Greetings, and welcome to the K12 Fiscal 2015 Second Quarter Earnings Call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It's now my pleasure to introduce your host, Mike Kraft. Thank you. You may begin.

Thank you, and good morning. Welcome to K12's second quarter earnings conference call. Before we begin, I would like to remind you that in addition to historical information, certain comments made during this conference 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 in 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 2014 Annual Report on Form 10-K. These filings can be found on the Investor Relations section of our Web site at www.k12.com. In addition to disclosing financial results in accordance with general 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 Web site. 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 Nate Davis, Chief Executive Officer and Chairman; Tim Murray, President and Chief Operating 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 Nate. Nate?

Good morning, and thanks for joining us on call today. Firstly, let me start by highlighting a few results for the quarter. Revenue was $231.1 million, up 3.3% year-over-year and within the range of our most recent guidance. Now, excluding the businesses we sold last year, revenue rose 5.5% versus last year. And revenue growth was largely driven by gains in our managed and non-managed public school programs as well as in our international and private pay schools. For the quarter, we posted operating income of $20.5 million compared to an operating loss of $8.9 million in the prior year and James will review how this significant increase in operating income is impacted by businesses we sold last year and charges we recorded last year. Today, I want to touch on two topics that I'm very excited about. Both will impact our growth going forward. First, our business development for managed public schools is good news. And second, the revenue growth trends we are seeing in our institutional group Fuel Ed are now coming in as we planned. From a school development point of view, we are working with various school boards to open new schools in both new states that don't get offer a virtual school option and new schools in states where we already operate at least one school. For instance, The Maine Charter School Commission voted 6:1 to approve the charter application as the Maine Virtual Academy. The school initially serves students in grade 7 through 9 with a plan to expand up to grade 12. The Maine Virtual Academy Board hopes to enroll about 300 students in 2015/2016 school year and to grow from there. In North Carolina, we continue to support our independent not for profit partner, the NC Learns Board, as they were the…

Thank you, Nate, and good morning everybody. I want to remind everybody that we took a charge in Q2 of last year of $32 million and we divested some businesses in Q4 of last year. So I will first take you through some actual reported results then focus some time on pro forma results, so that you have a more meaningful basis of comparison of the underlying business. As a reminder, we provide tables in the earnings release that lay up the quarterly trends from last year in our new format and excluding the sold businesses. First a few words on our reported results. We ended the quarter with revenue of $231.3 million, up 3.3% from the year ago quarter. Operating income was $20.5 million compared to a loss of $8.9 million in the second quarter of last year. And enrollment rose 0.9% from the year ago quarter with non-managed program growth of 41.3% offsetting a 3.9% decline in managed programs. Now, I will turn to the pro forma results excluding the impact of the $32 million charge in Q2 and the sold businesses. For the quarter, reported revenues of $231.3 million, I mentioned that represents a 5.5% increase over the pro forma Q2 2014 revenue of $219.2 million. We saw growth in all segments of our business. Revenue for public school programs rose 4.2% year-over-year, while enrollments rose 0.9%. You should note that we made some immaterial reclassifications for enrollments and revenues for the non-managed programs in institutional software and services for fiscal year 2014. And once again, we provided all the quarter-by-quarter detail in the appendices of the stated release. Managed program revenue rose 2% year-over-year, this was in contrast to enrollment decline of 3.9% on a year-over-year basis. The increase in revenues resulted from a 6.1% improvement…

Well, thank you, James. I believe that we are ready for Q&A. So if you got any questions, operator, Kevin, we are ready for questions.

Thank you. At this time, we will be conducting a question-and-answer session. [Operator Instructions] Our first question today is coming from Geoff Miller from Robert W. Baird. Please proceed with your question.

Yes. Thank you. So thanks for all the detail made on the business development activity glad to hear that going better recently. I guess can you help us understand, all the states and school boards and everybody that you have to deal with, are they recognizing all of the investment that you guys, this current management team has been putting into academics improving academic outcome, systems. So is that, what is driving the improved business development environment or if not what is?

Good morning, Jeff. So the answer is, obviously, it's across the board, it's different depending on the states that you are in. Some states we have been working on for a long time like Maine. Maine has been something we have been working on for a long time. Tennessee is a reserve situation. I think in Tennessee, there is some recognition of the progress that's been made. So while Maine has been – it's kind of a long standing story, Tennessee has really been more about the last 12 months of them understanding we are and the changes we have made and the progress we are making. So yes, people are beginning to recognize that. Even in the places that I didn't talk about boards that who have been concerned a year ago, two years ago are now saying to us, we like your change, we like what you are doing. And thank you. So we are getting some recognition for it. And we are pretty pleased about that.

Okay. Good to hear. And then I hear you guys on the working capital out of the tangible book value, but can you maybe talk about as the business transitions to or as you grow your Fuel Ed institutional business, what are the working capital requirements of that business?

So Geoff, its James. So I think what we see is and just referencing Nate's comments, we do think that the managed public school business show some growth going forward. So obviously, that's going to continue to be just given the relative sizes, a large part of what's driving our working capital. So I don't think the dynamics of our working capital on the balance sheet are actually going to change dramatically over the next couple of years. However, the dynamic that sort of the Fuel Ed business will drive it slight change in over time would be the way that we sell those services, some of them will drive greater deferred revenue on the balance sheet, I mean more cash upfront. So working capital wise, it's sort of offsets in the period in which you sell that business. And then they both sort of a track down over the course of the year to the extent that there is margin built into that obviously the deferred revenue weans off over the course of the year and we keep more of that cash. So you sort of have some slight working capital picked up, but I don't think it's really going to be material over the coming couple of years.

Okay. And then just finally, maybe an update on the systems investments and transitions and now that you have stuffed up your phase of investments spend, is this your spend level roughly the right level, the work-off going forward?

Hey, Geoff. It's Tim. First of all, yes. The current spend level we think is appropriate. We are seeing the benefits in terms of better efficiencies for our schools. We expect over time those spend levels will come down modestly. James, if you want to add anything to that in terms of the current expectations going forward?

I would – this is Nate speaking. Think about it this way. Our desired learn implementation comes in. We are in the pilot right now. We will turn up the high school experience in September. We have a decision to make as to whether we roll it down to the grade school level the following year. Work that we are doing on all of the content we should then expect to see in the next 18 to 24 months. CapEx start to come down. We are also doing a number of things in the area of the kinds of computers we buy and use of our content that will be more mobile sort of be on tablet devices as well. While, I expect to see the cost of computers in the next couple of years come down. So I expect to see that over the next probably 24 month period, you will start to see CapEx dip down. Right now, we are in a high CapEx period because of the investments we are making primarily in that new high school platform.

Okay. Thank you, gentlemen.

Thank you. Our next question today is coming from Corey Greendale from First Analysis. Please proceed with your question.

Hi, good morning guys. This is Tom Bakas on for Corey. Just noticing there is a pretty wide range of estimates for fiscal 2016, I suspect it has a lot to do with questions over the Agora impact. I know you have discussed it in broad terms. But I think it might be helpful to discuss more specifically just to help expectations?

Hey, Tom. Excuse me, its James. So I think there is a lot of variance out there. I agree with you in the essence for next year. I think if you actually – the easy way I think is, if you look at the consensus, I think the consensus has hit the impact models in about right. So unless you want me to – I wasn't going to – I wouldn't going to spend a lot of time detailing out, what I think I have detailed out in past couple of quarters. But, I think the consensus is factoring in the Agora impact next year appropriately. Does that help or do you want me to go into a little more detail than that?

No. It's really up to you. If you are not really want to make this point that's certainly okay.

No. I think – so just to be – maybe – just to be safe, I will go into a little bit of detail. If you remember, Agora is about $120 million, $130 million of revenue. About half of that is no margin revenue and all that no margin revenue is going away. The remaining half about half of that we won the business for, which is the highest margin business. However, so three quarters of the revenue approximately will go away, however, of the operating income, the operating income that we retain on the higher margin businesses serve the 25% that's retained is fairly a high margin. Having said that, we do lose some margin business on the Agora contract. Obviously, we are not going to go into all the details of exactly how much we gain or lose and we are still in fact internally working through how we make sure that we adjust our cost structure for the impact of Agora. So we don't have any real guidance out there. But, that sort of direction tells you I think we are – where we talked previously about the Agora contract and how it would impact next year.

And Tom, this is Nate speaking. I'm going to add one more piece of information for you, which I hope doesn't confuse you, but it's important to understand. And that is, when we talk about the high margin business primarily we are talking about the curriculum, we are still going to use the K12 curriculum. And that is the highest margin business we have. However, you have to remember that that would depend on a number of students. And we simply don't know that number of students. Now, if Agora maintains the number of students they have [times our] [ph] rate in our curriculum then we don't lose as much money. If Agora shrinks its school, which they may well decide to do. I mean we no longer manage so we don't know what they are going to do. But, if they were to shrink the school, then we would see additional shrinkage in revenue. And that's why James is hesitant to give you a specific number, he is more giving you a range because it is depending upon the enrollments next year, which they may or may not shrink.

Okay, terrific. That's very helpful.

Thank you. Our next question today is coming from Trace Urdan from Wells Fargo. Please proceed with your question.

Thanks. I'm afraid my questions are going to be rather mundane. So James, I'm trying to decide for all of the various restatements and tables here. In your prepared remarks you seem to suggest that the $231,304 number was the number that excludes that comparison the $231,304 versus the 223.9 is the number that excludes the write-offs includes the restatements and excludes the sold businesses, is that correct?

Sorry. The 231 is the 231. If you look in the table in the back you will see –

There are a lot of tables in the back. Can you just speak in terms of the numbers rather?

Yes. So the number four in the back that as the revenue for Q2 fiscal year 2014 that's comparable is 2 – sorry.

219.

$219,154 on Page 13 of the release.

Okay. So that $219,154 and everything that comes above it that's the apples-to-apples comparison with the business as it is constituted today?

Correct.

And that that's the 8% growth in the institutional business that Nate referred to?

Correct.

Okay. Thank you.

You are welcome.

Thank you. Our next question today is coming from Jeff Silber from BMO Capital Markets. Please proceed with your question.

Hi. Good morning guys. This is Henry Chien calling in for Jeff. I had a question – I think last call, you mentioned there were a few schools that maybe up for some kind of contract renewal or charter renewal. I was wondering if you could give any color on – is there any developments there, any expectations on any of these schools are transitioning to more of a curriculum type contractor, any color around there? Thanks.

There are no schools that we know off that are transitioning other than the ones we already announced. So obviously, Ohio and Colorado already made their decision instead of Agora. But, of the other schools that we are under negotiation with – none of them have made that decision and none of them have communicated that they are considering that decision. So we will believe there is going to be any movement beyond the ones that we have already announced. We think that the ones that are announced are – we have a good relationship and we moving in negotiations and the contracts are moving on. So I don't see any move from managed to non-managed from those current negotiations. Tim, do you know any of that I don't know off?

No. I think I would characterize all of those discussions and negotiations as being very positive, constructive and moving forward. We feel very good about them.

Great. And from the Fuel Ed perspective, a lot of publishers are seeing some very strong sales from their digital product as well. I mean, could you expand upon on where Fuel Ed has more of a say competitive advantage against some of the big publishers when you go through the adoption process which will let you are there?

Sure. Sure. Let me note that for the most part, we are not directly competing against a very large base of curriculum publishers. The category of competitors we are competing against are all typically in either the direct credit, supplement credit or credit recovery market. We think our advantage is coming in four areas and Nate touched on all of them in his remarks. One, very broad curriculum and content library Nate referred to it as PEAK library. We have the largest catalog in the industry. Second, we got full range of solutions. You can come to us and buy everything from courses to original credit to credit recovery to part time programs to full time programs where you can earn a diploma. And third, the PEAK platform that Nate mentioned is really simplifying the complexity that our customers are confronted with as they deal with more and more vendor solutions in a digital domain. Take those three things coupled with a great team on the field and we feel very good about our competitive position.

I would add to Tim's comments because I think he is 100% right. Number one, remember that we can go down in a grade school level with our online curriculum and most people cannot. They offer and they are focused on high school a little bit at that middle school level, almost nobody offers online courses at the lower level. And it's because we have done it in the managed public schools, we know how to do with this, what we call learning curve. So we can teach that. Secondly, we offer teachers, most people who sell their supplement content give it to a school and if its here it is, go use it. We say here it is but by the way we will have a teacher accompany that content. So if you don't know how to teach online, we will provide teachers to do that. That's our second advantage. And the third advantage that I talk about would be Middlebury languages. We offer world languages at all levels. And the world language capability is something that many schools are looking for. The last one I will talk about is not something that we actually are doing today. But, something that I think will be an advantage for us going forward. And that is not only will it be world languages, but helping us – the Obama administration is pushing everyone to do helping with English language learning. So we have some things that we are going to do there as well. So all of those I think are advantages for us that puts ahead of the competitors. Hope that helps.

I got it. Thank you. Thanks for the color.

Thank you. Our next question today is coming from Jerry Herman from Stifel. Please proceed with your question.

Thanks. Good morning everybody. Tim, I was hoping that you would maybe revisit the comment about consensus and I just want to be clear because it looks right now like the consensus for this year is $0.63 and the consensus for next year is around $0.43, which would suggest that the impact of Agora, if the numbers play out would be about that $0.20 differential, is that the way we should think about that?

Yes. And I think again just echoing Nate's comment, the Agora impact is very difficult to gauge as we sit today because of the enrollment factor. But, on a like-for-like basis, that is a range that that type of range is we think is pretty appropriate.

Great. Thanks. And Nate, I appreciate the comments on business development and your earlier commentary about contract load. Is it too early to get any read on Ohio?

It is. But, let me give you some color because I don't want to get ahead of the negotiation ahead of the Board and upset anybody. But, I will give some color. I met with them on January 12. I met with the entire Board. I met now couple of times the Chairman of the Board. Our Head of School, who has a really good relationship with the Board. We are working together on the things that Board is concerned about. So I don't believe the Board is concerned about K12. They are more concerned about a couple of other topics that relate to the way the schools are measured in Ohio and the way data and information is tracked by students in Ohio. So their concerns don't appear to be with K12. So I feel pretty good that the Ohio Board and K12 have a great relationship, they are working well together. And then I personally know the Board Chair. Unlike, I know you guys – I'm going to be probably more candid, if somebody might want me to be, but I'm just going to do it. I know you guys would be worried, how did Agora happen in, why wouldn't that happen in Ohio? In Agora, we had not as good relationship and they did not spend their time trying to understand K12. The Ohio Board has done the opposite. They have spent time with us. They looked at our curriculum. They come to visit our location. They love our Head of School. So it's a completely different situation. So I feel very good about the situation. I hope that helps Jerry.

It does. Thanks. And Tim, a question for you with regards to Fuel Ed, have you guys effectively sort of lapped the transition from a license model to the subscription model. And then sort of consistent with that, how do you think, or how should we think about OI margins, operating margins in that business and not to belabor the question maybe some commentary about your sales and just distribution there as well as a potential lever?

I will tag team this with James. As you heard us talk over the last six or eight quarters. We have steadily been declining the license mix, it was attributable to perpetual licenses and that is now a nominal part of our business. So short answer to your question is, yes, I think that is largely behind, it's single digit percentage of our revenue. The quality of our revenue has got much better as we now see greater than 50% of our revenue in annual licenses we see higher growth in our annual license and our per enrollment license type. So we feel good about the quality of the revenue there. In terms of sales, we continue to invest in our sales and distribution model. We just had our – in fact had our sales team in for four days of sales training just last week. We have extended that training into our resale channel as well, extended additional tools to some of our resellers to help them to be able to sell more effectively. So all in all we managed to improve our expense to revenue ratio from a sales perspective achieving greater efficiencies in our sales expense and we will continue to do that. James, do you want to comment on the operating income margin?

Yes. The only thing I would say is, so I think we sort of thought about this business at scale as being a pretty significant margin business. We talked about how we think of it as sort of a combination software service business that Nate mentioned in his comments. And a significant service component to it which includes predominantly teacher services and that structure had a lower margin. The way we defined scale is 100 plus million and so I don't think that right now we are at scale. And I don't think that you should think of our business at this size as having a margin that's materially accretive or dilutive to our overall business margins.

Thanks.

So hopeful that helps.

And let me just have one more question if I may, sorry, use of cash and in particular I think about the expansion of the portfolio in the software business. But likewise with the stock trading below book value, how you guys think about the relative investment opportunities?

Yes. You are right. This is Nate speaking. This is something we talk about at the Board level probably every quarter we have a conversation about what's the right place to put your money, is it putting it back to investors and directly in the form of dividends and share repurchases or do you put it into core business investments. And my core business investments doesn't just mean more teachers and more curriculum, it means new product development as well. And in the course, we will look at acquisition. I think there are a number of small acquisitions on the marketplace. The marketplace that we will do – can announce some specific ones, hold me to this specific one, but I can tell you that we are actively looking and wanted to expand the business especially the Fuel Ed business. And we are also looking into some new product ideas. You might imagine because you talked about this before, the new product ideas would be in the career readiness area, in English language learning that's the place we think it's smart to spend money. So right now, the Board is concluding that it doesn't make sense to go and do another share buyback program and above this $75 million we already did because these other opportunities are there and they should grow shareholder value more directly, so that's the current thinking.

Great. Thanks for the patience guys.

Thank you. We’ve reached the end of our question-and-answer session. I have to turn the floor back over to management for any further or closing comments.

Management doesn't have any additional comments. I just want to again thank everyone for taking time this morning to be on our call. And hopefully see our results within the guidance we gave. And we intend to do that again next quarter. And I look forward to talking to you again. Thank you.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. Have a wonderful day. We thank you for your participation today.