Mike Kraft - VP, Finance Stuart Udell - CEO James Rhyu - CFO.

Ken Wang - First Analysis Jeffrey Silber - BMO Capital Markets Chris Howe - Barrington Research.

Greetings and welcome to the K12 Fiscal 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Mike Kraft.

Thank you Mr. Kraft, you may begin..

Thank you and good afternoon. Welcome to K12's second quarter earnings call for fiscal year 2017.

Before we begin, I would like to remind you that in addition to historical information, certain comments made during this conference call may be considered forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and should be considered in conjunction with cautionary statements contained in our earnings release and the company’s periodic filings with the SEC.

Forward-looking statements involve risks and uncertainties that may cause actual performance or results to differ materially from those expressed or implied by such statements. In addition, this conference call contains time-sensitive information that reflects management's best analysis only as of the day of this live call.

K12 does not undertake any obligation to publicly update or revise any forward-looking statements.

For further information concerning risks and uncertainties that could materially affect financial and operational performance and results, please refer to our reports filed with the SEC, including without limitation cautionary statements made in K12's 2016 annual report on Form 10-K.

These filings can be found on the Investor Relations section of our website at www.k12.com. In addition to disclosing financial results in accordance with Generally Accepted Accounting Principles in the U.S., 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 for 30 days.

With me on today's call is Stuart Udell, Chief Executive Officer, and James Rhyu, Chief Financial Officer. Following our prepared remarks, we will answer any questions you may have. I’d like to now turn the call over to Stuart.

Stuart?.

Thanks Mike. Good afternoon and thanks for joining us on the call today. With my one year anniversary with K12 just around the corner, I've been taking some time to reflect on our business strategy, priorities and opportunities.

Today I want to review with you where I think this business is going and therefore how we are prioritizing our resources to support future growth.

Across all of our lines of business I see tremendous opportunity and after a number of years in which we faced stiff environmental headwinds, we believe that the recent election at both the federal and state level may contribute to a generally more positive environment for growth going forward.

In our managed schools business, demand in the first half of fiscal '17 has been stronger than we've seen in several years certainly in new enrollments, but just as importantly at the application level which is a good proxy for market demand.

Established states like Texas, Michigan and South Carolina continue to show strong demand for application and newer states like Alabama and North Carolina and Virginia posted solid enrollment growth. At the same time in some of our more mature states where we had programs for 10 more years, we saw flatter in some cases slight declines in enrollment.

On balance however, we believe that our uptick in managed school enrollment in fiscal year 2017 combined with the renewed attention on school choice and online education, portends a favorable environment for long-term growth in our managed public school business.

We also continue to see opportunities to increase the number of partner schools we serve across our existing state footprint and increase the number of states we serve with full time online program. In the last few years we opened up partner schools in North Carolina, Virginia, Alabama and Maine.

Over the next few years we're looking at opportunities to launch schools in several new key states. Remember opening new states is often a multiyear process but we remain optimistic about continuing our successful track record of bringing virtual school options to new states and more family.

While we are excited about the long-term growth prospects for managed public school program, in the current period we did see some pressure on enrollment levels due to a decline in retention rates.

To address this issue we've aggressively evaluated the entire student experience, reviewed operations on a school-by-school basis and rolled out new initiatives to complement the existing retention programs.

Everyone on the K12 team is keenly focused on what student retention means to the long run economics of our business and more importantly what persistent means to student level academic outcome. We believe that these programs and initiatives will have a positive impact on retention levels but we probably won't see that affect until fiscal '18.

Now turning to other key initiatives we're excited about the potential we see in our online career technical education program. As a reminder these career tech ed, or CTE program are attractive from many different types of students. For college-bound student CTE programs allow for a head start on specific career pass.

However for many students interested in a more direct and immediate career pathway, CTE offers the opportunity to earn a high school diploma along with specific career skills that can lead to a job which they otherwise may have never been able to achieve.

We launched five new CTE school this year and established more than a dozen CTE partnerships with school district and these programs are still in the early stages of development. We believe that over the next five years the demand for online career education will accelerate.

Should this happen, K12 will be uniquely positioned with established CTE programs and that's well-equipped to garner significant growth. Next, we remain enthused about future growth potential of blended programs in which K12 works closely with school districts that are looking for innovative ways to meet the individualized needs of their students.

Blended models allow districts to offer students more flexible alternative to the standard classroom instructional model. We've recently worked with some large city districts like Omaha Nebraska and Richmond Virginia to develop blended offerings designed to meet their specific goals.

In this innovative partnership, K12 provides curriculum, technology and a menu of service options such as instructors, program management and professional development. We see this model as an increasingly attractive alternative for school districts around the country to really innovate and better serve the individualized needs of students.

In total we believe the market demand in growth trend for online public schools over the next few years is promising. Moreover from a funding perspective, the average revenue per enrollment has been generally favorable and we believe we'll continue to be so with flat to marginally higher levels over time.

Turning to our institutional business, we see online learning and digital solutions grabbing an increasing share of the instructional curriculum and content market. Our product portfolio is one of the largest and most comprehensive of any digital publisher.

We have the product school districts won including career tech ed, core digital curriculum courses, world languages, credit recovery and stride our newly added practice and test preparation solution. We have also created innovative new programs to meet very customized 21-century needs of students.

For instance, in Colorado, Pikes Peak Early College team with FuelEd to help students earn college credit and professional certification at the same time by taking their core coursework in high school. Students can work towards an associate's degree while in high school and earn up 60 credits to transfer to a four-year college.

Student can also earn actual professional certification at no cost of student or family and add a fraction of the cost of a typical college education. This type of innovative approach is just one example of how K12 is working with school district to mitigate the cost of college for the average American.

It has been estimated that the aggregate market size per career technical education, world languages, credit recovery and supplemental courses is over $5 billion.

In our FuelEd business we've taken steps to ensure that we have the right team on the field to address these markets and drive us towards sustained and predictable double-digit growth over the long-term. This includes shifting the sales team focus to large account and larger contract sizes.

We believe districts are increasingly ready to adopt a strategic macro view that had to meet the diverse student needs and pursue scalable system-wide solutions.

Next, in a move that benefits our FuelEd, managed public schools, and private pay businesses, we are pleased to announce that Middlebury Interactive Languages is now fully owned by K12 as we've recently acquired Middlebury College's ownership interest in the joint venture.

At the academic leader in digital language learning for K12 students, Middlebury Interactive Languages has long been a key part of K12's value proposition to schools, districts and families.

With this transaction we have become better positioned in the world language marketplace, gained more flexibility and operating control and a more nimble governance structure to help schools, districts and families prepare students for college and careers.

The agreement to purchase the remaining 40% ownership share closed in December for $9.1 million. I also want to take just a minute to discuss the potential impact of the recent election on our business.

Though nothing is certain, we are encouraged that several key elected and prospective members of the new administration have historically held views that are supported the school reform and parent choice.

We have a shared belief that an equitable and high quality education are to be readily available to all students whether in public, private or charter school. We anticipate that this will contribute to an improved environment across the nation for school choice and more options for families and students.

While support at the federal level is important, of course most of the decision-making about education reform happens at the state level. This election cycle saw movement in key states which should help advance education reform, parent choice, charter school and innovation.

Practically speaking, we believe over the next few years we have an opportunity to develop new partnerships to open school in new states, open new specialized school like CTE within states, and see equitable funding levels for all students.

As an organization we will continue to work across both sides of the aisle to advance school choice options and alternatives for student. We were very pleased to announce a couple of weeks ago that Kevin Chavous joined our Board of Directors.

Kevin has been a tireless advocate for education reform, having advanced charter school and parent choice programs in Washington DC and around the nation. Under the Every Student Succeeds Act or ESSA, states are empowered with greater autonomy to determine how to measure school.

Traditional accountability systems create real challenges for alternative schools including many of the school that K12 manages as they do not fully take into account the notable differences in student mobility, at risk population, students who come to K12 high schools with significant credit deficiencies or even students who dropped out of school altogether before arriving to our school.

We believe that it’s a truly unique opportunity in time for policymakers to rethink how to best define and measure success for school and potentially make a course correction from static one size fits for all proficiency measures, to a true student centered accountability.

Rather than relying on systems that assign a grade to a school based primarily on annual high stakes tests and graduation rates, states can adopt dashboard approaches that gives a more complete picture of the school to parents.

That factor into demographics of the student body and allow regulators to determine how a school is fulfilling its unique mission.

For instance a report released just last week on Michigan school by the Mackinac Center for Public policy stated that some schools ranked poorly when only test scores are considered but when the social economic status of student is factored in, they are beating difficult odds and performing beyond expectations.

One of our partner schools Michigan Virtual Charter Academy or MVCA could be erroneously viewed as failing when looking solely at test scores but in fact what's determined by the Mackinac Center to be average across the state when adjusted for property.

Improvement and accountability standards would allow us to spend more time serving families and teaching students within a framework that more accurately reflects the progress students are making and the milestones important to parents.

More transparency across these multiple measures of interest the parent could directly impact overall interest in an online option and help to drive growth in the category. When all these policy and market developments are considered in their entirety, we believe the future is bright for an education technology company like K12.

We will therefore continue investing in our people, programs and products to ensure that we have an engaging and enriching environment to support student learning.

As you are aware, we've been investing capital at a very high level for many years to get to this stage in our development and now we are well-positioned in the market and can begin to taper our spending. As you can see in our updated guidance, this year we expect to spend between $55 and $60 million which is about $5 million below last year.

Over the next few years as many of the major capital programs near completion, we would look for capital outlays to fall below $50 million and ultimately stabilized in the $40 million to $50 million range with a corresponding increase in free cash flow.

I want to also emphasize that while we are bullish on the long-term future prospects for K12 for the reasons I have discussed, none of these directional changes will have an immediate impact on our financial for fiscal '17.

We will look for the result of these changes to start to materializing future periods as we work with policymakers on both sides of the aisle to provide more options and alternatives for students. Thanks very much for your support. I will now hand the call over to James to review second quarter results as well as our third quarter guidance.

James?.

Thank you, Stuart and good afternoon everybody. First a recap of our reported results. Revenue for the quarter increased 5.9% to $221.1 million. Operating income for the quarter was $18.3 million, an increase of $3.6 million or 24% from the prior year. Adjusted operating income was $22.9 million an increase of $3.2 million or 16% from the prior year.

As a reminder, adjusted operating income and adjusted EBITDA excludes stock-based compensation. Capital expenditures were $9.8 million, a decline of $1.8 million from the prior year. In each case these results exceeded the expectations we provided in our guidance last quarter.

Some additional details for the quarter; revenue was $221.1 million an increase of $12.3 million or 5.9% from a year ago. Revenue growth was largely driven by increases in our managed public school programs and some modest gains in our institutional business. Somewhat offset by declines in our private pay business.

As I mentioned on last quarter's call, the private pay business declined is a result of closing down our U.K. operations that we announced in fiscal '16.

Revenues for managed public school programs increased 7.1% compared to the prior year to $182.4 million, increase was a result of a 2.3% increase in student enrollments combined with revenue per enrollment increasing 4.6%. From a enrollment standpoint demand continues to be strong.

For the first half of fiscal '17 more students applied the K12 managed schools in the same time last year also as Stuart already mentioned. In Q2 we saw reduction in student retention rates compared to a year ago quarter.

We continue to roll our programs to improve our retention efforts and we believe those programs will take some time to take hold and we will have an effective fiscal '18 but we’ll not have an impact at fiscal '17. So while we look for improving retention level in fiscal '18, we may see continued retention pressure for the remainder of this year.

Revenues for enrollment increased 4.6% this quarter. We reiterate that the full-year revenue per enrollment is likely to be flat to moderately up on a year-over-year basis that means likely lower revenue per enrollment year-over-year growth in the second half of the year.

In our institutional business which includes both non-managed public school programs, as well as our institutional software and services, revenue grew 9.4% on a year-over-year basis, non-managed public school programs increased 13.1% versus the prior year helped by continued increases in our Agora program, as well as new school partnership in California.

Institutional software and services revenues were up 4.7%. This is largely a result of sales of curriculum credit recovery and our acquisition late last year of LTS. As our new product continues to rollout and gain traction, we saw institutional to be growth driver for K12 over the long-term.

You should also know as we previously mentioned, we expect revenue growth to be uneven pace particularly for the remainder of this year. We have an usually strong Q4 last year which will a be a tough comparison for us this Q4. Turning to our private pay business, revenues declined 22.3% to $8.3 million excluding the impact of the U.K.

operations revenue was largely flat year-over-year. As we’ve said in previous quarters, we're seeing interesting opportunities in the private pay space and believe we have the potential for growth in this business over the long term. Gross margins were 37.8% in the quarter and was largely flat compared to 37.9% year ago.

On a full-year basis we expect gross margins to contract by approximately 100 basis points compared to the prior year as a result of increased amortization related to the curriculum we recently put in service as an ongoing investment and driving stronger student outcomes and student mix.

Selling and administrative and other expenses increased by 1.5% for the quarter to $62.4 million. The sequential decline from the first quarter is in line with our normal seasonal patterns. Our spending as a percent of revenues declined about 120 basis points from last year.

On a full year basis we would expect selling administrative and other expenses to be approximately 1% lower excluding the impact of the California AG settlement last year in Q4. Product development expenses for the quarter were basically flat to the prior year at $2.9 million.

For the full year we expect these costs to continue to be flattish compared to last year. EBITDA for the quarter was $30.7 million increasing 18.6% from the same quarter last year. This increase was largely a result of our revenue gains, and solid cost controls in the quarter.

Adjusted EBITDA for the quarter was $41.6 million, an increase of 14.9% from the prior year. Year-over-year stock based comp declined approximately $400,000. Operating income was $18.3 million, an increase of $3.6 million on $24.4 million. Adjusted operating income was $22.9 million an increase of $3.2 million, a 16.2% from the prior year.

Now let’s turn to some other items, we ended the quarter with cash and cash equivalence of $182.1 million an increase of $10.8 million from the second quarter of fiscal '16.

This is significant considering some of the incremental outlays in the first half of this year including the payments for the settlement with the California Attorney General and the acquisition of the Middlebury interest which combines a little more than $16 million.

CapEx which includes capitalized curriculum and software development and property and equipment purchases was $9.8 million a decrease of $1.8 million compared to last year. This decrease was a result of lower capitalized software and property and equipment expenditures somewhat offset by larger investments and curriculum.

Our tax rate for the quarter was 41.4%. Before I move to our expectations for the rest of the year, I want to address two topics. First as we continually review on operations and portfolio of assets, we look for ways to improve long-term profitability.

And as a result we will be taking some actions during Q3 which include reducing our real estate exposure and lowering our human resource cost. From a real estate perspective we're looking to consolidate our corporate headquarters footprint and look to exit some underutilized school facilities.

From a resources standpoint we have proactively viewed our organization since Stuart joined last year and will refine our headcount in Q3 which will result in severance costs. Neither of these charges are included in the guidance we provided in our release today. We will provide more details on these charges in our next quarterly earnings call.

Second, as we’ve previously discussed we introduced some performance-based stock compensation last year which is a potential to best this year depending on whether certain performance metrics are met. So, we may see some variability in stock based compensation in the third or fourth quarter of this year.

We've introduced adjusted operating income and adjusted EBITDA in this year so, those metrics exclude the impacts of stock based competition but our normal operating income in EBITDA will include these potential charges, this vesting could result in charges about $4 million to $5 million this year that was not part of our original full-year operating income guidance.

Before turning to guidance from the third quarter as you may have already seen in our release we have improved our CapEx spend guidance for the full-year specifically as we continue to focus on improving free cash flow along with other operating results.

We are reducing our full-year range for CapEx to $55 million to $60 million from our previous $60 million to $65 million.

For our upcoming third quarter, we're looking for revenue in the range of $210 million to $220 million, adjusted operating income in the range of $18 million to $21 million, operating income in the range of $14 million to $17 million and capital expenditures of $14 million to $16 million.

As you will note, our guidance for the third quarter operating income is some up below consensus. However we would look for fourth quarter operating income that is about consensus.

As a reminder third quarter guidance excludes any charges we may take for the actions regarding facilities in severance I previously mentioned, also our full year guidance for operating income and adjusted operating income to prior stock based compensation cost of approximately $17 million. I believe the consensus is close to the $19 million.

This $17 million we have implied again exclude any performance based stock that may vest this year. Thank you for your support and I will hand the call back over to Stuart.

Stuart?.

Thanks you very James. Tim if you would queue up some questions, we would be happy to take them now..

[Operator Instructions] Our first question comes from the line of Corey Greendale of First Analysis. Please proceed with your question..

Thank you, this is Ken Wang on for Corey.

So just looking at Q3 guidance, it looks like it implies revenue would be down year-on-year, just wondering if there's any additional color you can provide there?.

Yes, I mean so it does imply slight deterioration of revenue year-on-year and I think as Stuart mentioned, we are seeing some softer retention rates and we’ll see how it actually forms up throughout the course of the quarter into what it actually means but there is some softness there that we probably expect largely driven by softness in the retention..

All right. Thank you.

And looking at the institutional software revenue growth, which looked like it slowed sequentially in the December quarter, what was the organic growth in the segment, and why did it slow? What do you expect for the rest of the year?.

Yes, the organic growth year-over-year was sort of in the low single-digit range and for the rest of the year the institutional software and services I mentioned earlier is – it's going to have some variability throughout the rest of the year particularly if you look at Q4 of last year we had a pretty significant Q4, I'd expect that to be actually down year-over-year but we probably won't post such a strong Q4.

If you look at fiscal year '16 sequentially Q3 is normally lower than Q2. We would expect some sequential decline again in Q3 so, sort of directional range of what you should expect..

And we continue to see obviously positive trends in the marketplace, I think as we’ve grown in institutional over time one of the things we felt, we needed to do was to top grade our talent a little and over the last quarter brought in new leadership for both our sales organization and our customer service organization which of course impacts retention in the institutional business.

So we’re very pleased that, have a team that we think and execute against kind of our longer term vision and growth prospects. .

All right, that’s very helpful. Thank you..

[Operator Instructions] Our next question comes from the line of Jeff Silber of BMO Capital Markets. Please proceed with your question..

Thanks so much. Just wanted to circle back to your outlook. If I'm looking for the full year fiscal 2017 revenues and adjusted operating income, I know there is going to be noise in stock based comp, but I want to leave that out.

Are you still comfortable with the guidance that you gave on the last quarter for the entire year?.

Yes, we're not changing our full year guidance at this time expect for the CapEx which we previously mentioned is coming down but full year guidance we are not changing..

Okay. Fantastic, I just wanted to double check on that. And you mentioned a few times the decline in the retention.

Can you give us a little bit more color on that? Is this something that just happened this quarter? What do you think happened, and how do you think you can fix it?.

Well, look you may have mentioned we alluded in our last quarterly call to a little bit of a challenge with launching our new technology for back-to-school which create a little bit of early year problem but as you know there is sensitivity in the model.

So if we have students that had a litter rougher onboarding experience, that can kind of play out through the year in terms of slightly higher attrition.

So, while we’re certainly not pleased with that and that little bit of carryover effect, it’s something we’re very confident will not happen again and when we look at, all of the programs we’ve introduced over the last year including some new processes we put in place to deal with ongoing retention, we had every reason to believe in the future that will be kind of back to where we were with those efforts.

So, we don't believe there is a systematic - we do not believe it’s the systematic issue..

Okay great. And finally, can you just give us an update on what progress you've been making in Ohio? Thanks..

Sure, Ohio the conversations are ongoing and I would say we are in a very normal and standard renewal process so where we would like and expect to be at this point..

And is there a time frame from when we would expect an announcement? How close to the beginning of the next school year does that normally come?.

Well it certainly varies in, it various by individual contract negotiations but so, I can speculate exactly when that might come to fruition but, we feel good about the pace of which is moving along..

Okay, great. Thanks so much. .

You very welcome. Thank you for the questions. .

Our next question comes from the line of Alex Paris of Barrington Research. Please proceed with your question..

Hi, good afternoon. This is Chris Howe sitting in for Alex Paris. A few of my questions have been taken.

But I was wondering if you could provide maybe some more color than you already have, in regards to the changes in Washington, and how this might affect your approach to the market? And I guess more specifically, how it might affect the progress you're making with states in regard to caps?.

Sure, well look as we talk a little bit certainly having a more favorable pro school choice environment in Washington is always helpful. We’re in a very different place than we ever really been historically in terms of that perspective. As I also mentioned it really is a state to state business.

There are obviously some changes in government as in several key space. We believe there a few key space that we have an opportunity to potentially open up over the next couple of few years if things continue to go well.

In terms of structural caps and individual stake, there are handful that our partner schools are working with but there are also individual kind of board and post caps that we have an ability - that our school boards has the ability to raise overtime and we expect some of that to happen along the way.

But again we have a very favorable national environment, the state environment I think eased up in some places and we’ll continue to work with advocates on both sides of isles, deal with issues like the ones you questioned..

Thank you for taking my question..

There are no further questions over the audio portion of the conference. I would now like to turn the conference back over to management for closing remarks..

Well, thank you very much for joining us this quarter. We appreciate everyone's time and questions and we of course look forward to rejoining you in three months. Have a great night everybody..

This concludes today's conference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful rest of your evening..