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

Christopher Howe - Barrington Research Corey Greendale - First Analysis Jeffrey Silber - BMO Capital Markets.

Greetings and welcome to the K12 Second Quarter Fiscal 2018 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 Mike Kraft, VP of Finance. Please go ahead..

Thank you and good afternoon. Welcome to K12’s second quarter earnings conference call for fiscal year 2018.

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 operating performance and results, please refer to our reports filed with the SEC, including without limitation cautionary statements made in K12's 2017 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. Our results for the quarter were solidly in line with the guidance we provided. Revenue for the quarter was $217.2 million, a decrease of 1.8% year-over-year and adjusted operating income was $20.9 million, a decrease of 8.7% year-over-year.

Both the year-over-year decline in revenue and adjusted operating income are largely result of positive performance in our managed public schools offset by lower performance in our institutional business. Year-over-year managed public school enrollment increased 2.2% with slightly lower revenue for enrolment.

Institutional revenues declined 15.4% year-over-year as a result of sales execution not being as effective as it needed to be especially during last summer's selling season. We are now halfway through the year and as our third quarter outlook suggests our expectations remain in line with our original guidance for the year.

Our team continues to focus on increasing long-term shareholder value by executing against our strategic priorities in the areas of academic outcomes, student recession, curriculum innovation, and diversification. We believe that by executing well on these priorities we will drive revenue and free cash flow growth over the long-term.

With regard to academic outcomes, after the initial rollout of the academic excellence framework last school year in year two, our school partners are laser focused on driving best practices and fidelity of implementation.

This comprehensive framework rooted in research and best practices from high performing school creates a consistent set of expectations across all of our partner school and areas such as curriculum, instruction, assessment, and school climate.

In fact we saw preliminary course passing rates for the first semester of the school year increased by 500 to 700 basis points for grades six through 12 year-over-year. We believe that the framework helped drive these games and that will form a solid foundation to support our partner schools in driving further academic improvement over the long-term.

In terms of the student retention I'm excited to share that thanks to a company wide effort including streamlining the student and family on boarding process and ramping up our strong start and fast efforts we are beginning to see improved retention levels especially at the beginning of the second semester.

Specifically we talked about improving student retention back to fiscal 2016 levels. We are currently on a trajectory which we believe will help us return to student retention levels we achieved in fiscal 2016 and potentially even better.

Continued execution on these retention programs throughout this year may allow us to enter the next school year with a growing student population.

We're also leveraging the student's first check in program to keep our fingers on the pulse of student and family sentiment and we've launched several pilot programs to better understand key drivers of student engagement and ultimately retention.

While there is obviously lots of work still to do I'm confident we're on the right path towards delivering improvements in student retention over both the short and long-term. Our product teams are hard at work building engaging highly adaptive curriculum and product offerings that will truly differentiate K12 in the marketplace.

This year we are integrating Stride's adaptive practice solution into our managed public school curriculum which will allow students more targeted practice time and ultimately drive performance. We are also continuing to upgrade the course catalogue, focusing development efforts on assessed subject areas of math, English language, arts and science.

And lastly we're executing on a holistic platform strategy to drive consistency across our technology platforms and reduced overhead costs over the long-term. We are still working hard towards diversifying our market presence through the expansion of our career technical education offerings.

In fiscal 2017 we added five new programs to bring the total to seven academies. Thus far 2018 enrollment in these seven academies has nearly doubled. While the absolute enrollment numbers are still modest we are encouraged by the early demand. This quarter we are focusing on expanding the number of destinations career academies for next school year.

Importantly early results from the seven academies in place support the premise that CTE is one of the most effective dropout prevention strategies known today. For students who take even one CTE course we're seeing improved withdrawal rates.

Furthermore students enrolled full time in one of our destinations career academies are retaining at an improved rate of several hundred basis points.

CTE is just one reason that we are optimistic that our business will be more efficient in the future and retaining students while also attracting more students to program, better helping solve the skills gap one of the most talked about problems in America's job market.

Management is also keenly focused on driving improvements and free cash flow by continuing our structured process around investment decisions on both an operating and capital basis.

As evidenced by our results this quarter operating expenses have declined year-over-year by about $3 million excluding stock based compensation and capital outlays were at the bottom of our guidance range.

We will continue to make careful build versus buy decisions for business model components to further improve operating leverage and cash flows over the long-term. And with a more efficient product development process we believe we are actually delivering more for less.

Overall from a financial and operational perspective we are right where we need to be at midyear to achieve our objectives for fiscal 2018 and set us up for fiscal 2019 and beyond.

Now before I hand the call over to James I wanted to mention two things; first, I want to draw your attention to an announcement we made about Bob Knowling joining the K12 Board of Directors.

Bob brings a wealth of CEO level business and financial acumen to the Board along with relevant experience in the field of education and most of all the same passion for helping students that motivates all of us here at K12.

Bob is a strong believer in the importance of developing bold and innovative leaders, the types who comprise the heart and soul of our business.

Bob's passion led him to become the Founding Chief Executive Officer of the NYC Leadership Academy, an independent nonprofit corporation created by then New York City Schools Chancellor Joel Klein and Mayor Michael Bloomberg.

Through his efforts the NYC Leadership Academy developed groundbreaking recruiting, training, and support systems to empower aspiring school principals with a comprehensive, sustainable approach to leadership development and program implementation. We are very excited to have Bob Knowling join the K12 Board of Directors.

Second, as many of you are aware a very large virtual school in Ohio ECOT formally closed on January 15th. In the wake of the ECOT closure the governing Board of our largest school partner has said that they want to help as many students families and teachers as possible who are displaced mid school year by this decision.

To date we have received thousands of phone calls from ECOT families and we look forward to working with our partner to serve a larger group of students in Ohio this semester and in the year ahead. On another Ohio note we learned last evening that the current authorizer for the Insight School of Ohio will not be renewing its charter for next year.

Insight Ohio enrollments represent only a small portion of the students we serve in Ohio. The governing school board is reviewing options and existing alternatives in the State. The non-renewal will have no financial impact this fiscal year.

Going forward and considering the ECOT situation net-net we believe the overall level of demand for virtual education services we offer through partners in Ohio will be quite strong. I will now hand the call over to James to review second quarter results as well as our third quarter guidance. Thanks very much for your support. James. .

Thanks Stuart. Good afternoon everybody. First I want to quickly recap our results. Revenue for the quarter was 217.2 million down 1.8% from last year, adjusted operating income 20.9 million declining 2 million from last year, and capital expenditures were 8.2 million which is 1.6 million lower than last year.

In each case these results met or exceeded the expectations we provided in our guidance last quarter. Revenue of 217.2 million was at the lower end of our guidance driven by the declines in our institutional business which I'll discuss more in a moment.

Overall however we feel comfortable with our full year revenue guidance and have already seen some positive signs for enrolments in January that bodes well for the rest of the year. In managed public school programs revenue increased 2.5% to 183.4 million compared to the prior year.

This performance was a result of a 2.2 increase in student enrollments offset by declining revenue per enrolment due to mix. However, as we begin the second semester in January we see mix improving in the first few weeks of the third quarter.

From an enrollment standpoint as Stuart mentioned we are beginning to see some improvement in retention as a result of our proactive set of programs we've ramped up over the past couple of years. We will continue to invest in these programs and believe that over time retention levels continue to improve.

And student enrollment activities during the quarter was somewhat softer as we've seen more enrolments push into January instead of December and the backlog of interest working through the enrolment process remained strong through the first weeks of January. Revenue per enrolment decreased 1.6% this quarter.

This decline is largely the result of school mix. That mix stems from indexing a bit more in newer states but below average revenue per enrolment. Additionally from a seasonal perspective we often see second quarter revenue per enrolment decline and increase sequentially in the third and fourth quarters.

We continue to expect full year revenue per enrolment to be largely flat on a year-over-year basis. In our institutional business which includes both non-managed public school programs as well as our institutional software and services, revenue declined 16.4% on a year-over-year basis which is in line with the expectations we outlined last quarter.

Non-managed public program revenues decreased 20.7% versus last year as a result of enrolments declining 16.7% and revenue per enrolment declining 4.7%. Some of our larger customers have experienced enrollment softness which is contributing to this decline.

Institutional software and services revenues declined 10.4% as a result of softer sales at the beginning of the season as Stuart mentioned and we outlined at last quarter's results. We are clearly not satisfied with these results and working to turn this around. Our sales execution over the past year has been poor.

In our private pay business revenues increased slightly to 8.4 million versus the year ago as we highlighted last quarter while we remain bullish on the long-term prospects for this business, we anticipate revenues to be largely flat in fiscal 2018 compared to last year.

Gross margins were 35.9% down 190 basis points due to the lower mix of institutional revenues in the period. On a full year basis we continue to look for margins that are about 200 basis points below last year. Selling, administrative, and other expenses were 62 million which is flat from a year ago.

However, net of stock based compensation expenses declined 3 million or 5.2% as a result of strong cost controls across the organization. Management continues to be focused on driving operating leverage over the long-term as being very judicious about incremental investments in the business.

Product development expenses were down 17% to 2.4 million which is consistent with our overall lower CAPEX as well. EBITDA for the quarter was 32.3 million compared to 37 million in second quarter of last year. This decline was largely a result of lower operating results in the quarter including a 2.6 million increase in stock based compensation.

The increase in stock based compensation was for performance based stock testing that we indicated may happen last quarter. We now expect full year stock based compensation of approximately $20 million give or take the 10% as we still have some additional potential performance based testing that may occur.

Adjusted EBITDA was 39.5 million compared to 41.6 million last year, operating income was 13.7 million or 4.6 million lower than last year, and adjusted operating income was 20.9 million or 2 million lower than last year.

Turning to some other items, we ended the quarter with cash and equivalents of one 189.5 million and in line with normal seasonal trends where we would expect to see our cash balance increase throughout the rest of the year.

CAPEX which includes curriculum and software development and infrastructure was 8.2 million, a decrease of 1.6 million compared to the second quarter of last year. We continue to make meaningful product investments but are doing so at lower unit cost.

So while we have lowered our CAPEX over the past couple years output is actually increasing and investments and innovation will continue. Our tax rate for the quarter was 4.1% and was heavily influenced by the new tax legislation.

The impact of the legislation on this year's result as well as our primary outlook for fiscal 2019 will be largely beneficial. As you are well aware the federal tax rate on corporations was reduced to 21%, however, since K12 operates on a junior end we struck up of the former tax rate and the new rate for six months each.

So for fiscal 2018 the statutory rate will be 28%. In addition we will also be able to take a benefit this quarter on re-measuring our deferred tax liability at the lower rates which was somewhat offset by some taxes that will pay off overseas earnings.

So all in for this year we will likely have an effective tax rate around 10% plus or minus a few percent. And as we look to next fiscal year we will get a full year's benefit of the new legislation and on a very preliminary basis excluding the impact of stock based compensation, next year's rate should fall to around 30% plus or minus a few percent.

Of course we'll update this as we provide more guidance in October. One more item I would like to update you on for next year as I'm sure you know there is a new revenue recognition accounting standard we just wanted to inspect. For K12 we will adopt this beginning in July for our next fiscal year.

We're making good progress on evaluating and implementing the new standard. We largely expect full year revenue to be unaffected by this new accounting standard. However, we will likely see some revenue shift from the first quarter to the rest of the year, likely a few to several tens of millions of dollars.

We will provide more guidance on this next year but I wanted to at least let you know that full year is not going to be impacted but the fazing throughout the year might be.

Let me summarize our guidance for the upcoming third quarter, revenue in the range of 224 million to 230 million, adjusted operating income in the range of 25 million to 27 million, and capital expenditures of 9 million through 11 million. Thank you and I will hand the call back over now to Stuart. .

Thanks James, appreciate that and we would be happy to take any questions that you might have..

[Operator Instructions]. Our first question comes from Alex Parrish from Barrington Research. Please proceed with your question..

Good afternoon, this is Chris Howe sitting in for Alex Parrish..

Hey Chris..

Hey, I had a question first off in regards to FuelEd, you had mentioned a resect to the strategy last quarter, just an update on this, how it's going, what you're seeing so far in regards to improving the execution going forward?.

Sure, well as you might imagine when you are in kind of an institutional sales cycle it's a reasonably long sales cycles. There are three entry points to the year. You can sell stuff at the beginning of the school year, you can implement new programs in the second semester call it January, and there are smaller summer school opportunities.

So you have to kind of back up from those entry points really on any new program. We started by revamping our team, putting new team on the ground back in May when we announced that Sean Ryan came in as the General Manager of that business.

We've recently over the last I say few weeks brought in a new Vice President or Senior Vice President of Marketing, I'm sorry sales, to help reorganize the sales team. So we're still I would say getting our footings but I think we're doing of good job articulating how our products align to markets and channels and very targeted opportunities.

So there is discipline around what we're doing but we have yet to really see that take hold. We do certainly expect that by doing the right thing, going into next school year we will have corrected the situation..

That's very helpful, thank you.

And I have one follow-up just in regards to what you saw this past quarter for safe and board imposed caps, were any caps lifted this quarter and if so in which State?.

No, I don't -- we really don't have that much in year listing of caps. We managed to sort of the capital levels throughout the year. If you know -- it's complicated in the sense that caps can be of all different varieties. Some are at overall levels, some are at grade band level, some are at high school versus elementary school level.

So but in general no major changes. We do as we look into next year, we're always looking to where we see strong demand push for higher cost so we can serve what we think is increasing demand for our programs but nothing to announce at this time..

Thank you so much, I'll hop back in the queue for now. .

Thanks Chris..

Our next question comes from Corey Greendale with First Analysis. Please proceed with your question..

Thank you, good afternoon. I'm in an airport so there's a lot of background noise, tell me, I don’t want to aggravate anyone, I can follow up offline but a couple questions on Ohio.

So first of all on ECOT, can you give us some sense, is there like a limit to the number of students you would take just in terms of you thought that how many you can serve well and can you just give us a quick primer on how the funding works in Ohio, so as you take students midyear will they be fully funded for the portion that you are serving them?.

You bet. Thanks Corey I'll take the first part of the question and then hand funding over to James.

There are no cast in Ohio Virtual Academy, the governing board there has really stepped forward -- I would say the only significant operator in the State or school in the State to say they're willing to take on more students and we think that based on conversations the State is very pleased with that because it's a very challenging situation.

As you might have seen in the press there were 12,000 students at ECOT. As I mentioned we have already received in ten days or so thousands of phone calls. So call that a meaningful portion of students who are looking for options.

Some will go back to brick and mortar schools, some may go to some other virtual but for the most part we've been the major player that has stepped up. Since there was so much preview time and it's a likely closure of the ECOT we had time to prepare and frankly lots of teachers from ECOT were reaching out to us.

So we've been able and this gets your question about quality of services. We've been able to ramp up teaching staff, support staff in anticipation of taking students on. So we think from a quality perspective we'll be able to continue to deliver the great services that Ohio Virtual Academy is known for.

Regarding your funding question I will turn that over to James. .

Yeah, hey Corey. Obviously the right question around the funding, we -- the funding model in Ohio is essentially a pro rata funding model. So we will get the Ohio school that we manage will get funding for the kids. It depends on engagement and attendance and things like that.

So it's not that there's an automatic funding so the kids that are transferring over mid-year given all the turmoil stuff they might fund at a slightly lower rate just because they're ramping up and we often see that with kids coming in mid year as a ramp up. So -- but the general answer is the funding will come for the half year that we serve them..

Very helpful and can you give us -- I realize the fluid situation, but have you included any contribution from those former ECOT students in your Q3 guidance?.

So, I think the Q3 guidance range is not necessarily -- doesn't necessarily contemplate what could happen because as we're putting this together as you can imagine it has been so fluid, we had a big weekend this past weekend of calls that came in and the reality is that we don't yet know how many will actually enroll with us.

So it's very hard to predict for Q3 or the balance of year what the actual impact would be. So it's just -- it was too early to really bake it in..

Okay, and if I could just one maybe couple part question for you James on the -- I know you are focused on free cash flow and you mentioned the up expenses coming down, the cash flow from ops is also down, it seems like its working capital moving around but if you could just kind of tell us what is going on there?.

Yeah, sure, so the good -- could pick up quickly on that. So, yes, working capital has gotten a little bit say negative on us. Our DSO's have gotten a little bit behind on us. We have a couple of large customers that are I think not a payment issue but funding, timing, and things like that and just working through some of those logistics.

But, largely I'd say a DSO driven issue which we expect to work through and not a long-term structural issue for us. .

Okay, and I appreciate the guidance on the tax rate impact of tax reform, can you give us some sense of what the cash flow impact will be?.

Yes, so it should be directionally positive for both this year and next year with the sort of the movement in effective rates and some other nuances to the tax collection that we've got in depreciation benefits of things like that -- it is fairly nuanced and it's still a thousand pages over the past month to digest.

So you may know that the SEC sort of given a year for everybody to really get their arms around this but I think from a cash flow perspective generically positive for this year. And likely I'd say positive also for next year. .

Okay, I will turn it over. Thank you..

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

Thank you so much.

Just one more question about Ohio, on a revenue per student basis is Ohio higher than your average, lower than your average from a mix perspective given the influx of students, how that impacts?.

It is a little bit higher than average although like I said just the whole capture element of it might as students transition on but statewide average is a little bit higher than average. .

Got it, okay and then I think Stuart I'm not sure if it was you that said this in the prepared remarks but when we were talking about retention and hopefully if you continue to improve I think you said you could potentially enter next school year with a growing population, what does that mean exactly, does it mean as of June 30, 2018 you'll be up year-over-year, if you could just explain that it'll be helpful?.

Yeah, I think if you look just over -- at the year-over-year comps, we hope to essentially, if you look at the Q2 year-over-year comp versus what we're hoping to see is the Q4 year-over-year comp we should see that expand if you will. And it gives us a larger base of students upon which to try to reregister for next school year. .

Got it and when you say Q2 and Q4 are you talking about the end of quarter population and the enrollment?.

Correct. .

Okay, got it, just wanted to clarify that, thank you. And then just one follow up on the institutional side.

I know this has been an issue for you for a while, you're bringing in new leadership, is it just sales execution, I mean what gives you the confidence that one, that the market's not shifting away from you or maybe you don't have the right product, if you can talk about that that would be great?.

I think first, sure, first of all we have augmented the product set so we've actually built that out I'd say considerably. We had historically what I call lots of courseware products. We have in the last year, year and a half or two brought in Stride, the LTS acquisition which is expand the product bag.

We recently did a Big Universe acquisition also helps expand the product bag. So it allows us to offer some lower priced supplemental products to help round out the bag a little bit.

While we're still certainly very bullish about our aggregate product set is that from a breadth perspective we just have what no one else we believe really have in terms of comprehensiveness, world class language programs. We have got TTE programs, and of course all of the core English, math, science, social studies from grades K through 12.

So when we think about what the possibilities are, the bundles and coupled with service we just don't see our product set as being a significant issue. So we really look towards execution in terms of leadership generally speaking and in terms of sales leadership. .

I would also tell you Jeff that one of I think actually maybe one of the prime indicators for us is that within our sales organization we had outstanding performance in pockets. So that tells us that we've got products that can be sold, we just haven't done it consistently enough.

And we've tried experimentation on Insight sales and things like that, that have worked really well. So we have pockets of actually strong performance that points to if we can do this consistently at greater scale it should bode well for the business. .

Okay, that's good to hear. Thanks so much..

Ladies and gentlemen we have reached the end of the question-and-answer session and I would like to turn the call back to management for closing remarks..

Well I want to thank everyone for your support and attention and questions. We look forward to doing this again in about 90 days from now. Take care..

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation..