2U Inc (TWOU) 2018 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the 2U 2018 Third Quarter Earnings Call. (Operator Instructions) As a reminder, this call may be recorded.

I would now like to introduce your host for today's conference, Mr. Ed Goodwin, Vice President of Investor Relations. You may begin.

Thank you, operator. Good afternoon, everyone, and welcome to 2U's Third Quarter 2018 Earnings Conference Call. By now, you should have received a copy of the earnings release for the company's third quarter 2018 results. If you have not, the copy is available on our website, investor. 2u.com. The recorded webcast of this call will be available in the Investor Relations section of our website. Also, we routinely post announcements and information on our website, which we encourage you to access and make use of. Today's speakers are Christopher Chip Paucek, Co-Founder and CEO; and Cathy Graham, CFO.

During today's call, we may make forward-looking statements, including statements regarding the company's future financial and operating results, future market conditions and the plans and objectives of management for future operations. These forward-looking statements are not historical facts but rather are based on our current expectations and beliefs and are based on information currently available to us. The outcome of the events described in these forward-looking statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from the results anticipated by these forward-looking statements. This includes, but is not limited to, those risks contained in the Risk Factor section of the company's annual report on Form 10-K for the year ended December 31, 2017, and other reports filed with the SEC. All information provided in this call is as of today. Except as required by law, we undertake no obligation to update publicly any forward-looking statements made on this call to conform to statements or actual results or changes in our expectations. Also, it is 2U's policy not to update our financial guidance other than in public communications. Non-GAAP financial measures discussed during this call are reconciled to the most directly comparable GAAP measures in the tables attached to our press release. I would now like to turn the call over to Chip.

Thanks, Eddie. 2U is changing higher education worldwide. Scale creates a huge opportunity for us, one that ed tech really hasn't seen before. We're driving outcomes for more students and building an incredible business in the process.

Let's start with another excellent quarter. Revenue for Q3 was $107 million, a 52% improvement year-over-year. In the grad segment, revenue for Q3 was up 36% year-over-year. This was driven by the continued reacceleration of FCE growth, which was 36% for the quarter. That's up from a 28% increase in FCEs in Q2. In the short course segment, revenue for the quarter was $17.2 million. This is a 299% above the $4.3 million in revenue for 3Q '17, which was the first period we reported financial results for short courses. This impressive growth shows that the 2 businesses truly are better together.

On the bottom line, adjusted EBITDA margin for the quarter was up 9.7 percentage points year-over-year. Cathy will talk more about our Q3 results later in the call.

Now looking ahead to 2019. We're expecting consolidated revenue growth of 33.2% at the midpoint of our range. We're pleased with the resiliency of our grad portfolio and the power of our short course business, resulting in the type of expected growth that puts us in rarefied air among software companies. Look, it isn't common that a company keeps growing north of 30% off of a base of over $400 million in revenue. We said in the past that we expect to keep revenue growth above 30% for the "foreseeable future". We're now confident enough in the overall portfolio and the strength of the pipeline to put a timeline on it. We think we can keep consolidated revenue growth above 30% for at least the next 5 years. Based on these current growth expectations, 2U expects to hit $1 billion in revenue in a little over 3 years. That used to be a long-range goal. Now it's right in front of us. We can see it. You'll hear more about the path to $1 billion in the coming quarters.

Let's talk about the segments a bit. First, the grad segment. Adoption in our grad business is accelerating. Schools are asking for more from us than ever before. And that's within our standard contract ranges, 10-plus years in length and 60-plus percent in revenue share. Our partners want more programs and we're working out -- we're working on building out our infrastructure to handle it. Online is here and now. I've been running this company for a long time and I've never seen adoption like this. Expect more announcements in the near term from our current and future partners. In addition, this segment continues to show strong cash generation in mature launch cohorts. As a preview of our cohort margins, we expect that in 2018, the greater than 4-year cohort will move into the low-40s margins.

Our grad segment continues to build long-term client relationships and greater adoption and is showing resiliency despite a handful of challenges we expect will impact our results in 2019. Note that these challenges are reflected in our 2019 preview. We've always been transparent with our business, and not just the good, but the challenges as well. So let me give you some color on 2 of our largest programs, USC Social Work and UNC MBA. We've had complications, program-specific, not portfolio-wide, in each. In the case of USC Social Work, the school is going through a very significant change of leadership and direction, which are not specific to 2U. In the interim, we expect this will have an impact in 2019. There's a new dean search underway. It's our belief today that the school is taking a step back from broader access and moving to different student requirements, which is certainly their prerogative. But given this, we're taking a cautious approach towards our 2019 expectations. As such, we've taken down our enrollment forecast for the school for next year.

On UNC, again, leadership change has shifted perspectives on student requirements, complicated a bit by the changing makeup of MBA applicants nationwide. Digital education creates access for qualified students that might not otherwise have chosen to pursue a graduate degree. Our partners are evaluating more diverse applicant profiles than they reviewed for campus programs. The new team at UNC is currently grappling with this shift somewhat, and we now believe this will have some impact on new enrollments.

I think it's important to note that leadership change or changing student requirements don't typically have this impact. Leadership change has worked in our favor many times in the past. What's unusual is that 2 of our larger programs are being impacted negatively, but we believe we've taken this into account, the challenges specific to USC and UNC, in our 2019 forecast. And the great news is that our portfolio can absorb these program-specific challenges.

On balance, our portfolio is strong, diversified and resilient and not riding on any one customer. We have 13 business programs, 5 Social Work programs and more coming on both. The fact that overall we're doing as well as we are, with consolidated growth expectations at 33% for 2019 and in the 30s for at least the next 5 years is notable given the challenges in those large customers. Customer concentration is less of a concern when you have a portfolio filled with the strength of older customers like Northwestern, GW and others and newer ones like Fordham, Harvard and Pepperdine.

And yes, the new ones are doing really well. Last call -- the last call I told you that on the whole, the 2018 launch cohort might be the best in our history. A number of programs in that cohort rapidly scaled enrollments over their initial class starts. When programs do that well out of the gate, it's critical we spend more on marketing to ensure they continue scaling to their full potential. But the success of the 2018 cohort, coupled with the large step up in new launches, created a bit of a unique problem.

So let's talk about our overall marketing spend levels. It's clear to me today that we weren't investing enough across the entire grad portfolio as we rapidly accelerated new program launches.

The portfolio nearly doubled from second half '16 to second half '17. It's now obvious to us, in hindsight of course, that this should have driven a larger step up in marketing spend than we actually had. On a portfolio basis, this would have resulted in little to no margin expansion from 2016 to 2017. Instead, grad segment profitability increased by 2.6 percentage points over that time period. So while the portfolio is strong, we had plenty of opportunities to see additional enrollment growth, which would have driven some additional revenue growth in the grad segment in both 2018 and 2019.

Before I turn to the short course segment, I want to talk about a major announcement with a top 3 customer, Simmons University. Simmons has agreed to extend all 4 of their DGPs to 2039. 2039. I'm proud to work with President Helen Drinan, Provost Katie Conboy and their teams. It's a win for both parties and a powerful reaffirmation of our shared success model. The original contract still had quite a bit of time on it. It didn't end until 2024, but Simmons wanted to stay with us for the long haul. And yes, the deal stays well within the standard range for revenue share even after some revenue share relief. That puts the tally of partners extending contracts to 13 programs.

So now, onto the short course segment. It's expanding rapidly and there are still many levers to pull. But clearly, we're seeing increased adoption of short courses by our grad partners with 6 universities signed up for both. We've added 7 universities since we acquired GetSmarter in 2017, including new schools at 2 existing grad partners this quarter. George Washington University, where all 3 of our DGPs are with the Milken School of Public Health, announced a portfolio of courses across multiple schools. And this morning, we announced we're expanding our relationship with Yale, where we had launched the physician assistant program with the School of Medicine. Now the Yale School of Management will work with us to launch a suite of short courses.

In addition to these broader relationships for multiple short courses, you may see single courses from other clients on our website. For example, we'll be piloting a nutrition science course this spring with Stanford Center for Health Education. It's important not to overstate the impact of a single course, but you'll see them so I wanted to make sure you knew.

Before I turn it over to Cathy, I wanted to quickly touch on competition. Higher education is one of the largest markets you could operate in. There are clearly more programs being launched, both by universities doing it themselves as well as with other companies. This should not surprise you, but this does not mean we're not getting the programs we want. Quite the opposite, in fact, we are in our standard contract ranges. We signed all of the programs for our initial 2019 target much earlier than for previous years. And due to the strength of the pipeline, we increased our annual launch targets for the next 3 years. Competition is and always will be relevant, but we believe increased adoption is an opportunity for us, not a challenge. We're winning. Higher education as a whole is fully embracing online education. They're realizing this is something they need to do and do it soon. Our current partners are asking us for more, and it's clear to me, we need to be in a position to say yes.

That means investing more today to drive scale over the long term. Powering more educational offerings at scale creates more options for students, which ultimately drives more outcomes and it will make us a much larger and stronger company in the long run.

Our bottom line preview for 2019 shows we'll be investing more with our expected adjusted EBITDA margin for the year at 2% to 2.5%. Investor alignment in this effort is critical. So I say to you, if you're an investor interested in long-term growth and long-term cash generation, 2U is for you. If you're an investor that believes in plowing cohort profitability back into growth, 2U is for you. If on the other hand, you're an investor looking for a CEO who will sacrifice future growth to build free cash flow in the short term, look elsewhere. The TAM is too large, the opportunity is too big and we have to keep digging the moat. Cathy?

Thanks, Chip. 2U's financial performance continued to be strong in the third quarter. Revenue came in at the high end of our guidance range, and earnings hedges were either at or better than the high end of the ranges we provided.

At $107 million, third quarter revenue exceeded the prior year period by 52%. In our graduate program segment, year-over-year revenue growth was 36% for the quarter, with our short course segment reporting year-over-year revenue growth of 299%. For the third quarter, fluctuations in currency from the rates prevailing in the third quarter of 2017 did not have a material impact on revenue or any of our other financial measures. Both graduate program and short course revenue growth continued to be driven by increases in full course equivalents. Graduate program FCE growth again trended upwards in the third quarter, showing a year-over-year increase of 36%, 8 percentage points higher than in the second quarter. This FCE growth was further enhanced by a small 0.3% increase in average revenue per FCE.

In our short course segment, FCEs increased year-over-year by 119% in the third quarter, bolstered by an increase in average revenue per FCE of 57%. This significant year-over-year increase in average revenue per short course FCE was due to higher-priced U.S. and U.K. university courses driving an increasing majority of this segment's revenue. Average revenue for short course FCE did drop slightly on a sequential basis, which was due entirely to currency fluctuations between the second and third quarters.

Turning to our earnings measures. At $9.9 million, third quarter net loss improved year-over-year by $4.8 million and the corresponding margin increased by 11.7 percentage points. Year-over-year improvement in net loss and in all of our earnings measures was generated both in our graduate program and short course segments. Beyond the impact of year-over-year revenue increases, the largest factors driving net loss improvement and improvement in all of our earnings measures for the period were a decrease in incentive compensation accrual percentages and a decline in professional fee expenditures following the go live of our ERP system.

Third quarter net loss was better than forecasted, largely because of adjustments to our expectations for vesting of certain performance-related stock grants. Additionally, a rising rate environment generated higher-than-expected interest income and we recognized somewhat lower-than-expected depreciation expense. After net adjustments of $9.3 million, third quarter adjusted net loss was $688,000 or 0.6% of revenue. This represented a $6.7 million and 9.9 percentage point year-over-year improvement to adjusted net loss and adjusted net loss margin, respectively. Adjusted net loss for the quarter was also better than expected, primarily because of the interest and depreciation factors that positively impacted our net loss. After a further net adjustment of $5.4 million, third quarter adjusted EBITDA was $4.7 million or 4.4% of revenue. This represented an $8.4 million increase in adjusted EBITDA and a 9.7 percentage point expansion in adjusted EBITDA margin over the adjusted EBITDA loss position in the prior year period.

From a balance sheet perspective, we ended the quarter with $442.2 million in cash and cash equivalents plus an additional $25 million in investments for a total of $467.2 million.

Our balance sheet also had $49.7 million in receivables balances, 97% of which was related to our graduate program segment and appropriate for the timing of graduate program class starts.

Now looking forward, we've provided guidance for the fourth quarter and increased guidance for full year 2018. The fourth quarter guidance we are providing is materially in line with the implied guidance that could have been derived from the information we provided with our second quarter results, and our full year increase is largely the result of third quarter over performance. We now expect revenue to be between $114.4 million and $115.3 million for the fourth quarter and between $411 million and $411.9 million for the full year. At their midpoints, these ranges represent year-over-year revenue growth of 32.5% for the quarter and 43.5% for the year.

Looking at earnings measures, we expect net income of between $2.4 million and $3.0 million for the quarter and a net loss of between $40.7 million and $40.1 million for the full year. At the midpoint of these ranges, it implies year-over-year margin improvement of 1.8 percentage points for the quarter and 0.4% for the full year. We're also expecting fourth quarter adjusted net income of between $12.3 million and $12.9 million, with an adjusted net loss for the year ranging between $4.9 million and $4.3 million. At the midpoint of these ranges, it implies year-over-year margin improvement of 1.9 percentage points for the quarter and 0.4% for the full year.

Adjusted EBITDA is expected to be positive for both the fourth quarter and the full year at ranges of between $19.8 million and $20.4 million and between $17.4 million and $18 million, respectively. At the midpoint of these ranges, it implies a year-over-year margin increase of 2.8 percentage points for the quarter and 0.3% for the full year.

With respect to our fourth quarter earnings measures, let me remind you that in both our graduate program and short course businesses, we reduced our marketing activities during the year-end holiday period so fourth quarter margins typically increase. Fourth quarter margin should not be viewed as a run rate going into the early quarters of 2019.

As we approach the end of the year and though we have not yet completed our budget cycle, we'd like to give you a first look at our expectations for 2019. But before we talk specifics, I'd like to make some directional comments about the impact of the late 2017 spend decisions that Chip hit on in his comments.

During the second half of 2017, we were marketing 22 new programs in addition to the 24 already operating. This was a big step up from the prior year where during the same relative time frame, we were marketing 8 new programs on top of the 18 we had in operation. In retrospect, and in an attempt to keep our commitment to advance adjusted EBITDA margins by low single-digit percentages annually, we did not deploy enough marketing spend to take advantage of all of the opportunities we had to acquire profitable enrollments, given the significant ramp up in new programs. In doing so, we generated an adjusted EBITDA margin increase of approximately 2.8 percentage points for '17 but cost ourselves revenue growth in 2018 and expected revenue growth for 2019.

And viewed on an individual enrollment basis, this additional spend would have been profitable. It's important to understand that the short-term impact on consolidated margins of investing in more profitable enrollment acquisitions would not be expected to have any impact on programs reaching fully loaded target margins in the mid-30% as they reach maturity.

We continue to believe that demonstrating the earnings power of our business model is essential. However, in this period of rapid program launch expansion, we are going to ask you to assess this more through cohort profitability margins than through consolidated margin advancement. Until the balance of existing and new programs and marketing shifts further out on the maturity curve, we will weight our spend choices more heavily towards maximizing profitable individual program spend than optimizing short-term consolidated margins.

This is a meaningful factor in why we now expect a year-over-year decline in margins across our earnings measures for 2019.

Additionally, however, we also expect that our technology and content areas we'll spend somewhat more as a percent of revenue in 2019. Technology is continuing to develop and support our existing platform, at the same time, is integrating and rolling out significant new functionality based on the Learn.co technology we acquired earlier this year. And because of our accelerating program and offering launch schedules, the increase in number of courses that need to be built by our content group in 2019 will likely drive production cost growth that significantly outpaces revenue growth. These enhancement and scale-related factors will also contribute to somewhat lower 2019 margins across our earnings measures.

For 2019, we expect year-over-year revenue growth of between 32.5% and 33.9%. We're not far enough along in our budget process to provide significant commentary on the distribution of revenue across the year, but we can say that we expect approximately 22% of 2019 revenue to be recognized in the first quarter.

Before turning to our earnings measure preview, I want to address any concerns you may have about year-over-year revenue growth in our graduate program segment for 2019. As Chip discussed, we are now forecasting that leadership changes at USC and UNC will impact enrollments in those historically large programs, and therefore, we're expecting a meaningful revenue impact as well.

To quantify, we believe that these program-specific challenges are likely to impact our previous expectations for graduate program revenue growth by about 3 percentage points for 2019. Given our long cycle time, we can't replace that revenue for next year at this late date. Though it does speak to the resiliency of our portfolio that we expect strong segment growth despite unanticipated declines in 2 of our largest programs.

We now expect that for 2019, we will generate a net loss margin of between 14.1% and 13.5%, an adjusted net loss margin of between 4.5% and 4.0%, and a positive adjusted EBITDA margin of between 2% and 2.5%. As with revenue, we're not yet in a position to comment on the distribution of earnings measures across the year, but we can say that for the first quarter, we expect a net loss margin of between 19.4% and 19%, an adjusted net loss margin of between 10.1% and 9.8%, and an adjusted EBITDA loss margin of between 4% and 3.6%.

I'd like to point out that the 2019 margin declines we expect to incur to fund additional investments in marketing, and to a lesser extent, in technology improvements and content scaling, represent only a small portion of the year-over-year revenue growth we expect to generate in 2019.

At the midpoint to the full year revenue and adjusted EBITDA ranges we've provided, it implies that we will invest only slightly more than 6.5% of our expected 2019 year-over-year revenue increase in rightsizing our marketing spend, making a significant technology transition, matching course production to our increasing launch cadence and driving continued growth in quality in years to come.

I'll also note that these additional expenditures have no impact on our belief that our current business plan is fully funded. In thinking about distribution of earnings measures across 2019, we expect that the full year margin declines we're forecasting will have a disproportionate impact on results in the first half of the year. While the impact of technology and content-related investments will be spread across the quarters, we get the highest revenue benefit in late 2019 and 2020 if we allocate a larger portion of our marketing spend to the early part of 2019. I'll also remind you again that in second quarter, we typically incur a disproportionate amount of annual costs that reduce our earnings measures related to meetings, trainings, graduations and other periodic events in our graduate programs business.

Conversely, we typically reduce our marketing cost during the year-end holiday period in both our business segments, which increases earnings measures in the fourth quarter. So all in all, we had a really nice quarter and are looking forward to a strong close to 2018. And while we're bringing down our margin somewhat in next year's preview, it's for all the right reasons: accelerating client demand, additional profitable enrollment opportunities, evolving product excellence and support of the increasingly visible and close-in path to $1 billion in revenue. Relative to the opportunity in front of us, the additional investments we expect to make next year are small, and the returns, though in subsequent periods, are predictable and meaningful. For the long-term health and value of our business, we'll make that trade-off. Chip?

Thanks, Cathy. We've been telling you for years that 2U is building the future of higher education and that the power of people, human interaction and community is central to our approach and success. That principle couldn't be more clear from what we've seen over the past 3 months from our global access partnership with WeWork. Let me give you a few numbers. More than half of all students in 2U-powered graduate programs have signed up for the global access benefit. More than half, over 1,000 of those have activated their WeWork key cards across 20 countries, 70 global cities and 228 individual WeWork locations. Those numbers are compelling but the impact on students is really what matters. Transforming lives, that's what it's all about. And with that, we're open to receive your questions.

(Operator Instructions) Our first question comes from Sarah Hindlian with Macquarie.

Chip, there was a big reacceleration in the core graduate business from 25% growth to 36% growth. And it looks like it came from both enrollment and tuition, but I'd love to get a little bit of a better sense of the color around where you sort of saw the reacceleration within the cohorts coming online. And then a follow-up. I think, given the headwinds you outlined at UNC and USC, what specifically is giving you confidence to raise the top line slightly for fiscal year '19?

So I would say the portfolio overall is very strong and it's really diversified. So the 2018 cohort is certainly one of the best we've ever had and launched with a bunch of really strong programs in some ways that surprised us. So not just Fordham, which I know the Fordham Social Work program was talked about quite a bit in the market over the past 3 months, other programs, like Harvard as an example, very strong out of the gate. So it's a pretty balanced portfolio. So what we're quite excited about is given some of the challenges we mentioned in 2 of the older programs, the fact that the portfolio can handle it, and we can see this kind of growth overall, makes us pretty proud of what we're building here. And we do feel like we've got that sort of covered for next year and we're looking at a forecast. So obviously, we're trying to be cautious about what we put out there. For those 2 programs in particular, and given that the rest of the portfolio's performing strong, I mean, you've got a bunch of older programs that are exciting like Northwestern counseling, and you have newer programs that are exacting like Pepperdine psychology, which is a good example of the program we haven't talked a lot about from the '17 cohort. So it's pretty broad based.

Our next question comes from Monika Garg with KeyBanc.

Chip, I have a question, first, on the USC and UNC. I guess, I'm trying to understand, given that these 2 have been very successful programs, what is surprising to the new deans who are looking to make changes at these programs?

So Monika, what I would say, one of the difficult things about us being a public company is that we try to keep as much of our university business out of the public market. It's really not that relevant and we don't want our clients to feel any impact to us being a public company. So we try to make sure that people understand when there are challenges, whether they be -- we've had leadership change plenty of times in the past and we've seen leadership change be quite positive for the company. We've also seen situations where leadership change has been a negative. In this particular case, USC Social Work, there actually isn't currently -- there's an interim dean and they're in the midst of a pretty big dean search. And so during this time period, the school has sort of pulled back a bit and that's certainly their prerogative and we're trying to be patient in the process and work through it with our partner. On balance, in both of those cases, we feel like not only can the portfolio handle it, but you're talking about 33% consolidated growth over the total business coming off a pretty high base. So in the end, sort of more detail from those 2 particular programs is tricky, given it's really not appropriate for us to get into it with public investors. What I would say is the strength of the overall relationship at the top, we feel very strongly about.

And then, Cathy, for your 2019 guidance, what is the growth of short courses you're assuming in it?

So as you know, we don't tend to give guidance on a segment basis, but I think that we've made some -- we've given some color commentary around both segments in prior periods. I think that if you were to look at the fact that we have said that we would give -- that there's about a 3 percentage point impact from where we were before on the graduate business, it does imply that the numbers we have given for short courses are going to be somewhat higher than we've talked about previously.

Our next question comes from Michael Tarkan with Compass Point.

Just on the competitive front. Maybe touched on it a little bit, but I guess is there anything that you're seeing out there that's driving up students acquisition costs? And then just as a follow-up, on the 2 large programs, is there any kind of saturation point that you hit when you get to a certain size that makes growing enrollment a little bit tougher?

So on the first question, we -- no, we haven't seen any materially different marketing expenses. I think our current LTR-TCA ratio for Q3 of 3.16 sort of says it at all. Candidly, that's too high for where we are right now. We should have invested more there and there's quite a bit of profitable options for us to drive quality enrollments. And the key there is remember, quality at their quality level. So in other words, it's not just about finding any student, it's about finding the right student, and that's tricky. So to get to the second part of your question, we said for some time that programs do reach a natural steady-state, let's say, year 5 or 6. So the fact that we are seeing growth in some of the older programs in the greater than 4 years bucket is impressive. So in these 2 particular programs, you're dealing with very program-specific things that there's a reasonable shot turnaround. And we just have to do the work on our side, working with our partner to be a good partner during these types of situations.

That's helpful. Second question is you talked about hitting a $1 billion dollar run rate over -- in a little over 3 years. Just so I'm clear, is that -- are you referring to 2021 annual revenue in that forecast?

We're talking about by the 3 years off of the end of '18. So certainly, the run rate by the time you're hitting the end of 2021 is really the timeframe we're discussing.

Our next question comes from Jeff Meuler with Baird.

I guess, just on the unit economic question and just, I guess, reiterate confidence for the market there. I guess, on the absolute margin guidance, I would think that some of the marketing spend from the UNC and USC programs would be redirected to the other programs. So I understand incrementally spending for marketing and program launches where you're seeing good unit economics. But I guess, what am I missing on why there's not more of a redirect and just anything further you can say on just investing more aggressively behind good unit economics?

So there actually is a redirect of some of that spend out of those programs where we don't anticipate that enrollments will be as high. However, beyond any redirected spend, there are still opportunities to do profitable enrollment acquisition. And so the additional dollars that we're talking about, particularly in the first half of 2019, are in addition to any redirect that we will do, given enrollment expectations or behavior by the schools.

I guess, what I would add to that is just remember the step up. As we tried to point out, the step up in program launches was more than we had ever seen, more than we had ever done before. And it's clear to us today and clear to me in particular as CEO that it's in the rearview mirror, of course, but that we had really good spend we could have deployed and should have put margin generation during that time period in the backseat.

Okay. And then just what are you seeing in terms of student quality? And I'm wondering if any of the -- what you're seeing from a macroeconomic sensitivity perspective with the tight labor market, if that's having an impact on student quality and -- in the pipeline at all?

So what I would say is, historically, MBA programs in particular have been countercyclical. There may be some of that impact more broadly. We think -- we didn't bring it up in prepared remarks because we thought it was pretty trivial, in our case, not the real story. So we didn't want to focus any time on it. Without question, MBA enrollments are in under some pressure because fewer international students are attending campus programs here. Interestingly, they're attending more campus programs in the U.K. so that potentially bodes well for our UCL MBA. But regardless, overall, we've existed during the worst economic period in all of our history, at least everyone that's on the call. I don't think anyone was alive during a period when the economic situation was worse than 2008. And we're doing great during what is a pretty bullish economy with very low unemployment. So we didn't focus too much on that because we really didn't think that was the story. It is clear that the MBA overall portfolio, student option -- students coming into the pipeline are definitely getting younger. That is a bit of a trend and one that we think over time we'll be able to take advantage of.

My friend, Peter Appert, might have been alive at that time.

Our next question comes from Corey Greendale with First Analysis.

So first question. I just want to clarify. I know you're not giving real specific guidance, but you had in the past talked about specific growth rate ranges for DGP for 2019 and 2020. I just want to be clear, like, I think you said in the past, 2020 you expected 33% to 35% growth. Should that not be relied on anymore or do you still, from where we stand today, expect that, that is achievable?

So Corey, I would say that given that we are obviously stepping back our 2019 guidance for short -- for the graduate program segment, I think it remains to be seen what 2020 growth rate will look like relative to that. So at this point, we're not prepared to make further comments.

Yes. What I would say, Corey, just to add to that is with the challenges we've seen in those 2 legacy programs, we are pleased that, number one, not only is the overall guide what it is but that we feel comfortable enough saying it will be above 30 in the consolidated for 5-plus years. And we have seen the acceleration we expected in the grad business. So we clearly have seen acceleration in the grad business. So the portfolio is sort of making up for it. From my perspective, there was a time period where this would have been a really, really big challenge, candidly. So we don't want to just focus on the positive. We're super psyched about where the company is, but we feel like we learned, as we've been public for almost 5 years, if we know something, we're going to tell you. So this is a forecast, to be clear. And when you get out, even though our business is super predictable, I do think what the rest of the OPM space, particularly those folks that are converting, are going to have to learn is that you're not in charge. And there are moments where programs will make decisions that have an impact on financials, and it is completely their prerogative to decide who is in the program and who's not in the program, whether we agree with it in that moment or not. So in this particular case, we're trying to apply what we know today to something that has not yet occurred and something that is a future forecast. So it makes it a little difficult to decide when you're dealing with interim folks in those programs that 2020 will be a certain something. So we're trying to give you what we can now.

I understand. And then I have 2 bottom line questions, one short term, one longer term. On the short term, Cathy, as you talk about increased spend in program development. Some amount of that is capital, at least I assume. Is there anything you can say about how that changes in 2019 or anything about free cash flow?

So we don't expect that our cap rates are going to change materially on either the technology or the content development sides. So I think you should assume that those don't have a material -- that no change has a material impact on our cash use for 2019.

Okay. And then longer term, actually, Chip, appreciate the 5-year 30-plus confidence. Just to be clear, is 2018 year 1 or year 0 of that?

2018 is year 0 on that. So it's 3 years off of the end of '18 for that. And Corey, just to go back to your sort of -- sorry, 3 years for $1 million, 5 years for...

He's asking for the 30%.

30%, 5 years.

5 years, yes.

Off the end of '18. We are -- I want to reiterate that nothing about what we're talking about in terms of margins or in terms of additional investment in 2019 in any way has us believe that we're not fully funded through self-sustaining on our current business model.

That actually answers my second question then. And Chip, that was about as clear a statement as I've ever heard from a public company CEO in terms of investor match, suitability. So appreciate that.

Our next question comes from Jeff Silber with BMO.

I wanted to circle back to the comments about some of the added investments in ramping up marketing spend next year. Is this a different type of marketing spend? Is it the same thing you've been doing beforehand? Any color would be really appreciated.

Well, the marketing, by definition, continues to evolve. It really never stands past, so we're -- our scene by definition tries to consistently innovate. And some of the scale we're seeing across various platforms, whether it be LinkedIn or even are -- we're even, in certain cases, trying direct mail, oddly, it working well in certain micro sort of targeted areas. So they continue to evolve. But overall, this is really a story of having a portfolio that is getting quite large, and we had a bunch of programs come out of the gate and be superstrong. And we should have just put overall more marketing dollars into the portfolio is really what it comes down to. So LTR-TCA this current period, Q3, was 3.16.

Okay. And then just kind of shifting back to the long term comment about the $1 billion dollar goal, I just want to confirm, is that organic and would we expect margins to start expanding again over that period?

So the $1 billion we are talking about currently is organic. Though we may supplement at some point, you never know. We look at a lot of things. But at this point, our existing business is moving in that direction for grad and short course.

Right. I mean, we've now -- the thing about the short course business, we've now in the short course business for over a year. We're clearly fully integrating, our clients are adopting it as quickly as we hoped. And we're at a point where it's so early still that there's a lot of levers to pull. So just as an example, early days of share. So pretty excited about what that means for growth across the entire portfolio.

I was just to say, as for your second question about margins, I think, that we need to be in a position at this point where growth takes precedence. That does not mean we don't believe that margin acceleration is important. But as I said, at this very moment and until we can get a little more balance between new programs in marketing and existing, we are going to sort of weight our decisions towards growth.

Our next question comes from Tom Singlehurst with Citi.

It's Tom here from Citigroup. I have other questions, if it's okay. First one, with regards to the Simmons deal, I think -- I can't remember the exact phrase but it was something along the lines of you talk about providing economic consideration to Simmons' universities over time in order to produce the effective revenue share. Can you just talk a little bit about the mechanics of that and exactly how that works. That's the first question. The second question was on situations like the one you described with USC and UNC. Just, I suppose, in principle, how you approach investment in marketing during those kind of hot periods of hiatus, I mean, given it's such long lead time, in terms of program marketing, do you keep a steady level going throughout what you -- until you find out what's happening? And then the final question. Backlog in terms of revenue, no one's asked. Whether you can give us something on that, that would be great.

Sure. Thanks, Tom. So on Simmons, this is -- as we've done with every extension that the company's had, they're all slightly different. But of course, we are giving some revenue share relief over the life cycle of the remainder of the contract, in this case, a very long contract. So we're super excited about the length, and we're staying well within our standard range. So we feel like great long-term outcome for Simmons and great long-term outcome for 2U. I do think one should sort of pause and get away from the -- just step back and think about it for a second. I'll be 68 when that contract ends. It's 4 DGPs and they extended it on top of the existing period by 15 years for what is revenue share relief that keeps it well within the range of where we typically would see our contracts. So love it and very proud to have that relationship and think that, that relationship will continue to grow. The second point, I've now forgotten entirely and Cathy will remind me. The third point, backlog, is very easy. $449 million at the end of the quarter. So getting to be quite a number. And the second was?

The second one was how do we approach thinking about deploying marketing within...

Yes. Well, I mean, the critical thing there is these are our partners and we have to do right by the partnership, and so we have to keep the business rolling. And while both of those businesses have taken a slight dip, let's also be -- remember that they're both really important programs that have a huge legacy at 2U and we think will continue to have a very important role in our overall ecosystem. So it's not that -- these are long relationships. And I would say the dean of one of those programs reminded me a long time ago that it does feel a bit more like a marriage. So as circumstances change in the marketplace, we have to continue to do right by the program. And that doesn't mean -- you could take an example of, in past periods, for those that have been with us for some time, there's a moment in time where Georgetown -- Georgetown's overall revenue declined year-on-year and we had many investor questions about it. And one of the things we said is, look, we had a faculty chair left the program and 2 of the 4 tracks for that program stopped running for 3 different separate cohorts. And it had an impact that showed up in our financials and then they hired somebody and those tracks started running again and revenue went the other way. So that kind of thing happens, this is a long story. So while it might be exciting to try to go find a particular number and talk about that number, what we're telling you is these will still be very large programs and are really critical to our long-term success.

One follow-up, if I may, Cathy. The question was on the predictability of the short courses business. In the past, you made a point of saying that you're still trying to get a -- sort of get a handle on how it works and predictability and so on. Do you feel that you are much more confident on being able to predict it sort of 2, 3, 4 years out?

So I think that we are certainly further along. And every quarter, we feel a little bit further along particularly as we expand the size of the portfolio. Portfolios are wonderful as they tend to mute changes in any one program or any one course. However, there are a lot of dynamics in the short course business that are vastly different than the graduate program business. While you find out about course performance a lot quicker, it can also change a lot more quickly as, for example, a course that has been a hot topic course for a several quarters or several years, all of a sudden, becomes more mainstream and isn't in the same kind of demand. So we are still in the process of figuring out many of those things because a number of these courses haven't been run for long enough for us to be able to see that pattern yet. So I still believe that we have a lot more variability in the short course business. And when we talk about it, we try and take that into account. But certainly, it is -- we understand a lot more and we think the predictability is better than it was when we acquired the company.

And our next question comes from Brad Zelnick with Credit Suisse.

It's [Bob] on for Brad. Nice to see you guys focus on the long-term opportunity, can you -- just on margins, can you guys give us any idea of any changes in the long-term thinking of marketing efficiencies surrounding MPVs? Has anything changed there?

No, we still feel very good about it.

And is that driving any changes or investments into '19 or is that just more and more program launches?

Yes, just a lot of launches and more coming.

Our next question comes from Brian Schwartz with Oppenheimer.

This is Tyler Page on for Brian. Just wanted to dig into the short courses a little bit. Great to see those 2 announcements from George Washington and Yale. And I'm wondering about kind of the pipeline and the selling motion there, how that pipeline is looking with your current partners. And then how those deals kind of played out and whether those were competitive deals or they came to you as kind of their preferred partner and never really had to compete with any of your competitors on that.

I think what I would say is every deal with every university is, of course, they're all -- there's no easy deal. They're all reasonably complicated. So in terms of competition, there are certainly other people offering short courses and so we are -- we were able to be compelling enough to those partners based on our track record, which I candidly don't think anyone else has, of driving both student outcomes and probably really strong business opportunities for the school.

Okay. And then, in terms of marketing spend on the short courses, do you have a grasp around how you're increasing for the new DGPs? How are you investing around the short courses? Are you ramping up marketing spend there as well?

So in that business, we do operate on similar looking at -- for digital marketing, just as though you would look at it in the longer-term program business, and there's a level of spend that is effective. So we are trying to get our arms around more of what the proper level of spend ought to be in that business, but ultimately, I believe the way we look at it will be very, very similar. The metrics may be different but the process is going to be pretty much of a mirror. We're not quite there yet but we do expect we will be.

Our next question comes from Alex Paris with Barrington Research.

This is Chris Howe sitting in for Alex Paris. Just had a few questions here. This perhaps asked in a different way, following up on the questions you've received on short courses. How would you characterize where the economic moat is today versus the time of acquisition and what your thoughts are on the TAM moving forward? And my second question is in regard to your comments about the single short course at Stanford. How many others are there like this and what's the potential for this as an entrée to new short course partners moving forward? And what kind of discoveries or learnings are you able to gather with these initial course offerings?

So that TAM on the short course business is somewhere in $300-ish billion. It's a big market. We think that there are many different hypotheses in terms of where short courses could play, given that you're talking about skills attainment. So we do think the opportunity for single course deployments is real. We're focused right now on supplying the short courses across the suite of partners we have. We have great partners, they're interested in the programs. So and it's -- we've deployed it out across the 2U ecosystem pretty effectively and you should expect to see more of that.

Let me add just to that, that I think, you mentioned the word moat and that is, as we discussed when we acquired GetSmarter and talked about the fact that this was adding an additional product that our clients were asking for, that we do believe that it is a key part to creating that moat and adding to the relationship that we have with our clients, the more we can provide for them across the spectrum, the better off we think our long-term relationships and the health of our relationships will be.

Okay. And then in regard to the other question about Stanford?

I answered it already. Was there a particular...

That's all I have, yes, it was just different learnings from the single course offering at Stanford and how many else -- how many others out there aren't there with partners as far as just shooting out an initial course and seeing how that plays at the partner?

Well, there's quite a few universities in the marketplace that we might target. As I mentioned, we're more focused right now in deploying it across our portfolio but you will see other opportunities where we deploy short courses first.

Our next question comes from Rishi Jaluria with D.A. Davidson.

Chip, just wanted to circle back to the idea that you may be under invested in marketing relative to what you should have done, in hindsight. Was this across-the-board or was this primarily with newly launched programs because if we look at your preview for mature cohort margins of up 40%, that's still pretty nicely above your long-term target in the mid-30s. Are you happy at the level of marketing that you've been spending in DGPs over 4 years and then just primarily kind of on the lower end? And then I have a follow-up for Cathy.

So I'll actually take this first one. We're sort of thinking about the level of underinvestment as being sort portfolio as a whole. I'm sure that there were places where it was not a new program phenomenon. And as I think you can probably see that our cohort margins in our older programs would give you the thought that there's probably still dollars there to be invested so -- because they're certainly above what our target would have been. So we tend to be thinking in -- of this in terms of the fact that it is sort of an overall portfolio phenomenon, not that we were sort of shorting any one area.

Got it. And sorry, just for clarification. The cohort margin for the 4-year bucket for 2018, that was 40% or did I get my notes wrong?

No, you have it right. We think they'll be 40% or north of 40%. And as you know, our target is in the mid-30%. So that would tell you that there is still profitable enrollment acquisition to be had in those courses.

Got it. Okay. And then just a quick follow-up, more of a housekeeping perspective. I mean, it looks like international revenue declined sequentially from Q2 to Q3. I know that's entirely on GetSmarter. Is that FX or is that related to kind of the seasonal patterns of GetSmarter or just something else there?

It is more seasonal pattern than anything else. The courses that are -- it is all a matter of when courses are run.

Our next question comes from Ryan MacDonald with Needham & Company.

I guess, this first question is really for Chip, and it's more of a conceptual question, Chip. As you look at the 2 announcements on the short course side, I thought it was very interesting that the short courses will be in areas where you don't have DGPs with these existing partners already. I was just wondering if you could give some color commentary around how universities are thinking about this short course opportunity, whether it's an area where they think that can enhance their on-campus graduate programs in these areas or if it's potentially a lead generator to see if there's enough to demand in some of these areas for a graduate program online longer term?

I would say, I think, a combination of both. There is -- it is clear that what we said strategically about GetSmarter is now obvious. In other words, by deploying short courses across the portfolio, we are becoming strategically more valuable to each client that we do this at. And what's sort of notable about today's announcements, Yale as an example, is that it's an entirely different school at Yale that we're working with. You go from the School of Medicine to the School of Management. That's good all around. So in some cases, you'll see a much more direct overlap between the short course and the DGP that we have, like at Berkeley. And then in some cases, you'll see us working across the entire university. We really like both, so we definitively believe that that's a huge part of the value prop to 2U as a business, it strategically definitely digs the moat deeper, keeps competition more at bay and makes us -- gives us greater influence over what's happening at the universities. So all of the above we like. Now in certain cases, we do think that short courses will be a lead in for someone to go all the way and take a DGP or a full master's degree. So we likely weren't getting those people anyway in the past. We convert a pretty small percentage of people across the portfolio from prospect to student. So converting a larger percentage of the prospects we bring in is a critical part of the strategy. We think short courses can do that.

Got it. And then just a follow-up, I guess, on the opportunity more broadly with the grad degree programs and maybe in particular, domestically. It's clear that by the acceleration of program launches that 2U has and has planned for '19 and beyond that there's a clear demand in the market for online. But obviously, we've seen an acceleration elsewhere with other vendors that are also launching more programs. Do you think -- when you think longer term, is the impact on terms of being able to provide partners with a broader pool of prospective students and then converting them, just given the broader adoption of online across multiple universities?

At this point, I feel like we are dealing with a scale that people in this business have not really seen yet, and we do think the opportunity is there for prospects coming into the funnel to be deployed across a bunch of different potential opportunities. And you're starting to see some of the benefits of that scale in various places across the portfolio. So we like our chances, be a more comprehensive solution to both the student and the university. And over time, you should expect to see more and more options for our university partners from 2U.

Our next question comes from Peter Appert with Piper Jaffray.

First, I'd just like to deny that I was involved in this business from 1929. I've been with it 2 or 3 years later. But at least I wasn't still in high school as Meuler was in -- okay, so Chip, I'm interested in any comments or thoughts you have on the selling cycles, both as it relates to new client universities or maybe even just core undergraduate enrollment numbers.

Yes. I mean, I would say it's definitely -- well, you mean selling cycle to the university or to the student, Peter?

Yes. Well, I mean both. I'm interested in both of those.

On the university, it's definitely changed, there's no question. Momentum has never been like this. So obviously, the pipeline is full for next year but the portfolio is booming and we're starting to see universities that have not worked with 2U asking for a lot day 1. And that's pretty exciting and it's getting shorter. And it's not as missionary. We have a lot of data, we're really good at it and we've got proof. And so our team is literally canvassing the globe and they are getting a great response. So to the university, it's definitely shortened. To the student, the GetSmarter business is definitely a shorter cycle. And so in total, it's probably shortened. On the University side, for the grad business, it's really not shortened. It's -- this is a nontrivial purchase for everybody involved. It's a pretty open kimono process and they're difficult programs to get in. So it's a challenging process for people that are applying. So that's not really shortened. The short courses is a different business and it's faster.

Okay. And then, separately, on the 40% current cohort margin in the context of the desire to step up the marketing spend to accelerate the -- or to extend the growth, is part of the conclusion that maybe the 35% margin is not optimal and that if you had a 30% margin, the scale of the business would be measurably larger?

No, we're not willing to go there today. We think we're managing the business with the right long-term margin structure in mind but it's also clear to us that we should have spent more on marketing.

Yes. And I guess, what I'll add to that is that if we had taken down our margins in the short run has absolutely nothing to do with getting to long run steady-state margins. It's simply a timing of how rapidly you're driving those opportunities for the individual programs to get to scale. So I don't think in any way additional spend makes any commentary at all about what we think are long term -- are the proper long-term margins.

Our next question comes from George Tong with Goldman Sachs.

Regarding your intention to spend more to drive enrollment growth near term, how have your enrollment and revenue expectations evolved? In other words, what's the expected return on incremental investment?

So I think that what we're talking about is that the return has been allowing our LTR to TCA in any period to stay around where it should be optimal for a steady-state portfolio. And the reality is we don't have a steady state portfolio. So our thinking has evolved in saying that as opposed to trying to keep the steady-state -- the entire portfolio at a steady-state rate during a period of high growth that we probably ought to be marketing at somewhat less than a steady-state optimal LTR to TCA across the portfolio in this period of rapid expansion. That -- as I sort of harking back to what I just said is that in no way makes any comment about what we think the long-term unit economics of those programs will be. Simply that there are student opportunities to get profitable enrollments in the short run that will accelerate growth for us and help ensure that path. And will still allow us to get to the right steady-state margins. It's just that there are opportunities now we are forgoing and we don't want to do that.

Got it. That's helpful. And then in terms of a follow-up, with your strong pipeline of new DGP offerings coming up, can you discuss how you expect class sizes after 1 year to compare with earlier programs due to changes in program mix or admission standards or other factors?

Class sizes of more than 1 year. Do you mean cohort sizes or class sizes?

Class sizes. So after 1 year, once the program has been live for a year, how a 1-year-old program now...

I believe you mean cohort.

Yes, cohort. Sure, yes. Cohort sizes after, yes, aged 1 year now versus, say, 2 or 3 years ago.

Well, MPV does ramp faster. So like the 2018 cohort has just -- it's just getting big because it's mostly MPV. We will end up having more verticals over time and those ramp slower. But if you remember, our '16 cohort was basically all new verticals, and our '18 cohort was mostly MPV so those should ramp faster.

What if you don't look at it on a cohort basis and you look at it on a program basis?

I mean, today, we still expect our -- we haven't changed our opinion in terms of our average program sizes, if that makes -- if that's what you're asking. Our average expectations remain the same.

I'm showing no further questions at this time. I'd like to turn the call back to Mr. Chip Paucek for any further remarks.

Thank you, everyone. So just for our earnings crew here, we have a couple of folks on the team that are celebrating weddings and we want to give them a shout out. So first, Sarah Muntzing married Zach Riggle this past weekend and we'd like to say congrats to Sarah. And in 2 weeks, our fine Edward P. Goodwin Jr., our Vice President of Investor Relations, will be marrying Nicola Barnes and we wish him the greatest wonderful life moving ahead. And with that, we end this call. We'll see you out on the road, folks.

Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have great day.