Earnings Call Transcript - LRN Q3 2023

Operator, Operator

Good afternoon. My name is Emma, and I will be your conference operator today. I would like to welcome everyone to the Stride Inc Third Quarter 2023 Earnings Conference Call. All lines have been muted to prevent background noise. Tim Casey, VP of Investor Relations, you may begin your conference.

Tim Casey, VP of Investor Relations

Thank you, and good afternoon. Welcome to Stride's third quarter earnings call for fiscal year 2023. With me on today's call are James Rhyu, Chief Executive Officer; and Donna Blackman, Chief Financial Officer. As a reminder, today's conference call and webcast are accompanied by a presentation that can be found on the Stride Investor Relations website. Please be advised that today's discussion of our financial results may include certain non-GAAP financial measures. A reconciliation of these measures is provided in the earnings release issued this afternoon and can also be found on our Investor Relations website. In addition to historical information, this call may also involve forward-looking statements. The company's actual results could differ materially from any forward-looking statements due to several important factors as described in the company's latest SEC filings. These statements are made on the basis of our views and assumptions regarding future events and business performance at the time we make them, and the company assumes no obligation to update any forward-looking statements made during this call. Following our prepared remarks, we will answer any questions you may have. I will now turn the call over to James. James?

James Rhyu, CEO

Thank you, and good afternoon. The underlying systems and institutions in the U.S. and across the world can be fragile. We have seen this repeatedly over many decades. Headlines in the banking and technology sector are just recent examples. But each time we see these cracks in the economy, the U.S. has been resilient. And more often than not, we search forward through innovation. These cycles have enabled the U.S. to progress in amazing ways. The ways in which we travel, bank, shop, and even eat have changed dramatically. It wasn't that long ago that we did most of our banking, shopping, and transacting in person. However, it has not permeated all sectors equally. One of the sectors that has not evolved as dramatically is the education sector, and most notably the K-12 education sector. With our recent experience going through a pandemic, I would have hoped we would have emerged with more fundamental change in the system, particularly given the customer feedback we have heard. But I see kids in school largely the same way as they have for decades. Sure, there are some minor tweaks that technology has enabled but no real substantive change. That both disheartens me but also gives me hope that Stride can begin to move the needle on the system that will power the future of this nation. From how we think about the trade-offs of skills versus knowledge, trade versus professions, college versus jobs, practical versus theoretical, should kids still be on a traditional belt schedule, or should they have flexibility? Should all students really be spending the exact same amount of time on each lesson? Should we enable our students to use their time efficiently in a manner that meets them at their point of need? And should we empower parents to have a say in how their children's time is being spent? At Stride, we are investing behind these themes. Our core full-time virtual business, both the career and general education aspects, is at the forefront of that investment to enable parents and families to really see how the next generation of schooling can break away from the traditional paradigm of the education system. And I'd love to invite the leaders of the traditional establishment to participate with us for the sake of our children, but I also fear the politics and fights for power often get in the way. I think the macro data and the trends in our business continue to support my thesis. While we began this year down 8% in enrollments, we saw in-year demand continue to outpace the prior year. We were down 4% at the end of the second quarter and were down just over 1% at the end of the third quarter. The strength of our third quarter was even more impressive in that we booked a trend. Last year, we lost about 5,000 students from the beginning to the end of the quarter, which is consistent with what we've typically seen. And this year, we're basically flat from the beginning to the end of the quarter as we continue to see strong demand for our products and services. We're always asked at this time of the year how things are shaping up for next year. And we always say it's far too early to tell. What I can say is that through today, the positive demand trends have continued in terms of application volumes. As I previously stated, these metrics are the best indicator of demand. So I'm optimistic that we will return to enrollment growth for this fall. And if you followed us since I took over as CEO just over 2 years ago, you'll know that I've pushed us to continue to innovate. I believe that schools and districts in the U.S. are too complacent. So I believe it's going to be up to companies like Stride to drive innovation that is focused on the customers, the students. For example, I've spoken previously about our career platform. Students and parents continue to want more exposure to career skills and opportunities, and yet traditional schools still fall short in delivering these options. For example, in a recent survey, the top priority for respondents was for students to develop practical life skills, and yet only 26% rated their local schools as satisfactory in providing these skills. Similarly, only 30% said their local schools have satisfactorily prepared students for careers. In a separate survey of Gen Z students, 44% said that school only taught them very basic computing skills, while 37% said that school education did not prepare them with the technology skills they needed for their planned careers. And at the same time, the number of organizations with a skills gap has increased from 55% in 2021 to almost 70% in 2022. The users of our Tallo Career platform, including the 1.7 million current users, have access to exclusive employment educational options. And employers, workforce organizations, and colleges and universities will be able to engage with a unique pool of talent seekers. The platform includes educational content, badges, credentials, and certifications in the top current interest areas, including health care, STEM, business, and education and training. As I've mentioned before, Tallo is available to anyone over 13 at no cost. Students in high school and college can join to showcase their skills and talents and connect with employment opportunities. They can take courses and prepare for in-demand certifications while developing durable skills to help them in any industry. On top of the opportunity to get connected to companies looking for their chosen skills, users can match with over $20 billion in scholarships. On the other side of that platform, companies and postsecondary organizations can use the platform to recruit specific talent based on interest, credentials, community involvement, and test scores. We can also track talent over time to provide predictive information on employee retention. I also want to talk about another product that I think can revolutionize the way parents, students, and teachers collaborate on education. We call this product our Learning Hub. For too long, the student's education has separated interactions between parents and teachers. Students feel like they need more help at home, and parents want to help but may not know how. Meanwhile, teachers want parental support and find it challenging to manage so many relationships. Our Learning Hub solves this by being a single platform for personalized content to enhance learning. The platform offers a comprehensive library of curated lessons and resources aligned with state standards. It uses best practices to suggest content for each individual student based on their past use and success. Since students, parents, and teachers all have access to the platform, support is seamless and comprehensive. We just launched Learning Hub last month, but we've already received positive feedback from teachers and administrators. The great thing about both these products is that we have a built-in user base that we can reach out to learn from and use to evolve the product. These products have the ability to address significant market opportunities outside of our core full-time offering. They allow Stride to diversify our revenue streams and reach more users, leveraging the expertise we've developed over the past 20-plus years. Now before I wrap up, I'm excited to announce that we're planning an Analyst Day sometime later this calendar year, likely in the late fall. By fall, it will have been 3 years since we provided our fiscal '25 targets, and while we remain committed to those targets, both Donna and I look forward to offering a deeper dive into our financial goals and strategic priorities looking out further, including some of the exciting things we've been working on. While we are exceeding expectations for this fiscal year, I'm even more bullish on our ability to help transform our educational system in the years to come. Now I'll pass the call over to Donna to give some commentary on our third quarter results and discuss our updated guidance. Donna?

Donna Blackman, CFO

Thank you, James, and good afternoon, everyone. First, let me quickly recap our quarterly results. Revenue was $470.3 million, an increase of 11.5% from the same period last year. Adjusted operating income was $80.2 million, up $10.8 million or 15.6% from last year's third quarter. Capital expenditures were $15.2 million, a decrease of $3.2 million. We remain very pleased with how the year is coming together. Our results this quarter for both revenue and adjusted operating income exceeded the high end of our guidance. We continue to see strong retention and new enrollments in the third quarter. We finished the quarter with total average enrollment of 181,800, up nearly 8,000 enrollments from the first quarter. This reinforces what we've said before about the continued demand for virtual options and serves our belief that we remain on a path to achieve our fiscal year 2025 revenue and AOI targets. Now for some more detail on our third quarter results. Career learning revenue was $180.7 million, up 71% from the third quarter of fiscal 2022. Continued growth in the adult learning business and strength in our middle and high school programs both contributed to the increase. Middle and high school career learning revenue was $150.8 million, up 81% from the third quarter of fiscal year '22. This was driven by a 60% increase in enrollment and a 13% increase in revenue per enrollment. As we've mentioned previously in the first half of the year, the revenue per enrollment improvement was somewhat timing-driven, and we now have a harder comparison in the back half of the year. That said, we now think we'll see overall revenue per enrollment growth in the mid-teens for the full year. Adult learning revenue in the quarter was $29.9 million, up over 32% from the third quarter of fiscal '22. We continue to see growth across all our adult learning brands and remain excited about the future growth prospects. We still expect to finish the year up around 30% from last year. Quarterly revenue from our General Education business was $289.6 million, down 8% from the third quarter last fiscal year. Despite the decrease, we are very encouraged by the in-year enrollment growth in this business. General Education enrollments in the third quarter were 114,600, up more than 2,000 enrollments since the first quarter. This strength in in-year enrollment demonstrates sustained demand for virtual options in the K-12 space. Revenue per enrollment for General Education increased 16% from the third quarter last year. We believe this business will finish the year with revenue per enrollment growth in the low teens. Gross margin for the third quarter was 37.3%, up 60 basis points from last year. We feel confident we can finish the full year with gross margins that are roughly flat to last year. Selling, general, and administrative expenses were $103.1 million, up $8.9 million from last year. The increase is mostly due to continued adult learning growth and investments in our new products, as James previously mentioned. Stock-based compensation was $4.7 million for the quarter. Adjusted operating income for the quarter was $80.2 million, and adjusted EBITDA was $103.9 million. Interest expense for the quarter came in at $2.2 million. The effective tax rate for the quarter was 26%, and diluted earnings per share totaled $1.30. Moving to our balance sheet and cash flow items. Capital expenditures totaled $15.2 million, down $3.2 million from last year. Free cash flow for the quarter was $69.8 million, down $4.8 million from last year. As of many years, we may see some timing impacts in the fourth quarter based on when states pay. So we don't expect free cash flow to be as strong as it was last year. We finished the quarter with cash and cash equivalents of $373.7 million. Turning to our guidance. For the full year, we are raising our revenue guidance, raising the bottom end of our adjusted operating guidance, and updating our CapEx and tax rate guidance. We now expect revenue in the range of $1.805 billion to $1.825 billion, up from $1.775 billion to $1.815 billion previously. Adjusted operating income between $193 million and $200 million, up from $188 million to $200 million previously. Capital expenditures between $65 million and $70 million and an effective tax rate between 26% and 28%. Thank you for your time today. Now I'll turn the call back over to the operator for Q&A.

Operator, Operator

Your first question today comes from the line of Jeff Silber with BMO Capital Markets.

Ryan Griffin, Analyst

This is Ryan Griffin on for Jeff. I was just curious if you can give any color on some of the early indicators and how it relates to General Education or Career Learning? And then if those are coming through the same funnel, do you have any updates on segregating those funnels at any point in the future?

James Rhyu, CEO

Yes. So right now, they're still primarily coming from the same funnel. I think we do have some initiatives that we're planning for this fall season that will hopefully open up some incremental core at specific funnels. But for right now, we're seeing the demand that's really from the same funnel. And I think that sort of the comments we've already made about the fall probably won't give that much more context around them. I think we've given a lot, probably more than we normally would give at this time just because we're so early in the season. Remember, anything that we're talking about now, we're talking about something like less than 10% of overall total enrollment volumes for the season. So while very encouraging, I think early on, it's still very early.

Ryan Griffin, Analyst

And then just one follow-up on the margins. I think in the past, you've spoken about some of the efficiency initiatives and about how you're also lapping some of the cost inflation you've seen this year? Just wondering if you can give any color on what we might expect from the cost to the P&L and what that implies for margins next year?

Donna Blackman, CFO

So one of the things we talked about this year is looking at some of those efficiency efforts to offset those inflationary pressures. So we're looking at automation and our size and scale as some examples of those efforts. We're always looking at how to continue to deliver student outcomes in the most efficient way possible. We will continue to look for ways to do that. So while many of those efficiency efforts mitigated the impact of inflation, it's not like next year, we sort of pulled back to the way we're doing things. We're always looking at how we continue to improve. With that, we think for this year relative to last year, our margins will be relatively flat.

James Rhyu, CEO

I also would point out that just sort of a data point that suggests that we're doing is actually paying dividends. We started the year with gross margins below the prior year. We said that we were going to really tighten our belts and look for efficiencies. We did it. In the second and third quarter, we've both seen gross margins above the prior year. I think Donna has mentioned this before, but most of those are structural in nature, meaning they should have legs into subsequent years. I don't think they're just quick one-off things that we won't see any benefit into next year.

Operator, Operator

Your next question comes from the line of Greg Parish with Morgan Stanley.

Greg Parrish, Analyst

Congrats on a strong quarter. I want to talk about the makeup of the students joining midyear here. I ask the enrollments have grown 8,000 since the first quarter, factoring in attrition and even larger numbers. So what's really driving these students out of brick-and-mortar in the middle of the school year here?

James Rhyu, CEO

There are a ton of different reasons why kids are leaving. What we're hearing from families, particularly post-pandemic, is that school districts, in spite of their experiences during the pandemic, are still struggling to treat their families like customers, to listen to the feedback that they received from them during the pandemic, etc. Families were expecting districts to hear them a bit more clearly post-pandemic, and when they revert back to pretty much status quo, or i.e. pre-pandemic type of everything, a lot of the feedback we receive is that it's disappointing for many families. Obviously, not all families feel this way, but there are increasing numbers of families who want something different. I think the pandemic ignited an enthusiasm for parents to explore different options. The in-year demand we keep seeing reflects the tension between parents' expectations and what they see in their districts compared to what we offer. We talk about our NPS scores, which are pretty robust. Parents find that we offer them something more flexible that meets their needs more effectively. That seems to be the general theme.

Greg Parrish, Analyst

And then thinking about next year, and clearly, this year was unprecedented with the way enrollments have come in coming out of the pandemic. But how do you capture these students in the summer that maybe are on the fence and last year defaulted back to brick-and-mortar schools, but clearly, the demand is still there? How do you go about capturing them before the school year starts?

James Rhyu, CEO

Right now, we're reaching out to families about next fall and specifically discussing things that we've heard from them. They've expressed wanting more socialization options, so we're talking to them about programs we're going to introduce for the fall regarding socialization. We're exploring new ways for students to communicate with each other. We're trying to listen to our customers, build improvements to our programs, and then proactively reach out to say, 'Hey, listen, we've heard you and are making these improvements.' We've already started doing this for the fall and will continue throughout the summer. We've seen improvements in retention rates as a result of this strategy. I believe this will continue to promote stronger retention for us.

Greg Parrish, Analyst

I just want to ask about the broader funding environment. Thank you, Donna, for the color on revenue per enrollment to finish this year. But I just want to think about high level how to think about funding for next year?

James Rhyu, CEO

From a high level, I would refer to the generic heat map we have around the U.S. for funding. Our generic heat map for funding continues to be largely green. There are one or two yellow-red spots, but by and large, it continues to be green. This is consistent with what we've said long-term; we believe the funding environment continues to be strong, certainly within the range of a 1% to 2% average funding increase across the board.

Operator, Operator

Your next question comes from the line of Alex Paris with Barrington Research. Your line is now open.

Alex Paris, Analyst

Congrats on the quarter. James, based on the momentum of the year-to-date period, I think you said in your prepared comments that you're cautiously optimistic that enrollment can increase next year. Is that correct? And then I think I heard you just say revenue per enrollment should be positive along the long-term trends of 1% to 2%. Similarly, I heard Donna say gross margins are flat next year. Would gross margins expand, given those metrics of rising enrollment and positive funding?

Donna Blackman, CFO

Let me jump in real quick. I want to clarify something. Whenever I mentioned gross margin, it's flat gross margins this year compared to last year. I wanted to add that point of clarity.

James Rhyu, CEO

Yes. Listen, my intent is to grow every year. We've grown revenue in each of the past 2 years, and I believe our intent is to grow enrollment for next year. The early indicators look good for us. Last year, we did deal with some execution issues, which we're improving on. I have optimism based on the facts and circumstances I understand and can see today that we have the ability to grow enrollments in the fall. As I said, we're still less than 10% into the season, so a lot can change. But based on what I can see and what our plans are, our intent is to grow enrollment. The funding environment—revenue per enrollment is somewhat of a proxy, but remember, mix and all these other factors come into play. I'm referring to the funding environment that is generally strong across the landscape of programs that we serve. We would expect that funding to be 1% to 2% higher long-term.

Alex Paris, Analyst

So with positive new enrollment, positive funding, leveraging fixed costs, is there room for gross margins to experience expansion in fiscal '24?

James Rhyu, CEO

Without getting into specific gross margin targets because a lot of that plays into our mix, it's hard to say. I do think, though, that it comes into play regarding adjusted operating income leverage. If we can grow enrollments and maintain a strong funding environment, I believe it translates into better leverage for our profitability.

Donna Blackman, CFO

And also from an efficiency standpoint, as James noted, those efficiencies are structural, meaning we'll continue that into next year.

Alex Paris, Analyst

Great. And then a big-picture question about marketing. Marketing must have changed over the last three years pre-COVID versus post-COVID. Pre-COVID, it was a missionary sale to some extent. How has it changed? And what's your go-to market now? Has it changed notably?

James Rhyu, CEO

Yes. It's a great question. The short answer is yes, it has changed. Both in messaging and tactics, I think there was significant missionary messaging that described a lot of how we went to market. A lot of that can still apply. But I think we’ve honed our tactics. There are several broad themes that resonate, within which are many specific tactics and messages. For example, safety resonates with families, whether it's about bullying or gun violence. While we used to go for more sentimental messaging, we've focused on specific messaging today, utilizing social media and digital marketing instead of broader media channels. We're finding these tactics to be effective for us.

Operator, Operator

Your next question comes from the line of Tom Singlehurst with Citi. Your line is now open.

Tom Singlehurst, Analyst

It's Tom here from Citi. Congratulations on the results. I had a couple of questions on the school side and one on adult learning if that's okay. You talked about the funding environment sort of being largely green. I'm just interested in the broader political risk. I know it's difficult across the entire footprint, but could you give us a quick run through of how you see the landscape in terms of risk around changes in the policy environment?

James Rhyu, CEO

Yes. In general terms, I would say that the broader political environment for us has actually improved from prepandemic to post-pandemic. It continues to sustain that improvement. Across the education landscape, we see policies that directly and indirectly look to be in our favor. One prominent example is laws around voucher-type programs, which seem to gain more traction, benefiting our programs. There are several states enacting laws in that favor, with more potentially coming in the future. As a generalized statement, we feel our risk profile has improved over the past several years.

Tom Singlehurst, Analyst

The second question is on the competitive landscape. Pearson has announced that they will follow a similar strategy to explore launching career-focused schools. Does this impact the competitive tension within the market?

James Rhyu, CEO

What I would say is I'm hopeful that Pearson is successful as it would grow the pie. We're more focused on having a larger pie instead of splitting a smaller one. I believe we need more career programs in this country, as research and surveys indicate. Competition is beneficial for our industry. It raises awareness and validity for our programs. I'm encouraged by the competition and hope Pearson succeeds as it benefits all of us.

Tom Singlehurst, Analyst

One final question regarding adult learning. Tech Elevator and MedCerts seem to be doing well. Are we overdue for allocating more capital to that area? Can you talk about your philosophy on that?

James Rhyu, CEO

I wouldn't say we're overdue. We are continuously looking for ways to allocate capital to all parts of our business with opportunities including internal investments and strategic M&A investments. We have a robust pipeline of companies that we monitor, and for the right deal at the right price, we would consider capital deployment for acquisition. We also consider internal investments to expand product lines and services for both adult and K-12 learning. There's a lot of opportunity to invest, and we aim to be disciplined, avoiding overpaying.

Operator, Operator

Your next question comes from the line of Stephen Sheldon with William Blair. Your line is now open.

Pat McIlwee, Analyst

This is Pat McIlwee on behalf of Stephen. Last quarter, you mentioned being comfortable with your teacher capacity. Recently, James, you mentioned being somewhat oversubscribed in terms of teacher capacity. Can you talk about the trends you're seeing regarding teacher salaries and staffing? Has some of the wage inflation subsided?

James Rhyu, CEO

I want to give a shout out to our teachers; we have the best workforce in the country. I get notes from teachers thanking me for allowing them to serve kids in a way that we enable them to. Because of that unique model and the flexibility we provide, we don't have a teacher shortage. A lot of districts are struggling with one, and we have helped several districts manage their teacher shortages. Fortunately, we do not face this situation. Currently, we have more applications than we need to run our programs. So while we were caught flat-footed during the first explosive growth of the pandemic, we've since normalized operations. We continue to hire and recruit teachers effectively. We're grateful to the fantastic teachers that help our students.

Pat McIlwee, Analyst

Switching gears. Last quarter, you mentioned some pilots for new products like the career platform and teacher development solutions. You talked today about launching the Learning Hub. Can you discuss how these pilots have been going?

James Rhyu, CEO

We've run a series of pilots. Our career platform pilot went well this past year, and we've learned a lot. We expect real traction this summer with the next iteration. The need for an end-to-end product in this space continues to be large. Feedback from pilots has reinforced our belief. We also received excellent feedback for Learning Hub, which fills a significant gap in the marketplace. We've run other smaller pilots around products meaningful for our core services. Recently, we launched a pilot—a virtual space allowing students to mingle and interact. That has also received tremendous feedback. Overall, the pilots we've run have been validating and positive.

Operator, Operator

This concludes today's Q&A session as well as today's conference. Thank you so much for attending. You may now disconnect.