a good quality education, get their student -- get their child up to par, and then transfer back into say a public institution. Are you seeing once they come in, they see the high quality, the high touch that they are starting to change that perspective? Are you seeing some dynamic shift there?

I do not think we see have seen a dynamic shift in that way, no. I think we are still going to get a number of students who come to us and after they have repaired whatever the issue may be, they still may be leaving us. What we are seeing though is, those that were leaving because we were not touching them right, and they may have had a systems issue, they may have not understood how to operate -- land on the system, we are doing a better job as Tim said of touching them, resolving their issue, and I think those are the things that we are really seeing the benefits on the edge. The students that are coming in and leaving in a short period. Those that are behavioral are coming in because they need to fix something, they are still going to leave in the same time frame as they were going to leave before, at least in this year.

Okay. Great, great quarter. Thank you very much.

I would now like to turn the call over to Nate Davis, Executive Chairman for closing remarks.

Okay, I want to thank everybody again for joining us today. We don't have any long closing remarks. As you've heard us all say, though, we are very proud of what we have done. I would like to mention one thing on May 22 we will participate in the Bank of America Merrill Lynch conference in New York. Other than that, thank you for your time and look forward to speaking with you more in upcoming sessions. Goodbye.

Thanks for joining today's conference. This concludes the presentation. You may now disconnect. And have a very good day.