Greetings, ladies and gentlemen, and welcome to the ITT Educational Services 2013 Second Quarter Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. Joining us today from the management of ITT Educational Services, we have Kevin Modany, Chief Executive Officer and Chairman; and Dan Fitzpatrick, Executive Vice President and Chief Financial Officer. Before we begin, ITT Educational Services, Inc., wishes to remind you that this conference call may include forward-looking statements. Actual results may differ from the information presented during this call. For additional information, please review the section on forward-looking information contained in today's news release or in the company's public filings with the Securities and Exchange Commission. Thank you. Mr. Modany, you may begin.

Thank you, operator. Good morning, ladies and gentlemen, and thank you for joining us on our conference call to review the second quarter 2013 results. Dan Fitzpatrick, our Executive Vice President and Chief Financial Officer, is with me on today's call. In our prepared remarks, we plan to provide additional color on the enrollment results that we reported this morning. We will also provide an update on a few of our key focus areas for the company. Following my prepared comments, I will turn the call over to Dan, who will provide additional remarks regarding the financial results that we reported earlier this morning. At the conclusion of our prepared comments, we will open the line for your questions. We'll attempt to be as efficient as we can with our prepared comments as to provide you with ample time to ask any questions you may have. With that said, let's begin with the new student enrollment results reported this morning. First, as we've previously indicated, we've been allocating a great deal of our energies towards stabilizing new student enrollment trends. Our focus has been on enhancing our communications to address our belief that prospective students currently have a heightened sensitivity to the cost of post secondary education and an increased level of uncertainty regarding the likely outcome of their investment in additional education. We also believe that we have an opportunity to emphasize ITT Technical Institute's differentiated position in the post secondary market with our communications to prospective students. We believe that our resident-based, career-oriented technology and health sciences-related programs of study that help graduates prepare for entry-level technician positions differentiates us from other post secondary institutions. We also believe that our 40-year history of offering this differentiated educational model to a career changer demographic presents us with an opportunity…

Thanks, Kevin. Revenue decreased $69.9 million or 21.2% to $259.9 million in the 3 months ended June 30, 2013, compared to $329.8 million in the 3 months ended June 30, 2012. The primary factors that contributed to this decrease included a 14.2% decrease in total student enrollment as of March 31, 2013, compared to March 31, 2012. An 11% decrease in total student enrollment as of June 30, 2013, compared to June 30, 2012, and $30 million of the $34 million increase, that Kevin previously mentioned, in institutional scholarships and awards provided to our students in the 3 months ended June 30, 2013, compared to the same prior year period, was recorded as an offset to revenue. The increase in institutional scholarships and awards was primarily due to the introduction of the Opportunity Scholarship at the vast majority of the ITT Technical Institute campuses in the academic quarter that began in March 2013. As Kevin already noted, all of the ITT Technical Institute campuses are now offering the Opportunity Scholarship to eligible students. Loss of educational services decreased $17.1 million or 12.1% to $123.8 million in the 3 months ended June 30, 2013, compared to $140.9 million in the 3 months ended June 30, 2012. The primary factors that contributed to this decrease included a decrease in compensation and benefit expense resulting from fewer employees, a decrease in course supply expense due to lower student enrollment. Cost of educational services as a percentage of revenue increased 490 basis points to 47.6% in the 3 months ended June 30, 2013, compared to 42.7% in the 3 months ended June 30, 2012. The primary factor that contributed to this increase was the decline in revenue, which was partially offset by decreases in compensation and benefit costs and course supply expenses. Student services…

Thanks, Dan. At this point, we have concluded our prepared remarks. Operator, would you please open the line for questions.

[Operator Instructions] Our first question comes from Peter Appert from Piper Jaffray.

Dan, can you give us any further insight on the status of the liabilities around student loan programs?

Well, there were no changes to our estimates in the quarter. We really haven't seen much in the way of any particular improvement or decline in terms of the overall performance, as far as the student loans under those programs. So really nothing's changed from the estimates we'd talked about on our last call.

Okay. And then in terms of the quarterly guidance. Anything unusual that would account for the -- I know there's normal seasonality in the business. But are there some expense items or something else that would impact the phasing of the quarterly results?

No. Nothing significant on expense variations, looking forward. We're making some investments in some strategic items, but that's not going to be a significant change. When you really think about it though, when you look at the enrollment change from last quarter to this quarter, just due to the increased graduation, our census is down. Therefore, if the revenue per student stays relatively flat from what we've had this past quarter, you'd expect the revenue's going to be down and expenses will be somewhat flat. So therefore, that's the variation between Q3 and Q4.

The next question comes from Suzi Stein for Morgan Stanley.

Can you talk a little about your plans for CapEx for the year? I guess, you're running low for the first half of the year. Just curious where you should be for the whole year?

Yes, we'll be lower than we typically have been, for a couple of reasons. One thing is, we really don't have any plans to open new schools this year. Can't say definitively, if that -- whether we'll be able to open any this year, but that in and of itself is a reduction. We're just trying to find ways to be as efficient as possible. So we'll probably be somewhere north of 1 point, maybe 1.5 point this year as a percentage of revenue relative to what we've been in the past.

Okay and then I guess as we think longer term about modeling some of the expenses, would you expect the year-over-year student services expense, just on an absolute basis, to be up? Or are there still efficiencies there? I mean, I guess, just in thinking about the enrollment starting to trend up, would you expect the absolute expenses to start trending up as well?

Well, no, that line really shouldn't really change dramatically relative to student census. In fact, we're expecting some improvements relative to bad debt, which is a component of that line. So really, if you think about it going forward, that line shouldn't move in relationship with census. And we'd actually see some leverage there.

Our next question comes from Bob Craig from Stifel.

Kevin, I was wondering, could you hazard a guess on what the estimated level of scholarships should be for the entire year?

Well, I guess, Bob, the best way to think about that as we sort of transition through the implementation of the scholarship program, is to think about it in terms of filling the gap that used to exist from a private lending perspective. So we had previously in the -- I'll say the old model, if you will, private lending that estimated around 12% of revenue, that was the gap that we typically had. For simplicity purposes, I can say that we've replaced that private lending gap with Opportunity Scholarship. So we're going to see this thing kind of settle in at about 12% of, I'll say gross revenues, once we get it all implemented. There's a little bit of a front-end component to the Opportunity Scholarship. Such that in the early quarters there's a little more of the scholarship than in the later quarters. So you're seeing a little bit of that front-end loading in the second quarter results. But overall, once this rolls out, I would estimate it to be in the area or in the range of 12% to maybe 14% of revenues. There might be a little bit uptick on the scholarship over and above what that private lending gap was, to make up for a little bit of the losses that we've seen from some of the adjustments in the Pell program. So that's our current guess. That's our current estimate. I think you'll see that play itself out over the next 3 or 4 quarters.

So Kevin, based on that comment about front loading then, RPFs, which was down, what, 8% this quarter, should start to moderate a little bit in the second half?

Yes, that's exactly right.

Our next question comes from Sara Gubins from Bank of America, Merrill Lynch.

Continuing on the revenue per student. So the decline should moderate a little bit in the second half. But as we head into 2014, can you talk about what rate of decline you would expect to see?

Yes, we'll probably see a little bit relative to the first quarter of next year before we settle in. If you think about it, we saw the big impact in this quarter for the Opportunity Scholarship, as Kevin mentioned, basically addressing that gap that previously was covered with private loans. So we should be anniversary-ing the pace of the revenue per student and basically stabilizing, if you will, in the second quarter of next year.

So it would be flat on a year-over-year basis by the second quarter of next year?

I don't have the first quarter's number this year but the second quarter -- yes, we would be settling in right about where we're at. I'm sorry, I was thinking about the first quarter rather than the second quarter. But yes, we should be in the neighborhood of what you're seeing right now.

I guess, I'm wondering why it wouldn't be more given that the reduction to tuition was in the 20% plus range.

Well again, I think what you're seeing there is a little bit of the front-end loaded in the second quarter results. So the Opportunity Scholarship is front-end loaded. We're seeing a bigger impact on revenue per student relative to implementation in the second quarter. That's going to start to sort of temper itself and you'll see less of an impact as we get into the second half of this year and into the first half of next year to where, probably by the third quarter, I'd say second or third quarter, we ought to see that revenue per student on a year-over-year basis flattening up. So it's just a front-end loaded sort of transition of this program as we implement it across all of our schools and it begins to be implemented with all of our students.

Okay. And then separately, how are you thinking about starts for the second half of the year? You've had a really good turnaround in this quarter. Do you think this is around the right pace? Or would you expect it to accelerate or decelerate?

Well, thank you for the positive comments on the results and yes, we're very pleased with what we're seeing right now in terms of the conversion rates on the strong level of interest that we're seeing. Not giving a whole bunch of guidance over and above what we've already talked about for the year. But I can tell you, as we're heading into September, we're -- we've experienced the last couple of weeks of application volume -- net application volume above the prior year, so we're trending positively. We would hesitate to really qualify it or quantify it any more than that and to say that this level is the right level or not, just because there's not as much clarity as we'd like. We're sort of reestablishing the model and we need a few more quarters of trending to really get a lot of confidence and comfort around our ability to project accurately. So we're kind of just sticking to a quarter at a time here in terms of thinking about our new student enrollment. But current data right now, as we speak, looking fairly positive. We should have an opportunity for a year-over-year increase. But again, we're cautious in that. The clarity isn't yet where we want it, and the trending isn't yet where we want it. But again, we're pleased right now with what we're seeing in the results of the implementation of the scholarship and some of the revised communications.

Our next question comes from Paul Ginocchio from Deutsche Bank.

Just 2 questions. First, can you give us an update on the free cash flow guidance? I think it was $50 million to $75 million for 2013. And second, I think you've stopped enrolling at a couple of campuses in Florida, Bradenton and Deerfield. Is that a part of a wider program, the cost-cutting program you're talking about, maybe cut some of these lower enrollment campuses?

Thanks, Paul. We're not giving any specific guidance on free cash flow. I know we talked a little bit about that early in the year to give some guidance and respond to some questions we had on that front. At this point in time, I will say generically, relative to our model and our projections and our internal goals, we're right on track with where we want to be. And so everything's kind of progressing as expected in terms of the model. And as far as new campuses or campuses in Florida you had mentioned, again, not speaking specifically to any particular campuses, but we mentioned before that we are monitoring several of our campuses, looking at those that may present an opportunity for us to make the network a little more efficient. And we'll continue those efforts and those are ongoing. We don't have anything specifically to report today on that front. But again, we're monitoring all of our locations. There's a handful of them that we've got our eyes on, just making sure that we're right- sizing and making them as efficient as possible. And that will continue. Obviously, as we see changes in trends on enrollments, that's the real driver for us in terms of making the model work. It's scale. So we're in a position right now that if we continue to see these trends, we're optimistic about what we should see from a financial perspective as well.

Our next question comes from Jeff Volshteyn from JPMorgan.

Could you help us think through the continuous student enrollment, kind of a 2-part question. When will the impact of the double graduations will diminish; is that second half of this year or is that going to trickle into '14? And what are the dynamics for the underlying retention for the next several quarters?

So from a persistence perspective, which would include both graduates and retention, just some general thoughts and some color. We should start to see that stabilizing on a year-over-year basis starting with Q3 and likely in Q4 as well. So we'll see stabilization there. We probably won't see -- and this is based on current projections and our current belief. Probably won't see that increase over prior year until the first half of next year. So again, persistence kind of flat in the second half of this year, Q3, Q4, and maybe some positive opportunities there in Q1, Q2 of '14. As far as the retention component itself, it's been fairly flat, slightly down. We haven't seen really a lot of degradation there but we've not seen improvement either. What we're looking at are a couple of our courses that -- our early quarter courses where we've recognized an opportunity to improve some of the curriculum design. And our academic team is working on that. They've already done the research on it. We've done some testing and the design has been completed. We're in the process of doing some developing on changing a few of those courses. And we will be implementing those in December. We are optimistic that we can see some improvement and retention in the early quarters which, as I'm sure you know, are the higher attrition quarters where we lose the majority of students, which is typical in post secondary education. And if we can have an impact there with these course revisions, we'd be optimistic that we can see retention improvements potentially in 2014, again, if those results are successful. So again, just recapping, flat persistence probably second half of the year. Opportunity for improvement in the first half of '14.

Our next question comes from Corey Greendale from First Analysis.

Sorry to go back to revenue per student. A bunch of people asked this and I'm still not 100% sure that I'm getting it. Why is it front loaded as opposed to being kind of pro rata over the course of someone's enrollment? And why don't you have kind of an increasing impact? You still have a bunch of people in the system who enrolled before you rolled it out who aren't going the scholarship. So as an increasing percentage of the population gets the scholarship, why don't you see a continuing impact from that in 2014?

Thanks, Corey. I heard 2 questions there that we'll provide some more clarity on them. Please feel free to get back in the queue if we haven't clarified it for you. But in terms of the front-end loaded components of it, that's just the way the scholarship works. And there's probably a little more clarity in our catalog that describes how the scholarship program works. It might be helpful to you, without getting into all the eligibility requirements here on the call. But it ultimately ends up where earlier quarter students are going to get larger amounts than what they would get later in their quarters. And that's just kind of how the program is designed and how we see it working based on our modeling, and actually what we're seeing in the second quarter. As you think about how this program is implemented further into the system, when you say more people will obtain the scholarship, that's certainly true in terms of the Opportunity Scholarship itself, but the point we wanted to make clear in the script, that I'll emphasize here again, is that 70% of our students receive some form of scholarship and/or award. And so, we've got a large percentage of our students receiving the awards right now, and/or the scholarship. It might not be the Opportunity Scholarship but it might be some other form of scholarship that we were providing, and/or award. And we had mentioned before that the Opportunity Scholarship itself would be a compilation of all the different programs that exist out there. So as we roll forward and people will move from one form of a scholarship and/or reward -- award, excuse me, to the Opportunity Scholarship, it's not necessarily incremental dollars for a lot of folks. So again, emphasize the point that…

A little. If I'm still on, just -- probably an easier question to answer. On the marketing side, why did you decide to reduce advertising spending in the quarter and what's your expectation for Q3?

Well, it was part of overall planning. And I would just say, generally speaking, we're trying to be as efficient as we possibly can across all fronts and that includes marketing. We had some opportunities to move some money around, look at some underperforming campaigns that we had, eliminate those underperforming campaigns, and net-net, seeing very positive responses to each spot that we're putting out there. So an improvement in response enabled us to get some efficiencies as well as just eliminating some campaigns that weren't being overly efficient led to that reduction in spending. If we looked at the model right now, it has a projection for us to have a slight increase over the prior year for Q3 and Q4. But I will tell you that we're going to do our very best to manage that and make that as efficient as we possibly can as well. There may be some opportunities to manage that.

[Operator Instructions] Our next question comes from Tim Connor from William Blair.

I wanted to spend a little bit of time on DSOs. The financial aid processing timing. Last quarter, you talked about that being kind of a 5-day headwind for DSOs. What was the impact in the second quarter?

Well, it's probably important just to point out right off the bat that, based upon our modeling, we believe that we've seen the high water mark for DSO and bad debt. I mean, as we go forward, we expect these things to go down. And then also, I think it's important to point out that we're in a transition period here. The folks that used to rely on private loans, right now, they're -- those who did not get in prior periods, the Opportunity Scholarship, still built some AR. So that's part of the issue we have. But these folks will work their way through the system. But you're right. Last quarter, in fact it's been the last couple of quarters, we've been working on some system enhancements. Ultimately, when we're all said and done, we feel as though we'll be processing the transactions more efficiently, more timely. The cost per transaction will go down. But we're still dealing with that. And I can't sit here and say that it will be completely resolved when we talk again in October. But I will tell you that we've caught up this time -- it was actually a little bit more. We're talking about close to $20 million is our estimate that was basically caught up in the processing, if you will, the vast majority of which we've got in-house now. But it certainly had an impact relative to the DSO at June 30.

And then how many days of DSOs were from federal loans only?

In federal loans only, I'm not sure that I have that number. I would say that, like I say, the processing itself was -- on a combined. I'm talking loans and -- because we're changing the system for processing both -- for loans and for grants, that was in the $20 million range. And then the other thing that, I believe, we touched upon earlier that some of the impact as far as the modifications from Pell, you can't tell exactly what that is. Because prior to this year, the award year, the student record really didn't clarify those folks that had lifetime limitation. But there's some impact in that, probably somewhere in the neighborhood of $5 million, but I can't pin that down exactly.

Just, I'll add a little color on that, to Dan's commentary. As far as the amounts that were delayed as a result of some of our systems modifications. The vast majority of that has already been collected in the third quarter. So -- and the same thing happened last time. We had the same exact issue. And as Dan mentioned, we're probably going to see these systems delays impact us a little bit in Q3. Ultimately, the goal of systems enhancements and modifications is to improve the efficiency. We think we had that opportunity, but we're dealing with a little bit of the transition on that as well, right now. But again, that $20 million he speaks of, the vast, vast majority has already been collected through disbursements that occurred in the third quarter.

Our next question comes from Trace Urdan from Wells Fargo.

Kevin, I just want to go back to something you were talking about before because -- I don't want to get too theoretical here, but it seems to me that the Opportunity Scholarship uptake ought to be close to 100%. Because I can imagine circumstances in which a student would not want to borrow money but certainly would want to be afforded the same level of discount that his peers are receiving. So can you just talk about that in concept?

Without getting into too much detail on the eligibility requirements, it is a need-based institutional scholarship. So there's a definition of need, which pretty much mimics what the Department of Ed has defined as need. And I'd say that, again, just sort of generically, not specifically. So students who are determined to have a need ultimately receive the scholarship. And not every one of our students are categorized by us or the federal government as having a need. So it kind of falls into that category, those people with need. And again, you can kind of look at eligible family contribution, which is what I'm referring to as a DOE eligibility or need calculation. And that's kind of the underpinning. It's not exactly that, but that's an underpinning of the determination of eligibility for Opportunity Scholarship. And we've never had 100% of our students who were determined to be of need. We don't have that today. We have a similar percentage of our students today that would be determined to be in a need situation as we've had historically. And again, I'm not getting to the specifics but generically, or generally, that's kind of why we don't see 100% of the students receiving the scholarship, nor do we anticipate that they will.

Our next question comes as a follow-up from Paul Ginocchio from Deutsche Bank.

Just another one on revenue per student. So maybe the way to think about it, easiest for me, would be if we look at revenue per student in 2012 and versus 2014, it's going to be down about 12% over that period, is that the right way to think about it? And then second, Dan, on the student services line, sort of the SG&A line, what percent of that line now is advertising expense, just on a rough basis, the student services and admin?

Sure, as far as revenue per student, I think you're thinking about it right. That should be the upper range, when we talk about being down 10% to 12%. We don't break out advertising as a percentage of revenue. The one thing we have said, just to provide some color, when you look at the industry, look at our fellow companies out there, we're pretty much in line with what folks are spending on just a percentage of revenue.

[Operator Instructions] And we do have an additional follow-up question from Tim Connor from William Blair.

I just wanted to clarify, so you expect persistence year-over-year to be flat in the third quarter, but you're also expecting enrollment to potentially be down despite the starts trends that we saw in the second quarter. Could you just clarify that and make sure that I'm thinking about that the right way?

Yes. So we do anticipate close to flat persistence in Q3. And in terms of total enrollments, we'll still be down on total. I think that's what you're asking about, we would still be down on total. But the persistent factor or the percentage of the incoming population that will continue on to the next quarter, we would expect that to be flat with the prior year.

Okay. And then I'm just trying to reconcile the third quarter guidance. Are there any significant sort of one-time-ish expense increases that we should expect in the third quarter that might get you down to the level that you got into?

No, there's no significant one-time expenses there. And I think as Dan had alluded to earlier, it's principally more related to the revenue. We've got the double graduating class that we're dealing with. So our carry-in census is a little bit less and that will result in a lower revenue number. The costs pretty much are going to be in line with -- on a quarter-over-quarter basis. Obviously, we've got some opportunity for some savings. We continue to work on our cost initiatives program and we're equal to or ahead of plan on that. But nothing unusual there. It's just mostly a revenue situation. Some related to that double graduating issue that we talked about in the prepared remarks.

We have an additional follow-up from Suzi Stein from Morgan Stanley.

Has there been any update on the SEC subpoena that you guys got back in February? Do you have a better sense of what they're looking at?

No real update or comments on the investigation at this point, except probably just repeating what we've repeated all along, that we've provided information as requested, continue to cooperate and continue to provide any other requested information that may be presented to us. But no real update on that front and no ability to indicate, specifically, what they might be looking at.

And our final question is also a follow-up from Corey Greendale from First Analysis.

Again, on the question of this quarterly guidance. So I understand what you're saying. I'm still having trouble getting to a revenue number low enough to make the Q3 guidance work. But even if you do, I don't understand how you get high enough for Q4 to be as high as -- are you expecting some meaningful drop-off sequentially in either cost line item in Q4?

No, there's nothing significant per se, other than what we typically see in some of the seasonality. Obviously, there's some savings opportunities that we would expect to see coming through. But there's nothing materially unusual in terms of what we're expecting to see there. I'd tell you, Corey, why don't you hook up offline with Dan. He'll walk you through or maybe answer some of your questions relative to some of the costs and whatnot and just repeat, for the most part, what we've been talking about here and maybe help you get there in terms of the modeling. And of course, that's open to the other analysts as well.

And at this time, I'm showing no additional questions. I'd like to turn the conference call back over for any closing remarks.

Thank you, operator. I just want to thank everyone for participating on the call today, and I look forward to talking to you all to report our -- when we report our third quarter results in October. Thanks again and have a great day.

Ladies and gentlemen, that concludes today's conference call. We do thank you for joining. You may now disconnect your telephone lines.