Ladies and gentlemen, greetings, and welcome to K12's Third Quarter Fiscal 2019 Earnings Conference Call. [Operator Instructions]. As a reminder, this program is being recorded. It is now my pleasure to introduce your host, Mike Kraft, Senior Vice President, Corporate Communications. Thank you. You may begin.

Thank you, and good afternoon. Welcome to K12's Third Quarter Earnings Call for Fiscal Year 2019. 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. These statements are made pursuant to the safe harbor's provision of the Private Securities Litigation Reform Act of 1995. They 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. These reports include, without limitation, cautionary statements made in K12's 2018 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 Nate Davis, Chief Executive Officer and Chairman of the Board; James Rhyu, Chief Financial Officer and President, Product and Technology; and Dr. Shaun McAlmont, President of Career Readiness Education. Following our prepared remarks, we will answer any questions you may have. I'd now like to now turn the call over to Nate. Nate?

Thank you, Mike. Good afternoon, everyone. Thanks for joining us on the call today. As you saw on today's press release, revenue was $253.3 million in the third quarter of fiscal year '19, an increase of 8.8% year-over-year. This is the third quarter in a row we've delivered strong revenue growth, primarily as a result of our fall enrollment season's performance. Tied to strong revenue growth, adjusted operating income for the quarter was $27.2 million, an increase of 11.9% compared to the prior year. Once again, our revenue, operating income and capital expenditures met or beat the guidance we provided last quarter. We've also tightened up our guidance for the fourth quarter and anticipate delivering results at the high end of the guidance range for the full year. Revenues are anticipated to be between $1,005,000,000 and $1,010,000,000 for the year, with adjusted operating income in the range of $58 million to $60 million. James will provide more detail on our results in a few minutes. I believe that this year's results clearly indicate a strong demand for full time, blended and online programs, which remains the cornerstone of our business. However, as I said before, while I remain optimistic about the strength of our core business and its potential for growth, that doesn't mean we won't face headwinds from time to time that can blunt some of that opportunity. Given that we now manage more than 70 schools in 30 states, one could expect in any fiscal year, there will be school closures at some periods of time and then we will have the addition of new schools at other periods with expansion of existing schools. We often face new enrollment caps, issues with per pupil reimbursement, school boards who choose to directly manage their own programs, or state law…

Thanks, Nate, and good afternoon, everyone. The program we're building is a comprehensive and innovative virtual approach to career readiness that, I believe, will allow us to serve tens of thousands of middle and high school students within the next 3 to 4 years. So let me go through some status updates. First, we're working with existing and new partners to expand the number of schools that offer career readiness. As Nate mentioned last quarter, we currently operate 13 schools across the nation. We anticipate increasing our footprint to 17 to 20 programs of varying types and sizes by the new school year starting this fall. All of the schools are called Destinations Career Academy, or DCA, which is the brand name that we will use to replicate and promote career readiness in the marketplace. Thus far this year, we've already opened new DCA programs for high school students in Missouri, California, Minnesota and Washington. This will afford nearly 3 million students in those states access to a K12 powered career readiness option. We're also working to open programs at the middle school level, so that students can start their career journey with early career exploration courses and be ready to embark on more comprehensive career studies in high school. We also believe that if students are engaged at a younger age, it will improve student retention and importantly their academic outcomes. We'll be launching this approach in Colorado this fall and provide access to more than 200,000 middle school students from across the state to a career readiness education. For both high schools and middle schools, we've created a DCA implementation map for schools to follow. This process includes measurements at every stage to ensure that schools are fully implementing the DCA design we prescribed. This will ensure students…

Thanks, Shaun and good afternoon, everybody. First, a quick recap of our results. Revenue for the quarter was $253.3 million, increased 8.8%. Adjusted operating income was $27.2 million, an increase of 11.9%. And capital expenditures were $9.4 million, which were largely flat from last year. As Nate mentioned, in each case, these results met or beat the expectations we provided in our guidance last quarter. For the quarter, Managed Public School Programs' revenue increased $22.1 million or 11% to $222.6 million. The growth in this business was driven by a year-over-year increase in enrollments of 5.7% and an increase in revenue per enrollment of 5%. While revenue per enrollment in the first half of the year benefited from the changes in revenue recognition, this quarter's performance is more in line with our expected full year increase of 4% to 6%. In our Institutional Business, revenues declined 6.8%. Nonmanaged Public Programs revenues declined 3.6%, primarily due to lower revenue per enrollment, driven by just some changes in school mix. The Institutional Software and Services revenues were down 11.2% as a result of softer sales we've talked about in previous calls. We expect our fourth quarter revenues in the Institutional Business to be flat plus or minus a few percentage points. For the full year, the business will finish down 15% plus or minus a few percentage points, which is in line with our original guidance. Private Pay revenues were $9.3 million, and the business remains on track to finish the year relatively flat compared to last year. Gross margins were 33.6%, down 250 basis points from the third quarter of last year. Margins were impacted by the changes to revenue recognition, coupled with our continued investment in school initiatives to support academic outcomes. We still expect gross margins to finish the…

[Operator Instructions]. Our first question comes from the line of Alex Paris from Barrington Research.

This is Chris Howe for Alex. Good quarter, guys. I have a few questions here in regard to the career readiness. As far as its future growth and your expectations for its growth, if we were to characterize short-term versus long-term potential across the five areas that I have noted here, course work pathways, blended versus supplementation, additional states, further penetration in existing DCAs and industry partnerships, how should we think about these five areas as you continue to drive the momentum in this area?

When you say -- this is Nate speaking. When you say how should you think about it, meaning, some kind of weighting, I assume, Not sure...

Yes, as far as -- yes, a ranking or waiting, yes.

I think the majority of the growth will come from -- in the short term will come from greater penetration in the schools that Shaun already talked about. So in the 17 schools and maybe 20 by the end of -- by the time we open up the school year next year, I think we're going to see greater penetration in those. Over the intermediate term, meaning 1 to 3 years, and I think it's going to come down to new states and new schools within states. Because as Shaun mentioned, our intention is to open up a DCA in every state that we're operating in. So that's at least probably 10 more -- 10 to 12 more states at that point. I think that's where the intermediate term opportunity is. From there, it's, as one of my old bosses told me, if anybody can predict what happens at 4, 5 years out, they're better than all of the rest of us. I think it's difficult to predict what happens from there. I do think that one has to look at the overall market opportunity, both internationally as well as in the states that today don't allow virtual schools. Because some of which Shaun talked about are blended schools. And blended schools would be operating in some of the states that we are not in today. As you know, as you heard Shaun talk about, we very much believe in blended programs for this kind of program, a lot more hands-on experience, and that's maybe more accepted in those states. So I think new states, greater penetration in existing states in short-term, new states in immediate term, and quite honestly even international long-term. I hope that helps you.

That does, that does. And one follow-up, just in regard to that. On the last conference call, you had referenced the market potential or the access that you would have being around 30% and the potential for that to rise to 50%. I guess, of the percentage of high school and/or middle school students in the future that have access to career readiness, what are you seeing right now in terms of rate of adoption and where that can go moving forward? And if it does go to 50%, how should we quantify the potential or the material impact this should have on the success of career readiness?

Repeating some of the steps that Shaun highlighted, I think when you hear people say 10% to 20% of them are open to the idea, I expect us to get a couple of the percentage points of those. So when you start looking at 50% of the students in high school are available, the math would say something like 2% to 4% of those would actually be a take rate. I don't think we know for sure, it could be greater than that. I think it all depends on how good our programs are going to be and what kind of support we get from the state. In my conversations with Governors, my conversations with State Departments of Education, they all seem to want to support having more career readiness content in their state, and therefore, I think we'll get greater support and those numbers could be higher than the ones I just quoted. But I think we're looking at pretty good penetration rate. The other part of your question is, what are we seeing today. It's very early in the process today. So it's a nascent level. You know that last year, we had about 7,000 enrollments and that was across a fairly small base. So while we are seeing a lot of excitement about it, I think this enrollment season will tell us more about penetration rates, hard to project it.

Our next question comes from the line of Corey Greendale from First Analysis.

Few questions. First, the -- your prepared remarks at the beginning, Nate, were very sort of balanced and sounds like you are wanting to make sure people don't get ahead of themselves. But I just wanted to make sure, is there anything specific happening that you'd highlight that is resulting and you're striking that sort of balance, keep in mind that there -- things can happen on the state level or individual program that could be headwinds. Is there anything behind that?

No, there is nothing specific. Whenever I talk to lawyers, they make me put these risk factors in, and so I make sure some were in there, but it's not. There is nothing specific. I just wanted to contrast that versus the career readiness space, which I don't think has the ebbs and flows. I think it has more of an upside. And in the core business, we can have some ebbs and flows, but there is nothing specific that I'm highlighting.

Okay. And so a couple of questions on that latter point. As the lens that you're looking at this through, at least the way you're talking about it, it's sounding potentially more and more expansive. And by the way, good to talk to you, Shaun. Is there anything we should be thinking about in terms of upfront investment that may be sort of out of the range of what we would expect from the core business, so fiscal 2020, should we be thinking about an increase in SG&A or CapEx or anything associated with that greater investment in all those pieces of career readiness?

No, I think that we've been able to shift a lot of our investment into this space. So I think you're going to see in the same range. We could be plus or minus a couple million dollars, but you're not going to see a dramatic increase in CapEx. Now, what you could see is some of the cash we're sitting on getting deployed by acquiring because we do believe in inorganic growth, but not anything to announce, but that's the place you might see it. But in terms of our CapEx or SG&A, I don't see any dramatic change in those numbers for the long-term projections we've been talking about.

So -- and within the -- in terms of marketing, you don't expect you'd have to sort of increase -- you would reshuffle spend, you wouldn't increase spend because now you've got more programs to market?

Not in any dramatic way. I mean, we -- you could see small changes here or there, small increases, but nothing that's going to change the direction of the business. So I could spend a few hundred thousands more, but you won't see that in any change in percentages. I mean, the long-term projections we've given are still going to hold.

Okay. And given the, at least, to my mind, more expansive way you're talking about the opportunity there, can you just tell us how you're thinking about the competitive set. And I don't want to name names, but some of the things you're saying sound more potentially competitive with community colleges, although you could partner, some of it actually sounds like it's getting into more Chegg territory. So can you just talk about who you view as the key competitors for that career readiness business?

Quite honestly, in the high school, and Shaun, you can jump in on this in a second. But in the high school and in middle school areas, I really think the competition is the brick-and-mortar schools. Others are providing content, others are providing schools, but at the end of the day, we are all small relative to brick-and-mortar schools. So the real competition here is, can we provide a product that's more engaging, more technologically advanced and more widely available than the brick-and-mortar schools do. That's really where the competition is. I even think it's a bit of coopetition in the sense that we'll provide some competition, but we'll also be able to provide our content to the brick-and-mortar schools and partner with them. And in fact, I know Shaun is working on such a deal right now, where students would be allowed to enter as a brick-and-mortar student to come into our programs and take 1, 2, or 3 courses. And one of the states is actually moving toward an unlimited number of courses in our program. So I think you're going to see more teaming, but it's going to be around the brick-and-mortar. The post-secondary guys, I don't really see us strongly competing with them across the board. We may have specific content in IT or specific content in a particular area, but overall, I don't see them as being the big competition. I see it as brick-and-mortar.

Corey, I would agree wholeheartedly. And I think that our goal is to move this readiness effort earlier and earlier into the high school students career, into middle school as well. And I think that the way we expand our market really is expanding through the brick-and-mortar schools as they adopt programs, et cetera.

Our next question comes from the line of Henry Chien from BMO Capital Markets.

I wanted to ask about the career readiness program, just to tack on another question. For the kids who are taking career readiness, in terms of the value that they get, are they typically going straight to the workforce and getting jobs? Or is this like an additional preparation to go to college?

Yes, it's additional preparation, Henry. I mean, if you think about it, this whole career readiness effort is to expand their opportunities, and so it's college and career readiness. If they decide to go on to work, we want them to be better prepared to do that. If they decide to go on to college and work while they're in college, they'll also be better prepared. So we're really increasing opportunity post high school graduation.

Got it. Okay. And the job matching service, that's for college grads? Was that, that you guys were talking about?

No. The Tallo platform really is unique to high school students. We also have college students on that platform, but it really is a great opportunity for high school students to display a digital portfolio of their work, badges that they've earned, certifications, et cetera. And by the way, they're exposed to employers and colleges who are seeking talent. So it's great platform for them.

I want to add something. This is Nate speaking. I don't know if it was Chris or it was Corey that asked a question about will we see the expansion opportunity. But in the area of Tallo, the product you're talking about is Tallo, we actually see Tallo as starting off and very heavily being used by high school students to help them get summer jobs and internships and scholarships. But I also see it expanding into the postsecondary world and expanding into adult learners. Because anybody who's got a specific skill can go onto this platform and find a job with the employers that are looking for people with certain skills. So whether those skills be in computer science or technology and programming or they be in nursing or any other field, we want this to be a platform that's available to all three of those markets: adult learning, postsecondary and high school.

Got it. Okay. Yes, that's really interesting. And that is Talo, that's T-A-L-O?

T-A-L-L-O.

T-A-L-L-O. Got it. Okay. Great and that's -- okay, so Tallo is the networking platform. And I guess, kind of like broadly speaking, when you're teaming up and providing like the education that's related to the skills or the workforce, it -- how are you marketing or communicating like the results that students get? And -- I mean, I'm just thinking, I guess, in the frame of usually it's like job placements on the postsecondary side is, I wonder how it's communicated on the, I guess, the pre-postsecondary side of things, high school, I guess.

Look, I think right off the bat, high school graduation is a key outcome. Post that, if a student is looking to go to work, to go into the military or to go to college, I mean, we'll also track those outcomes. And so I think we'll track outcomes across the board based on student interest at that time.

We also want a tool to follow the student. So if we have a high school student that is on Tallo, it's not just about their first job. It's about helping them with their second and third job and continuing to update their skills. So if you're a student and you've worked on projects, you can upload your projects and your resume. But when you go to work, in your first job, you can upload things that you've worked on there as long as it's, obviously, not company confidential, but upload your skills and continue to build the profile, so that by the time you're an adult learner, you've got a more comprehensive profile of all the things you've been doing. So it's meant to stay with them. And there's a lot of marketing effort in Tallo that's meant to market to the person that you should continue to update your skills and continue to look for better and better jobs.

Our next question comes from the line of Greg Pendy from Sidoti.

I just wanted to clarify, when you mentioned in the call, you have 13 schools, ramping up to 17 to 20, is it at 17 to 20 you'd be exposed to 3 million students or is that currently at 13?

It's incremental for those four intakes.

Yes. So today we're at 13 -- and apologies, we've actually added four schools at this point. So we were at 17. Those four schools open up an incremental market of 3 million potential students.

Okay. Got it. Got it. And then can you just kind of give us any color on just you mentioned the industry certifications, is that existing right now in some of the pathways? And can you kind of -- is there any specifics you can give on that?

Yes. I mean, there are a number of certifications offered via different organizations. And so we by pathway have certifications available to students that will essentially validate what they've learned on a high school level and then they can have a badge for that within that Tallo system that we described earlier. But I think many people are familiar with CompTIA. So Microsoft certifications, et cetera, are available to students. And then there are other industry-specific certifications through a number of organizations that we're putting together, so that the students have that validation. I would say there are probably 10 or 11 certifying organizations that we'll use over time. And as those are put into place, we'll make sure that everybody is aware of what they are specifically.

Okay. That's helpful. And then just one final one. Just on the revenue per enrollment. I know the change in revenue recognition, but I guess, when we think about the fourth quarter, should that be more consistent? And then should that be more consistent, I guess, next year when we think about the out year, just -- the variations from quarter-to-quarter? Should the new revenue recognition make it more smoother, I guess, is -- or in a tighter range?

Yes. So this is James. So I think when you're going to -- in order to hit the 4% to 6% range that we gave as guidance, it sort of implies that Q4 revenue per enrollment for the Managed Programs year-over-year is going to be more or less flat. That's what the guidance would imply. So no, it's not going to be consistent with this quarter or previous quarters. For the upcoming year or years, we're certainly not suggesting that we're going to have full year average revenue per enrollment gains of 4% to 6% a year. I think Nate's been pretty consistent in saying that it's going to be down in the 0% to 2% on average sort of long term. But what I think that it will, starting next year, once we lap this revenue recognition, the year-over-year gains will sort of even out a little bit more. So you'll have a little more consistency across year-over-year, quarter-over-quarter gains.

[Operator Instructions]. Our next question is a follow-up from the line of Corey Greendale from First Analysis.

Just quickly, and I think this is a question for James. If you -- the quarter was very good and the career pathway sounds exciting. The one question I can see coming out of the quarter is the guidance implies, it looks like some costs were shifted from Q3 into Q4, so the Q3 beat -- looks like it somewhat translates into Q4 adjusted operating income guidance that's a little bit below what people were expecting. Is that timing or anything you would -- can you just explain that?

Yes. So I think right now the guidance -- so the short answer, I think, is a little bit of yes. The guidance right now implies that we'd be just a tad under, I think, the consensus for Q4. And I do think there's just probably a little bit of timing there, nothing that unusual, but there's always a little bit of Q3, Q4 timing, particularly depending on when we roll -- start rolling some things out and when we really start going heavier into the quarter and things like that for marketing, so...

Nothing changed in terms of the kind of thing I was asking about before? No new investments, no change in tone of business or anything like that?

No, Nate's answer still stands. There's nothing material that's going to change in the fourth quarter.

Thank you. Ladies and gentlemen, we have no further questions in queue at this time. I'd like to turn the floor back over to management for closing.

All right. Well, I appreciate and being respectful of everybody's time, we don't have any additional comments. To Barrington, to Corey, Henry, Greg, all of you guys, I appreciate you being on the call, I appreciate your engagement. And thanks, everybody. Have a great evening. Bye-bye.

Thank you, ladies and gentlemen. This does conclude your teleconference for today. You may now disconnect your line at this time. Thank you for your participation, and have a wonderful day.