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Edited Transcript of TWOU earnings conference call or presentation 7-May-19 9:00pm GMT

Q1 2019 2U Inc Earnings Call

Landover May 14, 2019 (Thomson StreetEvents) -- Edited Transcript of 2U Inc earnings conference call or presentation Tuesday, May 7, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Catherine A. Graham

2U, Inc. - CFO

* Christopher J. Paucek

2U, Inc. - Co-Founder, CEO & Director

* Ed Goodwin

2U, Inc. - VP of IR

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Conference Call Participants

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* Brad Alan Zelnick

Crédit Suisse AG, Research Division - MD

* Brett Anthony Knoblauch

Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst

* Brian Jeffrey Schwartz

Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst

* Corey Adam Greendale

First Analysis Securities Corporation, Research Division - MD

* Hannah Rudoff

D.A. Davidson & Co., Research Division - Research Analyst

* Jeffrey P. Meuler

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Peter Perry Appert

Piper Jaffray Companies, Research Division - MD and Senior Research Analyst

* Ryan Michael MacDonald

Needham & Company, LLC, Research Division - Senior Analyst

* Sarah Emily Hindlian

Macquarie Research - Senior Analyst

* Sou Chien

BMO Capital Markets Equity Research - Senior Associate

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the 2U, Inc.'s First Quarter 2019 Earnings Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. Ed Goodwin, SVP, Investor Relations. Sir, you may begin.

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Ed Goodwin, 2U, Inc. - VP of IR [2]

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Thank you, operator. Good afternoon, everyone, and welcome to 2U's First Quarter 2019 Earnings Conference Call. By now, you should have received a copy of the earnings release for the company's first quarter 2019 results. If you have not, a copy is available on our website, investor. 2u.com. The recorded webcast of this call will be available in the Investor Relations section of our website. Also, we routinely post announcements and information on our website, which we encourage you to access and make use of.

Today's speakers are Christopher Chip Paucek, Co-Founder and CEO; and Cathy Graham, CFO.

During today's call, we may make forward-looking statements, including statements regarding the company's future financial and operating results, future market conditions and the plans and objectives of management for future operations, including the pending acquisition of Trilogy. These forward-looking statements are not historical facts but rather are based on our current expectations and beliefs and are based on information currently available to us. The outcome of the events described in these forward-looking statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from the results anticipated by these forward-looking statements. This includes, but is not limited to, those risks contained in the Risk Factors section of the company's annual report on Form 10-K for the year ended December 31, 2018 and other reports filed with the SEC as well as our ability to successfully integrate the operations of Trilogy, achieve the expected benefits of the acquisition and manage, expand and grow the combined company. All information provided in this call is as of today. Except as required by law, we undertake no obligation to update publicly any forward-looking statements made on this call to conform to statements or actual results or changes in our expectations. Also, it is 2U's policy not to update our financial guidance other than in public communications. Non-GAAP financial measures discussed during this call are reconciled to the most directly comparable GAAP measures in the tables attached to our press release.

I would now like to turn the call over to Chip.

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [3]

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Thanks, Ed. Here we are 5 years into our public company journey. As you can see, we had a very good first quarter with revenue of $122 million, 32% growth over Q1 2018. Cathy will take you through the financials in more detail.

A lot has changed in the marketplace and at 2U over the past 11 years. But one thing has remained constant: 2U continues leading the way in the digital transformation of higher education alongside an amazing and growing portfolio of great universities. As we enter a new chapter for the company, we're excited about the strategic direction of our business. More people at more stages in their lives are investing in themselves and their futures, upskilling and reskilling along the career curriculum continuum to meet changing demands of today's digital economy. We see our partners essential to this new reality of lifelong learning, and 2U is better positioned than ever to help them seize the opportunity and deliver life-changing outcomes for students at every stage of their career. More on that later.

First, let's spend some time on the grad segment. A lot to unpack here. As you probably saw on the press release, we're taking down our consolidated revenue guide for full year 2019 to 30% at the midpoint. This is driven by a few challenges in the grad segment, some that are in our control and some that aren't. We've seen enough data and think it's important to get ahead of it, so we've made a decision to call it now and change our forecast. We expect that business to grow mid-20% for the full year.

As I take you through the specifics, you'll see there are still plenty of structural positives to report. Let's turn to 3 factors at play in our new 2019 expectations for the grad business. Number one, our partners are getting more selective, which impacts admit rate; number two, we're seeing some pressure mid-funnel on the rate at which prospective students are submitting their applications for review; and number three, we're seeing some slowness in the 2019 cohort, most importantly, one of our largest projected programs for the 2019 cohort had its launch date slip to later in the year for reasons beyond the control of the school and 2U.

Before I get into specifics on each of these, I want to make one thing clear. We do not believe the challenges we're seeing are attributable to weakness in our marketing efficiency at the top of the funnel. We've said that before and are reiterating it again today. Our data shows we're driving significant growth in the quantity of prospective students and started applications. We're doing so at an average cost that has remained consistent with historicals. It's actually down in many spots. Across the portfolio, applicant quality remains steady.

So let's talk selectivity, what we call admit rate. It's worth reminding everyone that who gets admitted into our programs is exclusively the province of our university partners. It's always been and always will be that way, not to mention a clear example of the fact that we don't control or own the product. The university does. Historically, admit rate has been a noisy number with lots of ups and downs, so it's inherently tricky to forecast. Having said that, we're now starting to see a more consistent trend emerge across the portfolio. Our partners are becoming more selective across the board, particularly as programs scale. Put another way, our oldest programs, while still large, are choosing additional selectivity over incremental scale, and we respect that. Although this may not serve our short-term quarter-by-quarter financial interests, this is part of the reality of what it takes to operate effectively in higher ed. We have to think long term. Pushing our partners here is simply shortsighted.

2U is still very much a growth story, but growth never was and never will be the only strategic driver of our business. Our success comes from the mission alignment we share with our partners. We have to think long term, respect boundaries and build trust. What's best for them is best for us. But that doesn't keep us from having to deal with the impact of their choices today.

Beyond admit rate, we're also seeing some changes in the rate of application submission even though we continue to generate strong prospect numbers at the top of the funnel. Now this is a complicated part of the business with many program-specific variables and a lot of process. One example of an issue we're seeing, more people are moving through our funnel without speaking to a counselor. We're addressing these in a variety of ways, which involves lots of blocking and tackling, but I can assure you, we're all over it.

The third factor with respect to the 2019 cohort is more straightforward, the delayed timing of the launch of the UC Davis MBA, the first online MBA in the UC system. You may remember that we expected this program originally to be part of the 2018 cohort, but it was pushed into this year. For 2019, we originally budgeted multiple intakes of new students. Approvals took more time than anticipated, so it will now launch later in the year, which means we'll only have one intake of students in 2019. The delayed launch means that the program won't contribute as much revenue as we expected in 2019. A delay but nothing concerning for the long-term size and health of that program. We've actually begun marketing that program now, and it's off to a fabulous start. Sometimes, we just have to be a little patient.

So what does this all mean for the grad segment moving forward? As I mentioned earlier, we aren't seeing declines in front-end marketing efficiency. We're generating more prospects and application starts than ever and doing so at a quality level and average cost that has been consistent over time. And the rate of admitted students that choose to enroll or yield has remained steady year-over-year. However, increased selectivity does put some pressure on total average spend per student. Now despite that, on average, our programs are generally more profitable than we anticipated. Across 2UOS, we are indeed getting benefits of scale in the nonmarketing cost categories. Investors have asked us for some time, are you underestimating the long-term cohort margins? And to date, we've cautioned patience. But the reality is the cohorts have been more profitable than we expected. We believe the cohort margin of our oldest bucket, which was 42% last year, will remain above our target for some time even with these challenges. One of the results of this is we can run lower-revenue programs at really strong margins. Over time, this should broaden the profile of the programs we can launch, including lower-tuition programs. And it gives 2U the opportunity to continue to invest in scholarships.

Looking at individual program size, it's clear that our largest programs aren't as large as they once were. Those with outside enrollment, outsized enrollments have scaled back. But at the same time, our portfolio as a whole became stronger, more distributed, more resilient. We're far less dependent today on a few large programs, and that's better for all involved over the long run.

You can see this trend in the numbers underlying the list of top programs by new enrollments. Each time we've given you this list, the new enrollments of the top 5 programs have been above the top end of our target range of 300 to 500. We believe that will remain the case in 2019. However, the average enrollment for the top 5 has come down. The average in 2019 is projected to be 20% lower than the average in 2017.

Now while our largest programs aren't quite as large, across the portfolio, our programs are scaling toward our target range of new student enrollments.

Looking at the top 15 programs by new student enrollments, the average in 2019 is actually projected to be 3% higher than the 2017 average. So we believe that the average will go up even with the decline in our largest programs. In fact, if you exclude the top 5 programs from the calculation, enrollments for 6 through 15 are projected to be up 32%.

So we continue to see programs across the portfolio scale toward our target ranges for new student enrollments. We still firmly believe in our runway of 250 DGPs. Pipeline for those programs is strong. We've got a bunch of announcements coming, but that's for another day.

Okay. Let's turn our attention to the evolution of the business. As we recently announced, we expect to close an incredible acquisition in the second half of May. Once that happens, 2U, the complete 2U, including GetSmarter and Trilogy, will have products and offerings across the full continuum of student needs to meet the demands of the 21st century workforce. The complete 2U will bring to bear an incredible new arsenal of technology, services and talent to our partners. Oh, and our partner portfolio goes from 36 to 68.

Once the transaction closes, we expect to report Boot Camp results in the same segment as our existing short course business. It's critical that investors understand the importance of these new credentials in the marketplace. So starting this quarter, we've renamed the short course segment the Alternative Credential segment. We've renamed it for a reason. We will have created significantly more options for students over the past 2 years and in doing so, we'll have fundamentally transformed 2U as a public company. We're evolving from a company entirely reliant on a single line of business, grad programs, to one where a considerable portion of our revenue will come from Alternative Credential.

We believe that revenue from short courses and boot camps is high-quality. Yes, revenue from those businesses is reported on a gross basis. But we think that long term, off gross revenue, the Alternative Credential segment can achieve margins in the high teens to 20% range. We would expect short course margins to be slightly lower and boot camp margins to be slightly higher. That's what we think today.

But there are certainly levers, prospect share and course stacking as examples that could provide upside to that estimate over time. But we'll start there in terms of expectations.

Our GetSmarter acquisition was our first move in Alternative Credential and it's been a resounding success. Short courses followed up a transformational 2018 with a great first quarter in 2019, growing revenue 54% year-over-year. Our clients are signing up for new short course opportunities. By year-end, our portfolio is expected to go from more than 90 courses to more than 120.

And as we expand our portfolio, we see tremendous potential for deploying courses modularly across the continuum, stacking courses into all types of certificates, embedding courses into boot camps and degrees, even short courses for credit, all of which gives students more choice, which leads to more outcomes. 93,000 short courses have already been taken. That's just the beginning.

Our second move in Alternative Credential is our pending Trilogy acquisition. Trilogy is a fast-growing business, meeting a critical need of the modern workforce and doing so at a very competitive price point. Students complete Trilogy-powered boot camps with both the university certificate and the skills needed to compete for some of the most in-demand technical jobs. We're bullish on the boot camp market and its ability to deliver a unique set of student outcomes. The product attributes fall nicely between a single course and a full degree program. Boot camps are in high demand across many technical subject areas, including coding, UX/UI, data science, cybersecurity and fintech.

Note, historically, 2U has not powered many offerings in science and technology verticals. That changes with Trilogy. Additionally, we're quite excited about Trilogy's enterprise channel, which is off to an encouraging start. We believe enterprise is a substantial growth lever long term for boot camps and that as part of 2U, we can add short courses and degrees into the channel. Together, it creates the right mix of offerings to anchor our full continuum into the enterprise. Expect more here over time.

From a financial standpoint, if we're able to recognize 60% to 65% of Trilogy's expected 2019 revenue and excluding the impact of purchase accounting adjustments on that revenue, we would anticipate consolidated revenue -- annual revenue growth for 2019 of 50% to 52%.

Finally, Trilogy enables us to differentiate parts of our grad product line. UNC Kenan-Flagler already announced that it will offer Python as part of its MBA@UNC curriculum after the transaction closes. Since the announcement, organic prospect volume for that program is up 30%. So we're looking forward to closing this deal soon and beginning our new chapter with Trilogy. We like where things are headed.

Cathy?

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Catherine A. Graham, 2U, Inc. - CFO [4]

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Thanks, Chip. 2019 started off with a strong first quarter. Revenue came in nicely ahead of guidance, accompanied by better-than-expected loss measures. At $122.2 million, first quarter revenue exceeded the prior year period by 32.4%. In our graduate program segment, year-over-year revenue growth was 29.3% for the quarter, with revenue from short courses growing 54% over the same period of 2018. Note that this is the last quarter in which we will be reporting our short course business as a stand-alone segment. Once we close the acquisition of Trilogy, we expect to combine the boot camp business with our existing short course business into a segment we have now renamed Alternative Credential.

In our graduate program segment, revenue growth continued to be driven by an increase in full course equivalents. For the first quarter, FCE showed a year-over-year increase of 32.7%, offset by a 2.5% decline in average revenue per FCE. The decline in average revenue per FCE was driven primarily by a combination of admit rate-related FCE declines in larger higher-priced programs and higher FCE growth in lower-priced programs between the periods.

In our Alternative Credential segment, which, in first quarter, consisted solely of our short course business, revenue growth continued to be driven by increases in both FCEs and average revenue per FCE, reflecting new course launches and a continued shift in course mix towards higher-priced U.S.- and U.K.-based courses. FCEs showed a year-over-year increase of 52.1% for the first quarter, enhanced by a 1.3% increase in average revenue per FCE.

Looking at our first quarter loss measures. All experienced the year-over-year increase in loss and decrease in margin driven primarily by our previously announced decision to increase graduate program marketing spend during the period. Relative to expectations, this additional spend was offset somewhat by temporary savings related to projects that were slowed or pushed off as we focused on the Trilogy acquisition. At $21.5 million, first quarter net loss widened year-over-year by $6.7 million, and the corresponding margin declined by 1.5 percentage points. Note that relative to our prior expectations for the period and in addition to the cost timing shifts already mentioned, net loss benefited from lower-than-anticipated stock compensation expense and higher-than-forecasted interest income, but was impacted by $1.9 million in unanticipated transaction costs related to the pending Trilogy acquisition.

After net adjustments of $12.9 million, first quarter adjusted net loss was $8.6 million or 7.1% of revenue. This was a $2.5 million and 0.5 percentage point year-over-year decline to adjusted net loss and adjusted net loss margin, respectively. In addition to the timing shifts in certain expenses, adjusted net loss also benefited from the higher-than-expected interest income that also impacted our net loss measure.

After further net adjustments of $5.4 million, first quarter adjusted EBITDA loss was $3.2 million or 2.6% of revenue. This represented a $1.7 million decline in adjusted EBITDA loss and a 1 percentage point widening in adjusted EBITDA loss margin over the prior period. Relative to expectations, adjusted EBITDA loss largely benefited from pushing project spend out into later quarters as we focused on the Trilogy acquisition.

From a balance sheet perspective, we ended first quarter with $423.6 million in cash and investments. We also had $70.3 million in receivables balances, $33.1 million of which was related to one university partner which paid that balance in April.

Now looking forward, we are providing guidance for second quarter and full year 2019 before giving effect to the Trilogy acquisition that we now expect to close in coming weeks. I will give you additional color around how we now think Trilogy will perform this year after discussing the existing business, and we expect to formally update our guidance as soon as practicable after closing the transaction.

Now as Chip discussed in detail, we are seeing some decline in expected graduate program enrollments beginning in the second quarter and continuing through the rest of the year. As you are well aware, our graduate program business is a long-cycle accumulating revenue business and enrollment changes in any period impact revenue for multiple future periods. Therefore, as a direct result of softer graduate program enrollment expectations, we're bringing down our 2019 revenue guidance in increasing amounts over the remainder of the year to account for what we now believe will be a mid-20% year-over-year growth rate in this business line for full year 2019.

We currently expect consolidated revenue of between $124.3 million and $125 million for the second quarter and $534 million and $537 million for the full year. At their midpoints, these ranges imply year-over-year growth of 28% for the quarter and 30.1% for the year. Based on these expectations and particularly on the accumulating impact to revenue of our current enrollment forecast, we now expect that approximately 48% of second half 2019 revenue will be recognized in the third quarter.

With regard to our earnings and loss measures, you'll recall that we reduced our margin targets for 2019 so that we could increase our marketing spend to attract students that we felt we were leaving on the table. While knowing what we know today, we'd likely rethink that decision. We have already deployed a large portion of that incremental marketing spend in the first and early second quarters, so we'll still feel the margin impact for the year. In the longer term, however, we believe that by following the lead of our university partners and stabilizing our graduate programs at slightly lower-per-program enrollment expectations as they hit scale, we may give up a few percentage points in consolidated revenue growth, but we can more reliably drive towards target margins. Beginning in 2020, we expect that our business, as it will be constructed after the acquisition of Trilogy, can return to delivering consistent year-over-year low single-digit margin improvement as measured at the adjusted EBITDA level.

In our current view of full year 2019 earnings and loss measures, you'll see that we expect to generate cost savings that offset the anticipated decline in revenue, leaving our adjusted earnings and loss measure forecast largely unchanged and driving a slight increase in the corresponding margin expectations. We believe we can drive this result primarily because our servicing costs are largely variable, there should be some marketing spend reductions related mostly to lower forecasted admit rates, and we anticipate getting additional cost efficiencies from accelerating already in-flight projects that bolster our ability to scale.

We now expect a net loss of between $36 million and $35.5 million for the second quarter and between $79 million and $77.2 million for the full year. Note that our expectations for full year net loss have improved somewhat from our last guidance due primarily to a decrease in expected stock-based compensation expense related to the expiration of certain performance shares and a small increase in expected forfeiture rate. However, also be aware that we have not included any estimate of remaining transaction-related costs or adjustments that will impact net loss, but be excluded from our adjusted earnings and loss measures. We will include these items when we update our guidance to reflect the Trilogy acquisition. We now expect an adjusted net loss of between $20.8 million and $20.3 million for the second quarter and between $20 million and $18.2 million for the full year. We also expect an adjusted EBITDA loss of between $13.1 million and $12.6 million for the second quarter and positive adjusted EBITDA of between $12.5 million and $14.3 million for the full year. In looking at the distribution of our adjusted earnings and loss measures across the second half of the year, I want to remind you that cost seasonality typically improves margins in the fourth quarter of each year, and we expect this pattern to hold true for 2019.

Now while we haven't closed the Trilogy acquisition and aren't ready to include it in our guidance, I can provide some updates and additional color on what we now expect for that business for 2019. As we said when we announced the transaction, for calendar year '19, we expect that Trilogy will deliver $135 million in revenue on a stand-alone basis. Assuming that the transaction closes in the second half of May, our preliminary expectation is that we would consolidate between 60% and 65% of annual revenue before applying any purchase accounting adjustments. We do expect to have a material adjustment to the revenue we can recognize in the second, third and to a lesser extent, fourth quarters. But the magnitude and per-period impact will not be determined until after closing. Additionally, we anticipate generating a onetime discrete tax benefit from the acquisition.

Even before the magnifying impact of purchase accounting adjustments, we do expect that Trilogy will be dilutive to our earnings measures and margins for 2019. We'll provide additional detail about the impact to 2019 periods as well as additional information around the acquisition becoming accretive to our adjusted EBITDA measure in 2020 when we update our guidance. In the longer term, however, we now believe that our Alternative Credential segment, as constructed to include both the short course and boot camp businesses, can achieve long-term steady-state adjusted EBITDA margins in the high teens to 20%, with boot camp margins being somewhat higher than short course margins.

So while we aren't exactly where we expected or wanted to be for the remainder of the year, we're still in a good place. We have a business that we expect to continue growing 30% even as it passes $0.5 billion in revenue. We're confident in our ability to return our business to a steadily improving profitability profile. And we're about to complete an acquisition that not only expands our ability to put universities at the center of career-enhancing education, but accelerates a path -- our path to $1 billion in revenue probably by a year. Okay. So the path isn't always a straight one, but we have more going right than wrong. For the long run, I wouldn't bet against us. Chip?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [5]

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Charting the course for the company in our sector is a challenging job. We have the responsibility of the dual bottom line. We have to hit our numbers and deliver societal benefit, not through charity, but through the actual delivery of the business. Looking back in the past several quarters, I want to tell this community I've been thinking quite a bit about our positioning with the Street. We've always put students first. We have historically, and that won't change. It has become clear in the rearview mirror that we were prioritizing growth a bit too much based on the feeling -- on feeling the need to meet past expectations. I should have seen these admit challenges more broadly and simply taken some air out of the balloon. It would have been better for my team and my clients. I didn't do that. Call it a lesson learned in the life of a public company CEO.

Moving forward, we now have exciting new growth levers, and our grad business is still growing really nicely and probably, more importantly, appropriately, given the positioning and needs of our clients. We have a really profitable and powerful engine of social mobility and one that I'm personally committed to steering to increasing margins overall. I think we've transformed 2U with our strategic M&A. I think we're solidly set for the long term. I'll be out in the road the next couple of weeks to meet with you about our prospects. I'm excited to begin that conversation now.

With that, we're happy to take your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from the line of Ryan MacDonald with Needham & Company.

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Ryan Michael MacDonald, Needham & Company, LLC, Research Division - Senior Analyst [2]

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I guess starting with the updated guidance. Can you maybe unpack a little bit more just the contribution across the 3 kind of areas of the guidance change, between partners getting more selective, the mid-funnel and then the slowness or the delay in the new cohort?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [3]

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Well, we're not going to -- we can't go through intimate details about each. We sort of put them -- the selectivity question we spent more time on for a reason. It's pretty significant. The cohort -- it's interesting. The UC Davis MBA has started superstrong sort of validating the fact that we obviously wanted it for a reason and expected originally to be in '18, and then it went through a pretty long approval process that we didn't expect. So that's a good chunk of students right there that just comes out of the forecasts. And then the submit rates or the mid-funnel stuff is it's really quite a long list of individual program-related details and then a couple that go across the system. But we're not overstating on that one when we say it's really -- it's a lot of different things that are often program-specific. So I would say there's a reason we focused more on selectivity. That's a big component of it. And that more than anything is what caused us to sort of call it and effectively reset this segment.

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Ryan Michael MacDonald, Needham & Company, LLC, Research Division - Senior Analyst [4]

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Got it. Got it. And then just a quick follow-up. I think that when you looked at sort of the initial launch cadence for 2019, there was a, I think, a fairly large group of new program launches in the April and May timeframe. To the extent that you can, can you talk about sort of all the trends you're seeing for the enrollments for those new program launches recently?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [5]

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We're getting there in terms of them getting up and running and launched. So I would say that nothing out of the ordinary. It's -- they're launching. I would say the one that is sort of in there that's the most -- that was the most unknown is the -- our first non-U. S. MBA, the UCL MBA. If you look at the 2 MBAs that are in that cohort right now, UCL and UC Davis, they are now #1 and #2 in first month prospect volume. So they launched very strong.

The difference between the 2 and the reason that we aren't willing to look at UCL sort of exceeding forecast in that particular program is that it's our first program in the U.K., we have GDPR front and center, and there will be a variety of different things about that program in terms of how we handle the admissions process, in part because of GDPR. We have the Chief Privacy Officer, the former Chief Privacy Officer of the Federal Trade Commission as a 2U employee.

And so we're sort of prepped for in handling GDPR as we speak. So that one, prospects have started great, but we're just not willing to sort of take outsized credit for it yet because candidly, it's brand-new and we got to walk before we run in the U.K. Beyond that, they're launching. I'm not sure -- they seem fine. So it's -- this is more of a story of, unfortunately, we had multiple cohorts expected for the one that we really thought would be the big one.

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Operator [6]

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And our next question comes from the line of Sarah Hindlian with Macquarie Capital.

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Sarah Emily Hindlian, Macquarie Research - Senior Analyst [7]

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My first question is for you, Chip. Chip, I think it would be really helpful, given that you've called out pretty strong marketing conversion still at the top of the funnel and consistent students' demand, if we could talk about the other side of the model. And by that, I mean, are you seeing any potential pressure on contract economics as deals are in the pipeline? And then my second question is for you, Cathy. Cathy, I was hoping you could walk me through some of the puts and takes in terms of the deceleration and growth around Trilogy's initial outlook for '19.

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [8]

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So Sarah, thank you. So I would say, first of all, the new deals and signing new deals really has no direct relation to what's happening in our forecast for the Street. It's really can we deliver for our clients, do we deliver something that satisfies their needs. And interestingly, this sort of reset does align us really well with our clients versus the opposite of pushing too hard on driving a particular growth forecast. We just can't think that way. So they're really not related. In terms of new programs economics, not really. I mean to be clear, everyone is in a negotiation, and of course, everyone in any negotiation would always like something cheaper. That's not new news to anybody for negotiating anything, whatever you're buying. But we've seen no sort of sea change there at all in terms of the way we're thinking about new programs and how they're being negotiated and therefore, like what the rates are. So we're still well in our target ranges for new signings.

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Sarah Emily Hindlian, Macquarie Research - Senior Analyst [9]

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All right. That's great. It makes perfect sense.

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Catherine A. Graham, 2U, Inc. - CFO [10]

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And Sarah, with regard to Trilogy, I'm obviously limited in what I can say as we haven't even closed that transaction yet. But I guess what I would say is at announcement, we gave and we've reconfirmed what we think that their stand-alone business will be, and a lot of that is based on their forecast of the business that they have today and the kinds of courses that they are running. We don't know about what purchase accounting adjustments will do to the kind of revenue that we will get to recognize. So pulling that out, I think that we have -- we've looked at what we and certainly the management of Trilogy believe are the things that are pretty much baked into their forecast. And obviously, they have some initiatives that they're working on, but we would not want to be taking credit for all of those at this point.

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Operator [11]

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And our next question comes from the line of Brett Knoblauch with Berenberg.

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Brett Anthony Knoblauch, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [12]

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I was wondering if you could just dig in a little deeper with the selectivity you're seeing and I guess, in particular, at the more expensive programs and why they are choosing to reduce their intake.

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [13]

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So Brett, the selectivity has nothing to do with the expense level of the program. To be clear, we have seen it happening system-wide, really irrespective of what their price is. So those are not related points. We're at a point now where we felt like we just needed to call it and get ahead of it because we are seeing this trend. And obviously, this is something that historically has moved around a lot. And we've had certain quarters where we've said things like, well, people say wow that was a really surprising quarter. We say, well, everything kind of went to the positive. In general, the everything tends to be this. And now that we're in a period where it seems to be going against us over some time period, we felt like we just sort of needed to get ahead of it. And so that's where we are.

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Brett Anthony Knoblauch, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [14]

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Okay. Then could you just touch on the UNC and USC programs? I know you hinted at most of those problems being behind you. But are there any additional problems this year? Or is that mostly in the rearview mirror?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [15]

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Yes. I would say managing the relationships are critical, but candidly, those 2 programs are not the reason that we're here. Now clearly, they were a part of the -- admit rate was definitively a huge part of the USC Social Work program. But my point is are changed to our expectations going forward, and remember, it's a forecast. Interestingly, our Q1 was outstanding. We're just seeing this across the system and felt like we've got a pretty predictable model. When that's positive, we tell you about it. Honestly, when it's not, we tell you about it. And that's what we're doing now. So we feel like we've got enough data for the rest of the year to be able to call what we think will result in softness in the segment due to the admit rate. Interestingly, USC Social Work and UNC MBA are actually up in this period. So they're not related to -- they're not part of the reason that we are giving this new set of expectations.

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Operator [16]

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And our next question comes from the line of Rishi Jaluria with D. A. Davidson.

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Hannah Rudoff, D.A. Davidson & Co., Research Division - Research Analyst [17]

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This is Hannah on for Rishi. First up, I was wondering if you could just expand on the second factor you mentioned, the rate at which applicants are submitting applications. I'm not sure if I understand correctly how this is impacting growth. So could you just walk me through that?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [18]

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So we're getting a tremendous amount of activity top funnel, and we take people through the application and we have people that are pretty deep into the application. And for a variety of programmatic reasons, and there's a really long list, that has softened on us. So therefore, the actual percentage of people submitting their application to be reviewed is lower than it was in our prior forecast. Is that helpful?

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Hannah Rudoff, D.A. Davidson & Co., Research Division - Research Analyst [19]

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All right. Yes, that is helpful. And then I was wondering if you could provide information on international performance in the quarter. Anything you saw are noteworthy?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [20]

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On international performance?

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Hannah Rudoff, D.A. Davidson & Co., Research Division - Research Analyst [21]

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Yes.

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [22]

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Well, on the grad side, it's all very new. So we have -- UCL MBA is our -- is really our first in Europe. And then we have the Monterrey Tech MBA that, literally, I think we have like 2 days of marketing on it. We're excited about both, but they're just -- they're brand-new. As I mentioned earlier, the UCL MBA looks very positive, but it's too early for us to really give any significant color on it. We are gearing up in international opportunities, but just not a lot to put on the board yet.

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Operator [23]

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And our next question comes from the line of Corey Greendale with First Analysis.

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Corey Adam Greendale, First Analysis Securities Corporation, Research Division - MD [24]

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So a couple of questions on the trend in selectivity. So I know a lot of things can impact that, but are you pretty -- are you feeling good that sort of where it's at now is stable? Or do you see this as a trend? And are you assuming sort of increases in selectivity in the guidance, or what are you assuming?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [25]

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So we obviously -- given that we don't control it, I can't tell you that it's -- that I'm positive that somebody doesn't make a change to something. But we feel very good candidly about where we've reset this. We had to come up with a plan that sort of takes the air out of the balloon, takes a little froth out of the system, stands by our partners, and we feel like where we set it, Corey, is really solid.

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Corey Adam Greendale, First Analysis Securities Corporation, Research Division - MD [26]

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And if you look at the notional model of the business, all right, based on where we are today, are you still comfortable with a model that says that maturity programs are doing the 300 to 500 per year and the margin profile, you have to...

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [27]

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Yes. Sorry, go ahead, Corey, I didn't mean to cut you off.

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Corey Adam Greendale, First Analysis Securities Corporation, Research Division - MD [28]

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No. No, please.

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [29]

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Yes, we thought that was a really interesting part of the analysis of the whole thing. It's clear that like on some level, some of the programs that got really big, probably in our best interest overall to hit our 300 to 500 and not drive every program to its maximum size. And it's clear that the top ones have come down. Now at the same time, if you exclude the top 5, it's also clear that the next 10 are really going great. So you end up with this sort of clarity that the average, we like. We feel very good about the 250 still. We don't feel like we have any reason to not believe that that's well within our opportunity set. We feel strong about the ranges. But it's clear that the big ones did come down. So once again, felt like we should call it.

Consider that an IPO in 2014, 2 programs at 1 school were about 75% of our revenue. So I feel like the business interestingly has -- we've been able to sustain the business during a time period in which we had extreme customer concentration. And I actually do think that, overall, there's -- not to paint the silver lining of a guide down, we recognize that we are bringing down the estimates. But when you think about where we are, to be at $0.5 billion, to have this segment solidly at 25%, this kind of growth, with a lot less reliance on any single program and therefore the whims of any single program, I just think makes us a lot less risky candidly and makes it less risky for the leaders here that are managing it.

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Operator [30]

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And our next question comes from the line of Jeff Meuler with Baird.

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Jeffrey P. Meuler, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [31]

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I guess Chip, what gives you confidence that not only is the cost per lead at the top of the funnel not eroding, but I'm more focused on the quality of the students coming in to the top end of the funnel that they're as good of a quality of prospect as they've historically been.

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [32]

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So we hit those -- both those points pretty hard because we have really good data for both. And not only is prospect generation solid and high, it's at a cost that's totally within line and in a lot of places, lower. We didn't spend a ton of time getting into GPA on the call, but just as a data point in support of quality, it's pretty reasonable based on the data we have, and we have a lot of data, to say that the overall quality is probably up a bit oddly, which is one of the reasons why it's pretty hard to make this call. You could argue that -- and even further, the marginal students have historically performed very well in the programs. So this is not a story of students not performing and therefore maybe they shouldn't have been let in. So that, at times, makes it difficult. But I've been running this company for a long time, and I learned a long time ago, the more you're hitting on this particular metric with the school, it doesn't create the right dynamic between us and the university. It's not our call, it's theirs. And so it makes it hard at times.

I also will tell you, Jeff, it makes it very clear, anybody dealing in our segment of higher ed will, over time, have to deal with this. And it's also something that we do like about our professional certificates category, is those tend to have much better admit rates overall. So we are diversifying the business in a pretty substantial form, not even just with Trilogy and GetSmarter which obviously are very different, but the professional certificates, and you'll see more of those where we've had quite a bit of interest from our clients. Those open the funnel up a little bit on this metric. So we like that.

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Jeffrey P. Meuler, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [33]

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Okay. And then just given that, as you stated it's a long-cycle accumulation model from a revenue perspective, then it sounds like the new enrollment trends are softening, and then on top of that, I think you're going to be pulling back on marketing expense going forward based upon the margin expansion commentary. You previously gave some multiyear growth targets. I'm assuming those are off the table. But just curious if you can help us understand how much you're expecting them to reset lower.

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [34]

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Well, Jeff, we've kind of reset the number at 25%. And in part, we are dealing with the fact that, long ago, we gave long-term expectations on a segment basis because we were worried about a reaction to an acquisition. And the reality is, at this point, we do feel like we've reset them solidly. You can obviously see the cadence. And with that cadence, you can have your own estimates as to what you believe will happen. But at this point, giving outyear guidance on a segment basis, we believe, is not the right call. Now to be clear, we do feel like we did reset this in a way that we feel very solid about.

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Jeffrey P. Meuler, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [35]

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And the resetting to 25%, that's only applicable to 2019? We shouldn't be inferring that you're saying anything beyond 2019 with that recalibration, correct?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [36]

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Sorry, say that again?

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Jeffrey P. Meuler, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [37]

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Yes. The 2015 -- or the 25% growth rate recalibration, that's only a comment on 2019? It's not a recalibration of an ongoing growth rate, correct?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [38]

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Yes. That is only a comment for 2019. It is not a recalibration for the future. And to be clear, our launch cadence is a factor in what we will think will happen in the outyears.

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Operator [39]

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Our next question comes from the line of Brian Schwartz with Oppenheimer.

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Brian Jeffrey Schwartz, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [40]

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Kind of following up on the topic of the last question. Chip, you've always talked about the business end as being a 30%-plus grower here for the foreseeable future. Is that still your kind of vision and expectation?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [41]

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Yes. I mean we did give consolidated guidance of 30%. So we still feel like that's where we are. You obviously heard a lot of commentary, Brian, about consolidated because we are -- we think kind of, overnight, we became the market leader in Alternative Credential and we feel like people may just not understand what that is when we had them just labeled as short courses and do feel like we haven't really had much investor focus on that segment. And we think that segment is a pretty meaningful long-term growth lever and pretty critical to the future of higher ed, to the future of lifelong learning. We think it substantially improves our enterprise opportunities. And there's a very different selectivity and price point to it. So you look at all across the board, we feel like it diversifies 2U really nicely, and that's part of the reason that Cathy gave some color on what we think will happen for profitability in that segment.

It is a segment that should not be ignored. Now at the same time, grad segment growing at 25% this year, off of the base that it is, still higher growth than most people in our segment, most people in our space. So we do think it's right to sort of give this reset, but we feel very bullish about the long-term prospects for the company on both sides, grad and Alternative Credential.

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Brian Jeffrey Schwartz, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [42]

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And then, Chip, just kind of moving forward throughout the year, can you give us confidence on how you're going to manage? Clearly, you're having the reset that you're talking about today. So your back is going to be up the wall -- against the wall here for the next several quarters. At the same time, you are going to be closing and having to integrate Trilogy, which is, by far, here -- the largest acquisition in the company's history. Can you kind of talk through here how you'll be able to handle both of those things without getting distracted between one or the other?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [43]

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Oddly, Brian, I would actually say our backs are not up against the wall. It's kind of the opposite. It's part of the reason we're doing this, is for our team. This is not a story about growth over everything else. It's a story about setting a really reasonable agenda for the company, standing by our partners and still delivering pretty fantastic growth overall while we bring in what is a transformative company and team into our broader -- into the broader 2U. The opportunities across both the 2U clients and the Trilogy clients for cross-selling is nontrivial. We knew that this call, that the balance of this call would be talking about the grad business. We didn't want to spend too much time talking about the Trilogy acquisition because we didn't want to be accused of these aren't the droids you're looking for, move along. But the reality is, we are really excited about what that all means together. And as we close it, which is pretty imminent, we'll be able to give much more color about the plans, about how we integrate the company and more importantly, about the larger opportunity because when you start looking at next year and you get into what the consolidated growth looks like for next year, it's pretty damn impressive.

So we just didn't want to shy away from the grad business. But interestingly, Brian, I do think it's sort of -- it's the opposite. It doesn't put our backs up against the wall. It allows us to have reasonable growth that is totally achievable, that we know exactly how to go get while we integrate Trilogy.

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Brian Jeffrey Schwartz, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [44]

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And then, Cathy, if I could just ask you 2 quick questions here on the balance sheet. One was just a line item, just a clarification. I hadn't seen before, it was the right-of-use asset. I was just kind of curious what that was. And then the second question is I wonder if you can just help us at all with an approximation of what you think the cash and the debt balance will look like on the balance sheet after the Trilogy deal closes.

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Catherine A. Graham, 2U, Inc. - CFO [45]

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The right-of-use assets are around lease accounting, so we had to adopt the new lease standard in the first quarter. So that's what those are related to. Brian, can you give me your second question again?

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Brian Jeffrey Schwartz, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [46]

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Yes, it was just a little help as we forecast out our balance sheet, so if you had any idea what the approximation of the cash and the debt balance will look like on the balance sheet after the Trilogy deal closes.

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Catherine A. Graham, 2U, Inc. - CFO [47]

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We're not putting forward that kind of forecast at this point, but what I will tell you is that we do believe that we will be fully funded following the acquisition to get the company to cash flow self-sustaining.

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Operator [48]

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And our next question comes from the line of Peter Appert with Piper Jaffray.

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Peter Perry Appert, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [49]

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Cathy, I think you said, and please correct me if I've got this wrong, that to protect the margin in the context of slower enrollment growth, you -- one of the things you do would be to trim marketing spend. And so the question is it seems like that could be a little bit of a slippery slope in terms of the overall sustainable revenue growth rate. So can you expand maybe on your thinking around that?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [50]

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Yes. So Peter, I would say, this is Chip, that when you -- there are categories of students that when schools aren't going to accept them, you don't market them. Just think about it that cleanly. Like if it's clear that a school is not going to take somebody at a certain GPA level, then you just don't market to them. So that's how you save the money there.

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Peter Perry Appert, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [51]

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Got it. Okay. And then Chip, you said perhaps you had prioritized growth too much. And I'm wondering if a corollary to that is maybe underemphasis on profitability. Does it suggest any shift in terms of your focus here in terms of trying to drive the profitability metrics over the next couple of years?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [52]

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Yes, it does. So the reason that I gave the line that I'm personally committed to steering towards overall margins is we think, at this point, that is the right way to think about the business. Long term, we think that thinking about the way ¡Viva! runs their business over time, certainly not this year, but over time, is super interesting and useful.

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Operator [53]

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And our next question comes from the line of Brad Zelnick with Crédit Suisse.

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Brad Alan Zelnick, Crédit Suisse AG, Research Division - MD [54]

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Chip, Cathy, I really appreciate the transparency as to what's happening with the graduates out of the business. And I'm just trying to square up some of the comments that you've made. For example, with student or applicant quality actually getting better top of the funnel, I'm trying to then understand why the greater selectivity, not even just in certain universities, but across the board. And what's driving that? Is it simply a desire to protect their on-campus offerings and as well as there may be a broader shift in the leadership of some of these universities rethinking the online programs more holistically, or is it nothing of the sort?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [55]

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Yes. Unfortunately -- I mean, Brad, I appreciate the question. Overall, we have a lot of partners now. So for us to make this call, we've seen it across enough that that's notable in and of itself. We don't really believe it's related to their campus programs in general. Clearly, as schools have gotten larger, it does become easier when you have a long list of applicants coming in for selectivity to sort of gradually increase. That's something we're definitely seeing. And when we were debating how to handle this, one of the tricky things about our model being very predictable is it's entirely possible that admit rate goes the other way and gets better on us, and then we end up in a situation where we go through this reset and -- but we felt like we had enough data that it was important just to get ahead of it and call it, particularly in terms of how it will impact this year.

You should know, historically, this is definitely the hardest number to predict. It always has been. Going back to our venture-backed days, I had many a Board meeting where this was a pretty big discussion because we had one or 3 or 4 partners, and any change to a particular cohort was devastating at the time. It's not anymore. And we have to sort of stand by them.

Now one of the questions around the table here at 2U for some time is -- has the overall sort of tenor of what's happening in higher ed right now with regard to the scandals, has that impacted things? It's entirely possible. We don't have quantitative data to tell you that, but certainly, a lot of qualitative. So entirely possible. There had been some leadership changes. Once again, leadership change, to be candid, is something that has happened over our history, and it has worked for us more often than worked against us. We happen to be in a little bit of a period here where we've had some that's really worked against us. And to my partners out there that are listening, we are definitively standing by the schools. That's really what this is about. So we kind of just have to deal with it, roll it forward and drive the best possible growth we can. And as I mentioned, I do feel like we've hit -- we've leveled it at a place that we feel very comfortable.

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Brad Alan Zelnick, Crédit Suisse AG, Research Division - MD [56]

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I appreciate the color, Chip. And maybe just as a quick follow-up and as we try to wrap our heads around what you're seeing out there, can you give us a sense how many programs are actually being more selective? Is it the majority? Is it 90%? Any way to contextualize this?

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [57]

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I would say I really think it's -- probably, I've learned the hard way over the years that getting into details about my clients' businesses, I think, is a little tricky. I will tell you that this is not an isolated couple of programs that we're talking about. So it was broad enough that we did this, so that might be, in and of itself, somewhat self-explanatory.

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Operator [58]

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And our next question comes from the line of Jeff Silber with BMO Capital Markets.

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Sou Chien, BMO Capital Markets Equity Research - Senior Associate [59]

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It's Henry Chien calling for Jeff. Just a quick one. Just a quick follow-up on a lot of this questioning around the slowing growth. Just for 2020 and not looking for guidance or anything, does that -- the step down in -- for '19, is -- does that get worse in 2020, or is it stable? Or just how you're thinking about, I guess, 2020 or whether it's just a temporary blip or not.

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [60]

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Yes. Just to reiterate, we feel like we've set it in a place that we're very comfortable. And I think you do have to factor in the cadence increase in terms of what that will do longer term. So at this point, we're not going to give you estimates for 2020. But we're trying to give you enough color to understand where -- how we feel today, that we're -- that we've set it in a place that we feel like we can build up from here.

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Operator [61]

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Ladies and gentlemen, this concludes today's Q&A session. I would now like to turn the call back over to Chip Paucek, CEO and Co-Founder, for any closing remarks.

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Christopher J. Paucek, 2U, Inc. - Co-Founder, CEO & Director [62]

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We'll see everyone out on the road. We wanted to offer a quick congratulations to our VP of Investor Relations, Ken Goff, who has been accepted into the USC Integrated Master of Design. Congratulations, Ken. All right. We'll talk to everybody out on the road.

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Operator [63]

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Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program, and you may all disconnect. Everyone, have a wonderful day.