Grand Canyon Education, Inc.
Q2 2018 Earnings Call Transcript

Published: 9 Aug 2018

[Operator:]

Good day, ladies and gentlemen, and welcome to the Second Quarter 2018 Grand Canyon Education Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct the question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, this conference call may be being recorded. I would now like to turn the conference over to Dan Bachus, Chief Financial Officer.

[Dan Bachus:]

Thank you. Joining me on today's call is our Chairman and CEO, Brian Mueller. Please note that many of our comments today will contain forward-looking statements that involve risks and uncertainties. Various factors could cause our actual results to be materially different from any future results expressed or implied by such statements. These factors are discussed in our SEC filings, including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K. We undertake no obligation to provide updates with regard to the forward-looking statements made during this call, and we recommend that all investors review these reports thoroughly before taking a position in GCE. And with that, I'll turn the call over to Brian.

[Brian Mueller:]

Good afternoon and welcome to Grand Canyon Education's Second Quarter of fiscal year of 2018 Conference Call. On July 1, 2018, GCE consummated an asset purchase agreement with Giselle University. Prior to the transaction, GCE owned and operated Grand Canyon University. Upon the closing of the transaction, Giselle University changed its name to Grand Canyon University or New GCU. As a result of the transaction, GCE transferred to a New GCU, the real property and improvements comprising the GCU campus as well as tangible and intangible academic and related operations and assets related to GCU. And New GCU assumed liabilities related to the transferred assets. Accordingly, GCU is now owned and operated by New GCU. In connection with the closing, GCE and New GCU entered into a long-term master services agreement. Pursuant to, which, GCE will provide identified technological counseling, marketing, financial aid processing and other support services to New GCU, in return for 60% of New GCU's tuition and other revenue. Accordingly, the results of operations discussed on this call reflect GCE's operations prior to July 1, 2018, which was made up exclusively of the operations of GCU. The results of operations in future periods will reflect the operations of GCE as a service technology provider, and it will be sum update just the progress being made by GCU and it's growing role in higher eduction. As a result of this transaction, various aspects of GCE's operations have changed in important ways. These changes include, but are not limited to the following

[Dan Bachus:]

Thanks, Brian. Revenue exceeded our expectations in the second quarter of 2018, primarily due to higher enrollments and higher ancillary revenues. Revenue per student decreased in the second quarter of 2018 compared to the prior year due to a shift in the timing of start dates for its ground traditional students, resulting in one-month revenue producing day in 2018. In addition, revenue per student for online students declined slightly between years due to a higher percentage of doctoral learners moving into the dissertation phase which generates a significantly lower per student revenue and due to the timing of graduations. Scholarship as a percentage of revenue for all students increased from 14.5% in Q2 2017 to 14.7% in Q2 2018 due primarily to an increase in online scholarships as a percentage of revenue, partially offset by a decrease in ground scholarships as a percentage of revenue year-over-year. Bad debt expense as a percentage of revenue stayed flat year-over-year at 1.6%. Our effective tax rate for the second quarter of 2018 was 23.3% compared to 28.0% in the second quarter of 2017. The lower effective tax rate year-over-year is a result of the Tax Cuts and Jobs Act, which was signed into law on December 22, 2017. The act reduces the corporate federal tax rate from a maximum of 35% to a flat 21% rate effective January 1, 2018. In addition, excess tax benefits of $1.2 million and $5.2 million from share-based compensation awards that vested or settled in the second quarter of 2018 and 2017 respectively was recognized. We repurchased 10,000 shares of our common stock in the second quarter 2018 at a cost of approximately $1 million. We had $96.2 million available under our share repurchase authorization as of June 30, 2018. Turning to the balance sheet and cash flows, total unrestricted cash and short-term investments at June 30, 2018, was $298.2 million. CapEx in the second quarter of 2018, excluding our offsite development of $0.2 million, was approximately $43.7 million or 18.4% of net revenue. Going forward, GCEs annual CapEx should range between $10 million and $15 million and be primarily software development and systems related. We anticipate funding $65 million of CapEx on behalf of New GCU through the secured note in the second half of 2018 and another $100 million in 2019. This funding is to finish the 2018/2019 school year projects which include two apartments to our residence halls, a classroom building for our Jerry Colangelo College of Business and a parking garage and three apartment style resident falls and a parking garage for the 2019/2020 school year. We elected not to renew our revolving line of credit of $150 million, which expired on December 31, 2017 which resulted in lower quarterly interest expense in Q2 2018 as compared to prior year. Additionally, we increased our capital spending in the current year which resulted in higher capitalized interest as compared to the prior year. I would like to spend a few minutes talking about the impact of the transaction on our financial statement, some of which you can see in the June 30 financial statement and some will that will not occur until the period ended September 30, 2018. On the June 30, 2018 financial statements, you will notice that we have reclassified certain assets and liabilities as held for sale as of June 30, 2018. These are the assets and liabilities that were transferred to New GCU on July 1. The assets include all cash that have been considered restricted, all student accounts receivable, prepaid expenses and other assets related to future operations of New GCU and $869.1 million of fixed assets including the universities campus and furniture and equipment for New GCUs employed. The liabilities include deferred revenue and student deposit as well as certain accrued and other liabilities. In addition, GCE transferred $43.5 million of unrestricted cash of which $33.9 million was part of the closing to offset the net liabilities assumed and $9.6 million was to fund future employee compensation for New GCU employees. As a result of the transaction, GCU received the secured note for the transferred assets for $869.19. We are not expecting to have a book gain or loss as a result of the transaction. However, we are expecting to incur expenses in the third quarter of 2018 related to the transaction incurred on July 1, 2018 of approximately $23.7 million. Included in this amount is $17.4 million of share-based compensation expense resulting for the modification of previously issued restricted stock grants for New GCU employees the transferred employment for GCE and $3.0 million asset impairment? The guidance I will provide in a few minutes excludes those one-time transaction cost. Last, I would like to provide color on the updated guidance we've provided for the rest of 2018. The revenue guidance for the third and fourth quarters of 2018 have been adjusted to reflect the 60% revenue share with New GCU with an increase due to the slightly higher than expected enrollment. We are still analyzing the accounting classification of the fees received under the Master services agreement, but believe the entire amount will remain within operating income. We have provided projected revenues, operating margins, earning per share and diluted weighted average shares outstanding guidance for third and fourth quarters of 2018. As you will notice, earning per share for the second half of 2018 is approximately 2.9% less than previous guidance due primarily to the expected dilution of the transaction, partially offset by a lower effective tax rate, although the impact of that dilution is primarily in the fourth quarter. GCE will still be seasonal, due to significantly lower revenue in the second and third quarters as a result of the summer break for GCU traditional students. However, the seasonal effect will not be as great as previously. We estimate that GCE depreciation expense and share-based compensation expense will be approximately $16 million and $10 million repetitively on an annual basis going forward, rising only slightly year-to- year. We estimate interest income and interest expense will be $13.8 million and $700,000 respectively in the third quarter, and $14.3 million and $700,000 in the fourth quarter respectively. Interest income is primarily related to the seller financing and interest expense is up year-over-year as GCE will no longer be able to capitalize interest on the GCU campus construction. Our effective tax rate will be 20.8% in Q3 and 23.1% in Q4. The effective tax rate for these quarters have been lowered from the 24.6% in Q3 and 25.3% in Q4 due to a lower expected effective tax rate as a result of the transaction, and due to a $3.7 million contribution in lieu of state income taxes in July, which has the effect of increasing general administration expenses and to increasing income tax expense. The entire amount will be reflected as expense in the third quarter of 2018, and three quarters of that amount is reflected as a reduction in income tax expense in Q3 and a quarter of the benefit is reflected in Q4. Excluding the contribution made in lieu of state income taxes, we estimate the effective tax rate will be 23.9% and 24.3% in those quarters. Although we may repurchase additional shares during 2018, these estimates do not assume repurchases. The operating margin guidance excluding the contributions in lieu of state income taxes for the third and fourth quarters of 2008 are 33.2% and 43.0% respectively. On a pro forma basis, we estimate the operating margins for the third and fourth quarters are lower than the same period in 2017. As we have discussed previously, this decline in margins year-over-year in the second half of 2018 is primarily due to the reinvestment of a portion of the tax savings from the lower corporate federal rate into employees through bonuses, a higher 401(k) matching contribution and a higher medical benefits contribution. We plan to provide some level of pro forma information as part of the third quarter results. Our long-term objective of margin expansion of 20 basis points to 40 basis points on an annual basis has not changed. I will now turn the call back over to Brian to share a few final thoughts.

[Brian Mueller:]

As a President of GCU, I would like to say a few words on behalf of the University. Grand Canyon University is now within weeks of starting its 10 academic year since I arrived in 2008. As explained earlier, the University has now come full circle and returning to its non-profit roots. The University will begin this academic year with approximately 25,500 students on the campus and 78,000 online. The students attending GCU in 2018 don't look anything like the students that were attending in 2008. On GCU's traditional campus, the students in 2008 came with an average incoming GPA of 2.7. In 2018, the average incoming GPA of GCU’s new class of approximately 7,100 new students will be 3.5. GCE use Honors College on campus is growing to over 2,000 students with an average incoming GPA of 4.1. GCU's working adult student population studying online, if you include RN to BSN students is now 60% graduate students. The dramatic improvement of the quality of GCU student body has led to some very important improvements in critical measurements. The graduation rates of the students who started at the University in 2014 is 58% for the traditional students on this campus and 65% for working adult students studying online. 43% of GCU’s traditional students who graduate doing so in three years and 63% graduate in 3.5 years. This save those families thousands of dollars. GCU’s three year cohort default rate is now 6.2%, according to The Institute for College Access & Success. GCU students graduate with average debt levels less than state University students and far less than other private university students. A remarkable fact, given that GCE received no state subsidies. GCU is now posting it's graduation rates by college on its website. This has become important because the college scorecard publishes the graduation rates of Universities based on a cohort of students from 2018. Unfortunately, the incredible transformation of GCU makes those numbers from 2008 to 2012 totally meaningless based up who GCU is today. I will now turn the call over to the moderators. So that we may answer questions.

[Operator:]

Thank you. [Operator Instructions] Our first question comes from the line Jeff Silber of BMO. Your line is now open.

[Jeffrey Silber:]

Thank you so much and thank you for providing so much detail about what the two different companies I guess look like going forward? I am curious if I am student arriving on campus over the next few weeks and I was there last year, am I going to see any changes or is it just business as usual.

[Brian Mueller:]

The changes you will see are two new apartments to our residence halls, so brand new Colangelo College of Business of 170,000 square feet. You'll see a new parking garage and most importantly and a new Chick-fil-A location as a well as a new Taco Bell location. But as regards the transaction you know the students didn't really talk much about us as a four profit institution it made very little difference to them all they knew was that they were at a University with brand new facilities, classrooms, laboratories residence halls they were in classes with motivated faculty members and low class size and they were paying tuition levels that if they work during the school year might allow them to graduate without absolutely any debt. And so those things where the things that were important to them, our tax status meant little to them.

[Jeffrey Silber:]

Okay. That’s very helpful. I know your focus on Grand Canyon Universities which is like you should be focused on, but I was get questions about who's next or what's next. Can you tell us what kind of preparation you made in go to market to try to attract other partners?

[Brian Mueller:]

We have a strategic alliance, educational strategic alliance department and we have two people within that department who will be making calls on universities now as we move forward? We have done a lot of work internally? To evaluate the full breadth of services that we could offer. And then compared those to what we see being offered through other service companies. And so we are making preparations to go forward and to do something in the next six months. If I had to comment on specifically what I see currently it's a lot of companies don't want to touch the important processes that allow you to scale like the admissions work at transcript evaluation schedule building. Processing financial aid especially in a borrower based environment. Those are things that we built automated for and we probably wouldn't want to partner and less we were able to handle those things. Financial aid being an important consideration most often the private university or it will have a small financial aid department to take in financial aid files over the course of the entire year for the incoming class in September. And to you spread that work out over 12 months we have the capability of literally processing thousands of financial aid files and building schedules on a monthly basis. And so that's one of the things that we have spent time. Thinking about and that will be part of our think as we go forward which is look partners. They want to scale programs. And we have the ability from administrative processes perspective to do that work for them, but the relationship will be just like this with GCU. The institution determines what its admissions requirements are, the institution determines what its tuition level are, and its faculty requirements et cetera. But we have the ability then to recruit and train the faculty. We have the ability to process the financial aid work. And so we are a little bit probably more excited now than we were before, having looked at, what I think our capabilities and potential is. The other thing is, we just have to – we have to take a little time and make sure that we are positioned in the right place from a standpoint that we don't want to cannibalize any of our own programs and we need to look for universities whose programs wouldn't be cannibalized or who in a geographic area where we could recruit students for them that would never be students at Grand Canyon University. So does that help a little bit?

[Jeffrey Silber:]

Yes, it does. So this could be dramatically different than what we see from some of the “other OPMs” out there that just really focused on programmatic bases in terms of new MBA program or a new nursing program?

[Brian Mueller:]

It could be. I mean, we are – GCE are those departments that are supporting GCU are capable of supporting now 90,000 students and growing in a very, very efficient way. And so scale, because of the automated systems and the $200 million we’ve invested in that, are not an issue for us. And yes, I think it probably would be different and when you think about the revenue split, and I know you guys look at the 60% revenue split. When you look at the services GCE is providing for GCU, and could provide for other institutions, there's a lot of added value there for universities.

[Jeffrey Silber:]

Okay. That’s very helpful. Thanks so much.

[Operator:]

Thank you. Our next question comes from the line of Peter Appert of Piper Jaffray. Your line is now open.

[Peter Appert:]

Thanks. Brian just a point of clarification on potential new clients. Would you consider offering some of these support services on an à la carte basis? Or do you only want to have a, I guess more of a full-service relationship with potential university clients?

[Brian Mueller:]

I think that’s a very interesting question. I think it could go both ways. The focus right now, is on individual clients, individual customers a university. I think we could potentially offer a sense out of the services, but we could also potentially offer services for an entire system, for example. And the way we are thinking about it now, and also I do think we can create win-win situations. We made this huge investment, leveraging it for Grand Canyon University has been tremendous, but we do think it could potentially be leveraged for universities or systems in a way that would benefit students on both sides of it. But we're just at the beginning of it, we got to have lots of meetings and lots of discussion, and we want to take, like we said previously, about six months to make sure that we are placed in the right place in this space.

[Peter Appert:]

Understood. Thank you. And then the – Brian, the high single-digit stock growth you highlighted in your comments, I think that's a bit of an acceleration from what you saw last quarter. Number one, could you just confirm if that's the case? And then number two any color in terms of programmatic areas or specific offerings that are driving the enrollment growth on the stock growth, rather?

[Brian Mueller:]

It’s a slight acceleration, and what we can attribute that to, we don't know in the immediate, the starts that we're getting from the new programs are really helping. And so continuing to develop a new programs based upon where the economy is going to go and where the jobs are going to be is a very important part of our strategy. To say that the slight acceleration was a little bit of a tailwind based upon the anticipation of a not-for-profit status, it's too early to say that. But we don't know how many people didn't pick up the phone because well it was for profit institution. It was impossible to tell exactly how many that was, we'll see in the coming months, but I wouldn't put a whole lot into that slight acceleration in the short-term.

[Dan Bachus:]

Yes just to piggyback that, we – our guidance for the year was mid-to mid-high single digit start growth, depending on quarters. So we are generally in line with what we thought going into the year.

[Peter Appert:]

Okay. And then Dan, one last thing, you mentioned roughly 2% EPS dilution, I guess in the second half from the conversion. Do you think that's a good run rate number to think about, as we look at the 2019 profitability?

[Dan Bachus:]

Yes, I think it’s appropriate to look at I mean obviously, we want to continue to show margin expansion. This year was a little bit different with the tax change but we were planning on spending that money and have spend that money in the first half as well, and so yes, I think that on an apples-to-apples comparison is probably good guess going forward.

[Peter Appert:]

Okay, thanks gentlemen.

[Dan Bachus:]

Thanks.

[Operator:]

Thank you. Our next question comes from the line of Jeff Mueller of Baird. Your line is now open.

[Jeff Mueller:]

Yes, thank you. Just first administrative one, so you gave us the 8-K with the Q1 pro forma and your back half guidance is based on the pro forma classification. Is there any way where the Q2 numbers are provided on a pro forma basis? Or is that what you're providing when you report Q3, just any help on pro forma?

[Dan Bachus:]

Yes, we’re still working on that. Our plan – we're hopeful just to provide second, third, and fourth quarter pro forma information from 2017, next quarter as we release the Q3 results.

[Jeff Mueller:]

And for Q2 of 2018 and that's not provided today.

[Dan Bachus:]

Yes, correct.

[Jeff Mueller:]

And then Brian, you listed off all the capabilities of GCE and then at the end there was three capabilities, I think that you said our GCU capabilities that would need to be replicated. Could you just kind of go back to that not as much as there, but is the message that you would need to build out certain additional capabilities at GCE before you'd be able to provide service – school services to other universities or just, I guess just help me connect the dots on the message you’re trying to convey there.

[Dan Bachus:]

It would be building them out. They are already built out. It would be leveraging them for new partners. And so those are things that we kept on the GCU side because how core they are to our academic mission. But those are things that if a University felt like they would add to their core mission, we could certainly replicate those on the GCE side, that would be mainly a matter of leveraging of the investment that we've already made.

[Jeff Mueller:]

Okay. And then capital allocation and what are the priorities now, I understand you're still funding some of the CapEx there via an extended counterparty note, but capital allocation priorities and do you wait to get the full Department of Education, change in control approval before you I guess change the priorities?

[Dan Bachus:]

No, the priorities for GCE going forward are software development, continue to automate services, to continue to use technology to enhance everything that we do so that students and faculty can get the very best experience in the classroom that we could provide. That's mainly what GCE will be focused on. And then GCU will continue to build out it's campus, and right now, we're going to start to follow up with 20,500 students. Our goal is to build the University on the ground campus out to 32,000 students in the next four to six years, and so that will require CapEx investment in the early years, that's going to come in the form of the increase in the note, but as the cash builds up for the University, it will be able to afford its own CapEx development. And what we do then, past 30,000 students, we still have a decision to make, but the value proposition at GCU is providing for families and traditional students who are now coming from all over the country is so significantly superior in terms of the tuition rate that's two thirds less than most private university tuition rates, a very affordable room and board, the low debt levels comparatively speaking, the ability to do significant duel enrollment and graduate in three years. That value proposition when you compare it to – in the university system in California, they're taking five and six years to graduate and so significant that we'll just have to figure out once we get the 30,000 students on the campus. What is our next move, because it's clearly, we could provide service for a great deal more than 30,000 students with the value proposition advantage that we have.

[Jeff Mueller:]

Okay. And then just finally, could you just maybe take about your targeted digital marketing capabilities as I tend to think about the GCU historical advertising success, it's more reliant on like national TV advertising and I know there's others components to it, but a lot of the school services, online program management space is more targeted digital marketing. So if you could talk about the marketing capabilities and how transferable they are to potential other clients?

[Brian Mueller:]

Well, they are significant. When we talk about the Internet and digital marketing, we are heavily involved in all forms of social media communication, and so it's not that we withdrew from that, but the only thing that GCU has withdrawn from is the Internet lead generating companies. That was a process that was tremendously fruitful in the late 80s and through the 90s, but now that there are all these players seeking working adult students who want to study and earn degrees online. That thing has deteriorated tremendously. And so we have moved out of that into more traditional forms of marketing and advertising, but those also include lots of work with social media platforms, just not in the way that we would be working with lead aggregators. But an advantage that we’re going to have is that creative capability, but also the buying capability. We have a lot of leverage from a buying perspective. And if we add partners and help create media, our advertising campaigns for them, our ability to buy the media and have that as part of for package is significant, and so now there is going to be some learnings that goes on with all that, because we envision that there will be some targeted marketing based upon the geographic placement of certain partners. They are more likely to draw students in that area that they reside and in those areas we don't have as good as much of an opportunity. And so we have a lot of learning to do with regard to geo targeting, media placements and those kind of things, but we do have an experience group and significant buying capacity that we’d hope to leverage.

[Jeff Mueller:]

Okay. I’ll take my follow-up question offline. Thanks. End of Q&A

[Brian Mueller:]

We have reached the end of our second quarter conference call. We appreciate your time and interest in Grand Canyon Education. If you still have questions, please contact myself and Bachus. Thank you very much.

[Operator:]

Ladies and gentlemen, thank you for participating in today’s conference. That does conclude today’s program. You may all disconnect. Everyone have a great day.