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Edited Transcript of LRN earnings conference call or presentation 27-Apr-17 9:00pm GMT

Thomson Reuters StreetEvents

Q3 2017 K12 Inc Earnings Call

HERNDON Apr 30, 2017 (Thomson StreetEvents) -- Edited Transcript of K12 Inc earnings conference call or presentation Thursday, April 27, 2017 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* James J. Rhyu

K12 Inc. - CFO and EVP

* Mike Kraft

K12 Inc. - VP of Finance & Communications and Corporate Treasurer

* Stuart J. Udell

K12 Inc. - CEO and Director

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Conference Call Participants

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* Jeffrey Marc Silber

BMO Capital Markets Equity Research - MD and Senior Equity Analyst

* Ken Wang

First Analysis Corporation - Analyst

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Presentation

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Operator [1]

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Greetings, and welcome to the K12 Fiscal 2017 Third Quarter Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

I would now turn the conference over to your host, Mr. Mike Kraft, Vice President of Finance. Thank you, Mr. Kraft. You may now begin.

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Mike Kraft, K12 Inc. - VP of Finance & Communications and Corporate Treasurer [2]

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Thank you, and good afternoon. Welcome to K12's Third Quarter Earnings Call for Fiscal Year 2017. Before we begin, I would like to remind you that, in addition to historical information, certain comments made during this conference call may be considered forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and should be considered in conjunction with cautionary statements contained in our earnings release and the company's periodic filings with the SEC. Forward-looking statements involve risks and uncertainties that may cause actual performance or results to differ materially from those expressed or implied by such statements. In addition, this conference call contains time-sensitive information that reflects management's best analysis only as of the day of this live call. K12 does not undertake any obligation to publicly update or revise any forward-looking statements. For further information concerning risks and uncertainties that could materially affect financial and operating performance and results, please refer to our reports filed with the SEC, including, without limitation, cautionary statements made in K12's 2016 annual report on Form 10-K. These filings can be found on the Investor Relations section of our website at www.k12.com.

In addition to disclosing financial results in accordance with generally accepted accounting principles in the U.S., or GAAP, we will discuss certain information that is considered non-GAAP financial information. A reconciliation of this non-GAAP financial information to the most closely comparable GAAP information was included in our earnings release and is also posted on our website. This call is open to the public and is being webcast. The call will be available for replay for 30 days.

With me on today's call is Stuart Udell, Chief Executive Officer; and James Rhyu, Chief Financial Officer. Following our prepared remarks, we will answer any questions you may have.

I'd like to now turn the call over to Stuart. Stuart?

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Stuart J. Udell, K12 Inc. - CEO and Director [3]

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Good afternoon, and thanks for joining us on the call today. First, let me start by highlighting a few results for the quarter. Revenue for the quarter was $222.5 million, an increase of 0.5% year-over-year and slightly above our guidance provided last quarter. We posted operating income of $12.8 million, which included a set of specific charges adding up to $11.4 million as outlined in our press release and in our 10-Q. Without these specific charges, our business delivered $24.2 million in operating income in the quarter, an increase of 26.7% year-over-year. This $24.2 million was above our guidance of $14 million to $17 million as a result of the timing of some revenue events and expense actions as well as management's focus on expanding operating leverage and generating positive cash flow while continuing to drive improved academic outcomes.

Our forecast for the fourth quarter places our full year expectations in line with our original guidance for the year. This underscores K12's commitment to deliver on our financial objectives while remaining focused on our core mission to transform learning for every student we serve.

Now today, I want to focus on 3 key topics: upgrades to our platform and curriculum, programs to improve the student and family experience and then briefly on the policy environment. This quarter, we largely completed the monumental task of migrating all of our middle school programs to a new learning management platform provided by Desire2Learn. The new online middle school is designed to empower, engage and help students achieve even better academic results. More than 20,000 middle school students have been migrated to the new platform which provides a rich and engaging educational experience. The new user experience includes planning features that helps students stay on top of their schoolwork, powerful course management tool that allows teachers to tailor curriculum that best meets the unique needs of their students as well as a host of other features. Initial feedback has been positive from both teachers and students, both of whom cite a more seamless and connected user experience. We believe this will translate into higher student engagement and retention. This implementation also allows K12 to leverage Desire2Learn's ongoing investment in their state-of-the-art learning management platform. We believe this will allow us to deliver the best possible student experience at the lowest cost in both the short term and the years ahead.

Now as I mentioned on our last call, an implementation of this size is often not without challenges, and our initial fall rollout contributed to some in-year impact on student retention. That said, we've been mitigating these issues and are confident we are back on track to recapture our high-water retention levels or better in the next school year.

On the curriculum side, we continue to significantly upgrade our math and ELA courses into our new Summit Curriculum platform. We've garnered quite a bit of positive feedback from the initial rollout of courses and are continuing our development. By the end of fiscal 2018, we anticipate that a majority of our core math and ELA courses will have been launched, meaningly are down the home stretch in our conversion of the most critical curriculum to the Summit platform. As such, CapEx spending has trended lower as you can see in our financial results. We believe this trend will continue, resulting in lower CapEx spending levels in the coming years.

Now second, I want to touch on new programmatic support elements we've been working on to improve the student and family experience. This year, we've completed the 2-year nationwide rollout of Students First. You'll recall Students First is a series of programs that encompass the entire student experience, from onboarding to personalized outreach, to academic and support services for struggling students, to pulse check surveys for gauging satisfaction and adapting support services. We've also continued to hone our processes for making the transition to an online learning environment easier for families. As you might imagine, making the move from a traditional classroom and school to a virtual one is really a big step for students and families. New enhancements for back to school will include a simplified registration process, improved log-in experience, factored delivery of computers and materials and new open-hour sessions, where both new and returning families can interact even more frequently and easily with teachers and customer care representatives. These new and improved processes will help a student on boarding and we believe will have a meaningful impact on retention in the critical early days in a new school year.

We've also created an integrated set of learning to support and engagement strategies to help parents transition students to thrive in an online learning environment. These enhancements include a more user-friendly and comprehensive view of student courses, enhanced progress monitoring tools and personalized calendaring to provide clarity of students on the trajectory of their assignments. Through a massive amount of data analysis, we know the hows and whys behind making a successful transition to a virtual school, and our enhancements provide a more personalized pathway to each new family. Again, we believe that improving the user experience will drive engagement, motivation, retention, and ultimately, academic outcomes.

Now third, let me pivot to the policy environment. The latest budget proposals delivered by the administration in Washington calls for an overall reduction in federal education spending by an incremental $1.4 billion to school choice programs. This includes a proposed boost for charter schools, new school choice programs centered on private schools and an increase in Title I funding for economically disadvantaged students. While we will not comment on specific aspects of the proposal, it's certainly clear that the administration is continuing its support to expand alternatives, options and choice for families and students. We continue to monitor the budget process and federal policies to assess possible impacts on and opportunities for our partner schools.

We've remained focused on working within the current framework to expand choice at the state level through public, charter and private school partnerships. Our Managed Public School business continues to work to open full-time online and blended schools in these states. While we are certainly encouraged with the progress we are making, at this time, we believe it's more likely that we see new states coming online in fiscal '19 and thereafter. That said, we continue to work diligently and hope to bring on one new state in fiscal '18. We continue to heavily focus on developing new schools and programs within existing states as well as strengthening our current partner programs for the upcoming school year. In doing so, we believe we will continue to grow enrollments with some of our newer partner schools such as Alabama, North Carolina and Virginia. On balance, we believe we continue to show modest growth in Managed School enrollments in fiscal '18.

In summary, we posted solid results this quarter. The charges we recorded create structural improvements that support long-term growth and operating profit and cash flow. The national policy environment remains generally positive and could provide more choices to parents and students. We will continue to work within the current framework to be ready to pivot if any changes are enacted that impact K12. And importantly, the team has implemented systems, policies and programs to ensure that we are rock solid and ready for the upcoming school year. Our emphasis in this regard is critical to shareholders. The changes we've made, not only lower our systemic cost structure, but they also directly impact the student-family experience, student retention, and ultimately, academic performance. It's the quality of our products and services and the reputation as a quality education provider that will support growth and profitability in our business for the long term.

Now before I hand the call off to James, I wanted to mention 2 organizational changes. First, the Honorable Aida Alvarez has been elected as K12 Board of Directors. Aida was the first Latina woman to hold the United States Cabinet-level position, serving as the administrator of the Small Business Administration for President Clinton from '97 to 2001. She was also the founding Director of the Office of Federal Housing Enterprise Oversight, where she was charged with financial oversight of the secondary housing market, Fannie Mae and Freddie Mac. Earlier in her career, she worked for the New York City Health and Hospitals Corporation, Bear Stearns and the First Boston Corporation. Aida currently serves on the board of HP and formerly served on the board of Walmart. We're excited about the addition of Aida to our board and the public policy and financial expertise she brings to the team.

And second, as part of our restructuring of the Institutional Business that I commented on in past quarters, Sean Ryan will join K12 in mid-May as the new Senior Vice President and General Manager for Fuel Education, our institutional business. Sean will come to us from McGraw-Hill Education, where he serves as Senior Vice President of Sales, Service and Platform for the School Education Group. Previously, Sean served in growth-oriented leadership positions at Campus Management and at Scantron. Sean brings significant leadership, strategy, sales and business development experience in the education industry, and we're very excited that he'll be joining the K12 team.

I'll now hand the call over to James to review third quarter results as well as our fourth quarter guidance. James?

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James J. Rhyu, K12 Inc. - CFO and EVP [4]

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Thank you, Stuart, and good afternoon, everybody. First, a quick recap of our reported results. Stuart mentioned revenue for the quarter increased 0.5% to $225.5 million. Operating income on a reported basis was $12.8 million, a decrease of $6.3 million or 33% from the prior year. Adjusted operating income was $18.0 million, a decrease of $5.4 million or 23.1% from the prior year. And just as a reminder, adjusted operating income and adjusted EBITDA excludes the impact of stock-based compensation. Capital expenditures were $33.2 million, a decline of $7.8 million from the prior year's 9 months ending in March.

As you saw on our press release and as Stuart has already mentioned, our operating results for the quarter include $11.4 million of charges that I'll detail in a few minutes. These charges primarily stem from our ongoing effort to review our operations and portfolio of assets and to look for ways to improve our long-term profitability. In this case, we took a number of actions, including reducing our real estate exposure and lowering our human resource costs and recording some additional reserves for receivables that have been outstanding for a while. Excluding those charges, we would have reported operating income of $24.2 million for the quarter and adjusted operating income of $28.7 million.

A little more detail on the $11.4 million in charges. First, as we've previously discussed, from a real estate perspective, we're consolidating our corporate headquarters. And much like many corporations have done, we evaluated our space needs. We implemented some smarter guidelines, and we've reduced our footprint. In addition, we exited some unutilized facilities for schools that have closed in prior periods. In total, $5.5 million of the charge is related to the accounting for these actions.

Second, from a resources standpoint, we have proactively reviewed our organization since Stuart joined last year and refined -- and we've refined our headcount in Q3. This evaluation included overlaps caused by the acquisition of LTS last year and by the purchase of Middlebury Interactive in Q2 of this year and resulted in a modest workforce reduction, largely at our headquarter's location. In conjunction with these actions, we've recorded a severance charge of approximately $2.3 million.

And lastly, we took a $3.6 million charge for uncollectible receivables, largely associated with troubled accounts from years ago that we've been trying to collect for some time. These charges have been predominantly booked in selling and administrative and other operating expenses on our P&L. For your reference, we've provided additional information at the end of our press release that shows our income statement, excluding these charges on a line-item basis.

Now let me turn to some additional details for the quarter. I'm going to focus the remainder of my remarks today on the pro forma results, excluding the charges reported. Revenue was $222.5 million, an increase of $1.2 million or 0.5% from the year ago. Revenue growth was largely driven by an increase in our Institutional Business and some modest gains in our Managed School programs, somewhat offset by declines in our Private Pay business. Revenues for Managed Public School programs increased 0.9% compared to the prior year to $187.4 million. The increase was a result of revenue per enrollment rising 1.6%, offset by a 0.8% reduction in student enrollments.

In Q3, we continued to see lower student retention rates compared to the year-ago quarter, which resulted in enrollments being lower on a year-over-year basis. However, as Stuart mentioned, we have done significant work this year to address what we believe are the root causes of our retention issues and implemented a series of platform and curriculum upgrades as well as new programs to further improve the family and student experience. We believe that these actions will improve retention levels in fiscal '18. However, we may see some continued pressure in retention for the remainder of this year.

Revenue per enrollment increased 1.6% this quarter as a result of funding updates, better economics at a school level, improved capture rates as well as some other factors. The funding updates were across a number of states. Many of these factors help contribute to revenues being higher than our guidance expectations for the quarter. On a full year basis, revenue per enrollment is likely to rise between 1% to 2% versus the prior year. However, that does mean lower revenue per enrollment growth in the fourth quarter on a year-over-year basis as compared to what we saw in the third quarter.

In our Institutional Business, which includes both Non-managed Public School programs as well as our Institutional Software and Services business, revenue grew 10.4% on a year-over-year basis. Non-managed Public School program revenue increased 22%. Enrollment for Non-managed Programs increased 9.3% to 29,300, and revenue per enrollment rose 11.6%. Both increases were a result of the continued success, primarily in our larger programs, that have scaled throughout the year.

Institutional Software and Services revenues were 3.9% lower this quarter than the prior year. This is largely the result of some customer contracts being renewed at lower funding levels. Over the long term as school districts continue to adopt more digital alternatives, we continue to believe that Institutional Software and Services will provide significant growth opportunities for K12. However, in the near term, we continue to expect revenue growth to be on -- at an uneven pace. I also want to note that for Q4 last year, we had an unusually strong quarter, which is going to be a difficult comparison for Q4 of this year.

Turning to our Private Pay business. Revenues declined 24.5% to $8.9 million. However, you'll recall we exited U.K. operations. So excluding the impact of that exit, revenue was largely flat year-over-year. While it may take some time to develop, we still believe that there are a number of potential growth areas in the Private Pay business. While we don't expect to see rapid growth in this business in the near term, we believe over the long term, we do have some solid revenue opportunity growth for K12 in this area.

Gross margins were 38.7% in the quarter and were largely flat compared to 39.1% in the year-ago quarter. As I mentioned last quarter, on a full year basis, we expect gross margins to contract marginally, somewhere less than 100 basis points year-over-year. And this is really largely driven by the result of increased amortization for some curriculum we've recently put in service as well as some ongoing investments in driving stronger student outcomes and school mix.

Selling, administrative and other expenses decreased by approximately 10% from the year-ago quarter to $58.4 million. As a reminder, this is where we've recorded most of the $11.4 million of charges I discussed earlier. On a reported basis, the selling, administrative and other expenses were $69.8 million. We saw lower spending trend as a result of refining our headcount levels during the quarter and general belt tightening as we continue to improve operating leverage in the business. While we saw a strong favorability in the quarter, advertising and other expenses increased significantly in the fourth quarter in conjunction with enrollment seasons. Not all of the [saving] will flow through for the full year. So on a full year basis, we would expect selling, administrative and other expenses to be flat to marginally lower, excluding the impact of the California AG settlement last year and excluding the charges we just detailed for this quarter.

Product development expenses for the quarter rose to $3.5 million. On a full year basis, our outlook is for between $12 million and $13 million, which was higher than last year by a few million dollars. But total cash spend on product, which would include our CapEx spend, should be down significantly as you can see from our CapEx outlook.

EBITDA, adjusted for the charges mentioned above for the quarter, was $42.8 million, increasing $16.6 million from the same quarter last year. This increase was largely the result of our revenue gains and our solid cost controls in the quarter, somewhat offset by the year-over-year increases in stock-based compensation. Adjusted EBITDA for the quarter was $47.3 million, an increase of 15.6% from the prior year.

Operating income, excluding the charges mentioned above, was $24.2 million, an increase of $5.1 million or 26.7%. Operating income was higher than we had anticipate in our guidance -- the guidance we indicated last quarter as a result of better-than-expected revenues, which I previously discussed as well as some lower expenses. Our general focus on spending produced better expense levels overall Adjusted operating income was $28.7 million, an increase of $5.3 million or 22.6% from the prior year.

Turning to some other items. We ended the quarter with cash and cash equivalents of $194.7 million. This is a decrease of $4.8 million from the third quarter in fiscal '16, largely related to timing as well as payments we made in Q1 of this year for the California settlement and Q2 to purchase the 40% minority stake in MIL.

CapEx, which includes capitalized curriculum and software development and property and equipment purchases, was $9.3 million in the quarter, a decrease of $5.9 million compared to last year. This decline is part of our planned reduction in capital expenditures that we announced last quarter.

Our tax rate for the quarter was 34.4%.

Before moving on to reviewing guidance for the fourth quarter, I want to remind everybody that we introduced some performance-based stock compensation last year, which has the potential to vest this coming quarter, depending on whether certain performance metrics are met. So we may see some variability in stock-based compensation in the fourth quarter. We have introduced adjusted operating income and adjusted EBITDA this year as those metrics exclude the impact of the stock-based comp, but our normal operating income and EBITDA will include these potential charges. This vesting could result in charges of up to $4 million to $5 million this year that was not part of our original guidance for full year operating income or our guidance for fourth quarter that I'm about to review.

So with that as background for the fourth quarter, we're looking for revenue in the range of $215 million to $220 million, adjusted operating income in the range of $7 million to $10 million, operating income in the range of $3 million to $6 million and capital expenditures of $14 million to $18 million. As you will note, this range of revenue puts guidance at or slightly below the revenues we've posted in the fourth quarter of fiscal '16. This is for a number of reasons. First, as I mentioned before, enrollments have been down and should end the year marginally below last year, while revenue per enrollment continues to be positive. The net is that Managed School Public revenues could be down year-over-year. Second, Private Pay revenues have been lower every quarter as a result of exiting the U.K. business. And third, as I've mentioned previously, our institutional revenues continued to be lumpy, and we have a tough comparison against the fourth quarter of last year.

And operating income. While this guidance places full year operating income at $23 million to $26 million squarely within our previous guidance, the fourth quarter is somewhat below the fourth quarter of last year, excluding the impact of the California AG settlement. This is largely a result of some anticipated increases in marketing costs in Q4 to drive some early season enrollments. As we've mentioned previously, we believe the families who enroll early in the season are more engaged, and they persist longer in an online environment which will result in better economics overall for the students we enroll earlier.

You'll notice that our guidance for capital expenditures targets full year capital expenditures at $47 million to $51 million, which that are slightly below the low end of our guidance range we've previously provided. As we continue to refine our capital planning for the year, we've further reduced our expectations for current year expenditures. We view this as a positive trend and are more confident that over the next few years as many of the major capital programs neared completion, we should be able to lower and ultimately stabilize outlays in the $40 million to $50 million range on an ongoing basis that we previously discussed.

I also again want to remind you that our full year guidance for operating income and adjusted operating income implies stock-based compensation costs of approximately $17 million. I believe the consensus is closer to $19 million. This $17 million that we've implied again excludes any performance-based stock that could vest in Q4.

Thank you for your support, and I'll hand the call back over to Stuart. Stuart?

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Stuart J. Udell, K12 Inc. - CEO and Director [5]

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Thank you, James. Manny, if we have any questions, we'd be happy to take them now.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question is from Corey Greendale of First Analysis.

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Ken Wang, First Analysis Corporation - Analyst [2]

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This is Ken Wang on for Corey. So just going off of the press release yesterday on the North Carolina Virtual Academy seeing an increase in student applications. Just wondering if you can offer any additional color on whether you're seeing any similar demand increases in other states?

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Stuart J. Udell, K12 Inc. - CEO and Director [3]

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Well, we're fairly early in the enrollment season. It's very, very early. Most of our schools just opened pretty recently. North Carolina is an interesting state because right now demand greatly outpaces supply, and that's something that we hope the state will take a look at over time when you have so many families who are interested in getting in to school. But that's obviously a great situation. If we can get a school like North Carolina filled very quickly, we get to then focus on other areas.

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Ken Wang, First Analysis Corporation - Analyst [4]

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Absolutely. Yes, that's helpful. And then any change in your thoughts on use of cash?

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Stuart J. Udell, K12 Inc. - CEO and Director [5]

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So that's something we clearly think about periodically. And while we consider all options and have periodic conversations with our board about that, we are most focused on looking at M&A opportunities. We are very active in doing so, but we also remain very disciplined in our approach to strategic combinations and making sure that they provide the strategic value and that they are priced reasonably. So that's a discipline we have internally. As James shared, in the last year or so, we were able to close the LTS acquisition and acquired the remaining share of Middlebury Interactive, and it's something that we are certainly very focused on, on a management team. That is our primary anticipation of use of cash at this point.

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Ken Wang, First Analysis Corporation - Analyst [6]

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Great. And just one quick one for James. Anything you can offer on just expectation for tax rate in Q4?

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James J. Rhyu, K12 Inc. - CFO and EVP [7]

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Yes. I think, well -- I think on a full year basis, we should land well within sort of the sub-40% range, I think. So that -- I think that -- what that implies is for Q4, at least, we'll also probably be in the high 30s type of range.

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Operator [8]

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The next question is from Jeff Silber of BMO Capital Markets.

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Jeffrey Marc Silber, BMO Capital Markets Equity Research - MD and Senior Equity Analyst [9]

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Just wanted to go back to your initial remarks. And forgive me, I don't know if I even copied this down correctly. But I think you'd talked about a delay of potential new school openings from fiscal '18 to fiscal '19. Can you go over the reasons for that again?

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Stuart J. Udell, K12 Inc. - CEO and Director [10]

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Yes. That's not so much a delay. But as you know, I mean, we have roughly 16 or 17 possible new states within which we can open up a new state entirely. So every year, we queue up 2 or 3 that we hope to have a good shot at, and we're working hard in those states. We're not sure we'll be able to get a new state entirely open this year, but we certainly will continue to open new schools in existing states, and we'll be able to add programs like career and tech education to existing schools. So we're -- we remain very focused on growth via a number of avenues. But new states in and of themselves are binary. They either happen or not. We're working hard on a couple of them.

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Jeffrey Marc Silber, BMO Capital Markets Equity Research - MD and Senior Equity Analyst [11]

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All right. And then I think you said you were looking for "modest growth" in Managed Public School enrollment next year. How do you define modest?

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Stuart J. Udell, K12 Inc. - CEO and Director [12]

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Yes. I think it's a little early in the season. We continue to believe that we have growth opportunities. We're not really giving any guidance for the fall enrollment number, but we do think that the -- we do think that Managed School Programs is going to continue growing.

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Jeffrey Marc Silber, BMO Capital Markets Equity Research - MD and Senior Equity Analyst [13]

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Okay. And then I ask this every quarter, could we get an update on what's going on in Ohio?

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Stuart J. Udell, K12 Inc. - CEO and Director [14]

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Yes. We've been in conversations and negotiations around contracts, contract renewal for some time. It's part of the standard process. And I would generally say that things are going the way we want them to be going, so we'll hopefully have an update very soon.

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Jeffrey Marc Silber, BMO Capital Markets Equity Research - MD and Senior Equity Analyst [15]

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And is typically an announcement made publicly, and if so, does that happen before the end of the current school year?

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Stuart J. Udell, K12 Inc. - CEO and Director [16]

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Typically, it's not been our history to announce the contract renewals. But as I said, things are going quite fine in our estimation, and we certainly hope to get things moving along a little more quickly. But there are a lot of players involved.

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Operator [17]

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(Operator Instructions)

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Stuart J. Udell, K12 Inc. - CEO and Director [18]

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Well, thank you, again for listening in, everybody. We appreciate your continued interest and support. Manny, if there's no more questions, we are ready to close the call, and we'll join everyone again in about 90 days.

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Operator [19]

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Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time, and thank you for your participation.