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K12 INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") contains certain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Historical results may not indicate future performance. Our forward-looking statements reflect our current views about future events, are based on assumptions, and are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those contemplated by these statements. Factors that may cause differences between actual results and those contemplated by forward-looking statements include, but are not limited to, those discussed in "Risk Factors" in Part I, Item 1A, of this Annual Report. We undertake no obligation to publicly update or revise any forward-looking statements, including any changes that might result from any facts, events, or circumstances after the date hereof that may bear upon forward-looking statements. Furthermore, we cannot guarantee future results, events, levels of activity, performance, or achievements. This MD&A is intended to assist in understanding and assessing the trends and significant changes in our results of operations and financial condition. As used in this MD&A, the words, "we," "our" and "us" refer to K12 Inc. and its consolidated subsidiaries. This MD&A should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report. The following overview provides a summary of the sections included in our MD&A: º • º Executive Summary-a general description of our business and key highlights of the fiscal year ended June 30, 2014. º • º Key Aspects and Trends of Our Operations-a discussion of items and trends that may impact our business in the upcoming year. º • º Critical Accounting Policies and Estimates-a discussion of critical accounting policies requiring critical judgments and estimates. º • º Results of Operations-an analysis of our results of operations in our consolidated financial statements. º • º Liquidity and Capital Resources-an analysis of cash flows, sources and uses of cash, commitments and contingencies, seasonality in the results of our operations, the impact of inflation, and quantitative and qualitative disclosures about market risk. Executive Summary We are a technology-based education company. We offer proprietary curriculum, software systems and educational services designed to facilitate individualized learning for students primarily in kindergarten through 12th grade, or K-12. Our mission is to maximize a child's potential by providing access to an engaging and effective education, regardless of geographic location or socio-economic background. We provide a continuum of technology-based educational products and solutions to public school districts, public schools, charter schools, private schools and families as we strive to transform the student's experience into one that delivers individualized education on a highly scalable basis. We achieved revenue growth during fiscal year 2014, primarily in our online managed public schools. We increased revenues to $919.6 million from $848.2 million, a growth rate of 8.4% from fiscal year 2013. In fiscal year 2014, operating income decreased to $22.9 million from $45.7 million in fiscal year 2013, a decrease of 49.9%; net income attributable to common stockholders decreased to $19.6 million from $28.1 million, a decrease of 30.2% and EBITDA, a non-GAAP measure (see reconciliation of net income to EBITDA in "Item 6-Selected Financial Data"), increased to $115.5 million from $111.4 million, an increase of 3.7%. The operating income for fiscal year 2014 included $31.2 million of severance and related stock-based compensation, accelerated depreciation and amortization for certain curriculum, learning 60-------------------------------------------------------------------------------- Table of Contents systems, trade names, and other fixed assets that will no longer be used or developed and additional provisions for inventory that we previously anticipated using. Our Managed Public Schools line of business, which includes virtual and blended public schools generally under long-term turn-key management contracts accounted for approximately 88% of our revenue in fiscal year 2014. For both virtual and blended managed public schools, the governing authority with control over the school negotiates contractual terms with us for all aspects of the management of the school, including monitoring academic achievement, teacher recruitment and training, student recruitment and marketing, compensation recommendations for school personnel, financial management, enrollment processing and procurement of curriculum, equipment and other required services. For the 2014-15 school year, we expect to manage 77 schools in 33 states and the District of Columbia. Through our Institutional Sales business, we work closely as partners with a growing number of schools and school districts enabling them to offer their students an array of online education solutions, including full-time virtual and blended programs, semester courses and supplemental solutions. In addition to curriculum, systems and programs, we also provide teacher training, teaching services and other support services. The services we provide to these schools and school districts are designed to assist them in launching their own online learning programs which vary according to the needs of the individual school and school district and may include teacher training programs, administrator support and our PEAK management system. With our services, schools and districts can offer programs that allow students to participate full-time, as their primary school, or part-time, supplementing their education with core courses, electives, credit recovery options, remediation and supplemental content options. During the 2013-14 school year, we continued to provide these services to school districts or individual schools in all 50 states and the District of Columbia. We operate three online private schools in which parents can enroll students on a tuition basis for a full-time online education or individual courses to supplement their children's traditional instruction. These include our K12 International Academy, an online private school that enables us to offer students worldwide the same full-time education programs and curriculum that we provide to the virtual and blended public schools, The Keystone School, a private school that offers online and correspondence courses, and the George Washington University Online High School, a school that offers college preparatory curriculum and is designed for high school students who are seeking a challenging academic experience. In addition, during the past year, we owned and operated the International School of Berne, a traditional private school located in Berne, Switzerland and a recognized IB school serving students in grades Pre-K through 12. In June 2014, we completed a sale of select businesses, including the International School of Berne, to Safanad Education Ventures Limited. The other select businesses divested consisted of our interest in an existing Middle East joint venture currently operating with a Safanad Limited affiliate and our post-secondary business. Financial Statement Overview As a result of acquisitions, our business has evolved significantly, thereby impacting the comparability of period to period financial results. During 2012, we acquired KVE and Insight Schools (the "Kaplan/Insight Assets"). These acquisitions accounted for a portion of the increases in our revenue, student enrollments and operating costs, including transaction and integrations costs. In addition, we experienced growth from the new state schools added in recent years identified above and the continued ramp-up in student enrollments and associated variable operating costs from schools opening over the last five years. Student enrollment in our Managed Public Schools has experienced a shift in the mix of students with an increased level of high school students. The shift occurred as a result of our acquisition of the Kaplan/Insight Assets, which only serve students in grades 6-12, and from organic growth in many of the schools we serve. The continued expansion of our Institutional Sales and our International and Private Pay Schools also shifts the mix of our revenue and associated costs of providing services, including additional sales 61-------------------------------------------------------------------------------- Table of Contents personnel, third-party distributor costs and third-party royalty costs for our Institutional Sales. We may continue to experience changes in our enrollment, revenue and cost mix as we continue to expand into markets different than our traditional Managed Public Schools. Our headcount growth from approximately 3,300 employees at the beginning of 2012 to approximately 4,200 at the end of our 2014 fiscal year, including teachers associated with our enrollment growth, the development of the Institutional Sales, including the expansion of a sales force, and the decision to have more K12-employed teachers in our managed schools have also directly impacted our operating expenses during the last three years. We believe that all the above factors, particularly the significant infrastructure investments, acquisitions and the depreciation and amortization associated with our acquired assets and infrastructure investments, reduce the comparability of our operating results between periods. Key Aspects and Trends of Our Operations Revenues-Overview We generate a significant portion of our revenues from the sale of curriculum, management and technology services to managed virtual and blended public schools, where we provide turn-key management services. Approximately 88% of our revenues were derived from this source in fiscal year 2014. We anticipate that these revenues will continue to represent the majority of our total revenues over the next several years. However we also expect revenues in other aspects of our business to increase as we execute on our growth strategy. Our growth strategy includes increasing revenues in other distribution channels adding enrollments in our private schools and pursuing international opportunities to offer our learning systems. Combined revenues from these other sectors were significantly smaller than that from the Managed Public Schools in fiscal year 2014. Our success in executing our strategies will impact future growth. We provide products and services primarily to three lines of business: Managed Public Schools, Institutional Sales and International and Private Pay Schools. Factors affecting our revenues include: º (i) º the number of enrollments; º (ii) º the mix of enrollments across grades and states; º (iii) º management services provided to the schools and school districts; º (iv) º state or district per student funding levels and attendance requirements; º (v) º prices for our products and services; º (vi) º growth in our other customer types; and º (vii) º revenues from new initiatives, mergers and acquisitions. Managed Public Schools We define an enrollment as a student using our curriculum. Generally, students will take four to six courses, except for some kindergarten students who may participate in half-day programs. We count each half-day kindergarten student as an enrollment. School sessions generally begin in August or September and end in May or June. To ensure that all schools are reflected in our measure of enrollments, we consider the number of students on the last day of September to be our opening enrollment level, and the number of students enrolled on the last day of May to be our ending enrollment level. For each period, average enrollments represent the average of the month-end enrollment levels for each school month in the period. We continually evaluate our enrollment levels by state, by school and by grade. We track new student enrollments and withdrawals throughout the year. 62 -------------------------------------------------------------------------------- Table of Contents We believe that our revenue growth from enrollments depends upon the following: º • º the number of states and school districts in which we operate; º • º the mix of students served; º • º the restrictive terms of local laws or regulations, including enrollment caps; º • º the appeal of our curriculum and instructional model to students and families; º • º the specific school or school district requirements including credit recovery or special needs; º • º the effectiveness of our program in delivering favorable academic outcomes; º • º the quality of the teachers working in the schools we serve; º • º the effectiveness of our marketing and recruiting programs to attract new enrollments; and º • º retention of students through successive grade levels. In fiscal year 2014, we increased total average student enrollments by 5,696, or 4.8%, to 123,259, as compared to total average student enrollments of 117,563 in fiscal year 2013. In fiscal year 2013, we increased total average student enrollments by 13,274, or 12.7%, to 117,563, as compared to total average student enrollments of 104,289 in fiscal year 2012. We continually evaluate our trends in revenues by monitoring the number of student enrollments in total, by state, by school and by grade, assessing the impact of changes in school funding levels and the pricing of our curriculum and educational services. In fiscal year 2014 and 2013, the growth rate of our revenue exceeded the growth in our managed school average student enrollments primarily due increases in the per-pupil rate of achieved state funding in some states, other changes in state funding rates and higher utilization in federal and state restricted funding per managed student. Enrollments in these schools on average generate substantially more revenues than enrollments served through our Institutional Sales where we provide limited or no management services. Similarly, revenues earned per pupil across our private school programs vary. As we continue to build our Institutional Sales and increase enrollment in International and Private Pay Schools, enrollment mix is expected to shift and may impact growth in revenues relative to the growth in enrollments. In fiscal year 2014, we derived approximately 13% and 10% of our revenues, respectively, from the Agora Cyber Charter School ("Agora") in Pennsylvania and the Ohio Virtual Academy. In aggregate, these schools accounted for approximately 23% of our total revenues. We provide our full turn-key management solution pursuant to our contract with the Ohio Virtual Academy, which terminates on June 30, 2017. We provide our full turn-key solution to Agora pursuant to a contract with the school that expires on June 30, 2015. In fiscal year 2014, Agora elected to use a request for proposal process for the services and products required to operate the school for the 2015-16 school year in connection with its charter renewal application. The annual revenues generated under each of these contracts represented a material portion of our total revenues in fiscal year 2014; however, as our managed public schools expand and other business sectors grow, these proportions may decrease. Institutional Sales While Managed Public Schools constitute the majority of our revenue, there is emerging demand by school districts, individual schools and other educational institutions for more limited components of our online services and products than are used in Managed Public Schools. Sales to those entities are conducted through our Institutional Sales organization. While we expect long-term growth opportunities in our Institutional Sales business, the sector is currently experiencing significant competitive pricing pressures. 63-------------------------------------------------------------------------------- Table of Contents The Institutional Sales portfolio contains an array of curriculum and technology solutions packaged in a portfolio of flexible learning and delivery models mapped to specific student, school and district needs. This portfolio provides a continuum of delivery models, from full and part-time virtual to blended learning and other options that can be used in traditional classrooms to differentiate instruction. The Institutional Sales course catalog is comprehensive and enables districts to offer their students educational opportunities that otherwise might not be financially justifiable, such as Advanced Placement ("AP"), honors, world languages, remediation, credit recovery, alternative education, career and technology electives and college readiness. In connection with these solutions, we also offer highly qualified state-certified teachers, professional development and other support services as needed by our customers. Given the variables discussed in further detail below, we believe that the best performance metric for the Institutional Sales is revenues. The customers served by the Institutional Sales organizations purchase curriculum in a variety of ways, making consistent comparisons on the basis of enrollments less relevant. For example, we serve not only full-time students, but also students taking semester-long courses, students who recover credits through concentrated four to eighteen-week programs, students who are using our curricula as a supplemental enhancement to their traditional textbook, and teachers who may present our lessons on an interactive whiteboard as either the core of their instruction or as an engaging supplement to their lecture. Given all these variables, it is therefore difficult to identify a single metric (such as a full time equivalent or "FTE"), or combination of metrics (such as course enrollments or programs sold), that can accurately capture the entirety of the Institutional Sales. Indeed, our efforts to do so led us to the conclusion that at this time, revenue is the best performance metric for the Institutional Sales. Sales opportunities in the Institutional Sales are driven by a number of factors in a diverse customer population, which determine the deliverable and price. These factors include: º • º Type of Customer-A customer can be a U.S.-based public, private or public charter school, a district, regional education agency, or a commercial company that provides services to students. º • º Curriculum Needs-We sell our curriculum solutions based on the scope of the customer need, and a solution is generally purchased as end-user access to a complete catalog, individual course or supplemental content title. º • º License Options-Depending on the scope of the solution, a license can be purchased for individual course enrollments, annual seat, school or district-wide site licenses or a perpetual license (a prepaid lifetime license). We charge incrementally if we are hosting the solution. º • º Hosting-Customers may host curricula themselves or license our hosted solution. We are able to track all students for customers who use our hosted solution. However, more often in large-scale, district-wide implementations, a customer may choose to host the curriculum, and in that case we have no visibility of individual student usage for counting enrollments. º • º Services Menu-Instructional services may be provided and priced per-enrollment or bundled in the overall price of the solution. Additional services, including professional development, title maintenance and support may also be provided and are priced based on the scope of services. International and Private Pay Schools Private schools are managed schools where tuition is paid directly by the family of the student. We receive no public funds for students in our private schools. We operate three private online schools at differing price points and service levels. Our revenue is derived from tuition receipts that are a function of course enrollments and program price. In some circumstances, a third-party school may elect to enroll one of its students in a K12 private school course as a supplement to the student's regular on-campus instruction. In such cases, the third-party school may pay the K12 private school tuition. 64-------------------------------------------------------------------------------- Table of Contents Our private schools business has evolved over the past three years as we have acquired and developed new private school offerings with different structures and price points. This has made the use of full-time equivalent metrics no longer as meaningful. As a result, we report performance in the private pay schools on the basis of the student counts and semester-course enrollments which more accurately reflects the way revenues and expenses occur in the business. Student counts tell us how many individual students have been served at any point in time. As a result of the variation in the number of courses taken by students, we measure the total size of our schools by "semester-course enrollments" ("SCEs"). A semester long course is counted as a single SCE and a year-long course is counted as two SCEs. Private school students take courses ranging from a single, semester long K-8 course to a twelve high school course annual load. For example, a student who takes six courses per semester for two semester accounts for twelve SCEs. Some of our private school operations, notably Keystone and the K12 International Academy, start classes on a monthly or rolling basis. As a result, there are students in our system of education at any point in time who have just started a course, just finished a course or have partially completed a course. We believe our revenue growth depends primarily on the recruitment of students into our programs through effective marketing and word-of-mouth referral based on the quality of our service. In addition, through high service quality, we seek to retain existing students and increase the total number of courses each student takes with us. In some cases, students return each summer and take only one course. In other cases, students choose a K12 private school as their principal form of education and may stay for many years. The flexibility of our programs, the quality of our curriculum and teaching, and the student community features lead to customer satisfaction and therefore, retention. We have entered into agreements which enable us to distribute our products and services to our international school partners throughout the world who use our courses as a supplement to their on-campus academic programs. These courses provide students with additional electives, advanced placement (AP) courses, and sometimes include dual-degree programs that the school cannot offer on its own. Student enrollments derived from partner school programs are included in the count of SCEs for these private schools. We sometimes offer additional teacher assistance, counseling, clubs and other additive services to our basic course offerings. These additive services may carry additional fees that appear in our revenue. During the majority of fiscal year 2014, we also operated IS Berne, a traditional private school in Switzerland. Through the sale date on June 11, 2014, enrollments and revenue from IS Berne are included in our private school totals along with the numbers from our online school operations. We do not include students in our consumer sales business as we are not involved in the progress of these students in the same way as we do in our other programs. Instructional Costs and Services Expenses Instructional costs and services expenses include expenses directly attributable to the educational products and services we provide. The Managed Public Schools we manage are the primary drivers of these costs, including teacher and administrator salaries and benefits and expenses of related support services. We also employ teachers and administrators for instruction and oversight in our Institutional Sales and International and Private Schools business. Instructional costs also include fulfillment costs of student textbooks and materials, depreciation and reclamation costs of computers provided for student use, the cost of any third-party online courses and the amortization of capitalized curriculum and related systems. Our instructional costs are variable and are based directly on our number of schools and enrollments. In the near term, we expect high school enrollments to continue to grow as a percentage of total enrollments. Our high school offering requires increased instructional costs as a percentage of revenue compared to our kindergarten to 8th grade offering. This is due to the following: (i) generally lower 65-------------------------------------------------------------------------------- Table of Contents student-to-teacher ratios; (ii) higher compensation costs for some teaching positions requiring subject-matter expertise; (iii) ancillary costs for required student support services, including college placement, SAT preparation and guidance counseling; (iv) use of third-party courses to augment our proprietary curriculum; and (v) use of a third-party learning management system to service high school students. Over time, we may partially offset these factors by obtaining productivity gains in our high school instructional model, replacing third-party high school courses with proprietary content, replacing our third-party learning management system with another third-party system, leveraging our school infrastructure and obtaining purchasing economies of scale. We have deployed and are continuing to develop new delivery models, including blended schools, where students receive limited face-to-face instruction in a learning center to complement their online instruction, and other programs that utilize brick and mortar facilities. The maintenance, management and operations of these facilities necessitate additional costs, which are generally not required to operate typical virtual public schools. We are pursuing expansion into new states for both virtual public and other specialized charter schools. If we are successful, we will incur start-up costs and other expenses associated with the initial launch of a school, including the funding of building leases and leasehold improvements. Selling, Administrative and Other Operating Expenses Selling, administrative and other operating expenses include the salaries and benefits employees engaged in business development, public affairs, sales and marketing, and administrative functions and transaction and due diligence expenses related to mergers and acquisitions. Product Development Expenses Product development expenses include research and development costs and overhead costs associated with the management of both our curriculum development and internal systems development teams. In addition, product development expenses include the amortization of internal systems. We measure and track our product development expenditures on a per course or project basis to measure and assess our development efficiency. In addition, we monitor employee utilization rates to evaluate our workforce efficiency. We plan to continue to invest in additional curriculum development and related software in the future, primarily to produce additional high school courses, world language courses and new releases of existing courses and to continue to upgrade our content management system and online schools. We capitalize selected costs incurred to develop our curriculum, beginning with application development, through production and testing into capitalized curriculum development costs. We capitalize certain costs incurred to develop internal systems into capitalized software development costs. Expense Management We are constantly searching for ways to deliver more value at a lower cost for our customers and we take pride in our ability to deliver highly-individualized, effective education solutions at significant savings to taxpayers. We have sought to increase efficiencies whenever possible without affecting educational quality. We believe our scale and infrastructure investment positions us for greater efficiency in future periods while allowing us to deliver more value for students. Critical Accounting Policies and Estimates The discussion of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. In the preparation of our consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, as well as the related disclosures of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. The results of our analysis form the 66-------------------------------------------------------------------------------- Table of Contents basis for making assumptions about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, and the impact of such differences may be material to our consolidated financial statements. Our critical accounting policies have been discussed with the Audit Committee of our Board of Directors. We believe that the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements: Revenue Recognition In accordance with Accounting Standards Codification ("ASC") 605, Revenue Recognition, we recognize revenue when the following conditions are met: (1) persuasive evidence of an arrangement exists; (2) delivery of physical goods or rendering of services is complete; (3) the seller's price to the buyer is fixed or determinable; and (4) collection is reasonably assured. We have determined that the separate elements of our multiple element contracts with managed schools do not have standalone value. Accordingly, we account for revenues received under multiple element arrangements with managed schools as a single unit of accounting and recognize the entire arrangement over the term of the contractual service period. While we have concluded that the elements of our contracts do not have standalone value, we invoice schools in accordance with the established contractual terms and rates. Generally, this means that for each enrolled student, we invoice their school on a per student basis for the following items: (1) access to our online school and online curriculum; (2) learning kits; and (3) student computers. We also invoice for management and technology services. We apply ASC 605 to each of these items as follows: º • º Access to the Online School and Online Curriculum. Our proprietary learning management system ("OLS") revenues are generally earned on a per course basis from schools and school districts. Students enrolled through a school are provided access to the OLS and online curriculum. Revenues are earned ratably over the school year, typically 10 months, or over the semester depending on the length of the course. º • º Learning Kits. The lessons in our online school are often accompanied with selected printed materials, workbooks, laboratory materials and other manipulative items which we provide to students. We generally ship all learning kits to a student when their enrollment is approved. Once materials have been shipped, our efforts are substantially complete. Therefore, we recognize revenues upon shipment. Shipments to schools that occur in the fourth fiscal quarter that are for the following school year are recorded in deferred revenues. We also earn reclamation fee income when we reclaim materials for schools at the end of the school year or when a student withdraws from the school. º • º Student Computers. We provide many enrolled students with the use of a personal computer and complete technical support through our call center. Revenues are generally earned ratably over the school year and we also earn revenues for reclamation services when a student withdraws from a school and returns the computer which may occur in a subsequent school year. º • º Management, Technology and Educational Services. Under most of our statewide virtual public and blended school contracts, we provide the boards of managed schools with turn-key management and technology services. We recognize these revenues ratably over our fiscal year as administrative offices of the school remain open for the entire year. Our management and technology service fees are generally a contracted percentage of yearly school funding. To determine the pro rata amount of revenues to recognize in a fiscal quarter, we estimate the total funds each school will receive in a particular school year. Total funds for a school are primarily a function of the number of students enrolled in the school and established per enrollment funding levels which are generally published on an annual basis by the state or school district. 67 -------------------------------------------------------------------------------- Table of Contents To determine the pro rata amount of revenues to recognize in a fiscal quarter, we estimate the total funds each school will receive in a particular school year. Total funds for a school are primarily a function of the number of students enrolled in the school and established per enrollment funding levels which are generally published on an annual basis by the state or school district. We review our estimates of funding periodically, and revise as necessary, amortizing any adjustments to earned revenues over the remaining portion of the fiscal year. Actual school funding may vary from these estimates, and the impact of these differences could have a material impact on our results of operations. Since the end of the school year coincides with the end of our fiscal year, we are generally able to base our annual revenues on actual school funding. Our schools reported results are subject to annual school district financial audits, which incorporate enrollment counts, funding and other routine financial audit considerations. The results of these audits are incorporated into our monthly funding estimates and for the reported fiscal years ended June 30, 2013, 2012 and 2011, our aggregate funding estimates differed from actual reimbursements impacting total reported revenue by approximately 0.2%, (0.1%) and 0.7%, respectively. Under the contracts where the Company provides turnkey management services to schools, the Company has generally agreed to absorb any operating losses of the schools in a given school year. These school operating losses represent the excess of costs incurred over revenues earned by the virtual or blended public school as reflected on its respective financial statements, including Company charges to the schools. To the extent a school does not receive funding for each student enrolled in the school, the school would incur an operating loss for the unfunded enrollment. If losses due to unfunded enrollments result in a net operating loss for the year that loss is reflected as reduction in the revenue and net receivables that we collect from the school. A school net operating loss in one year does not necessarily mean the Company anticipates losing money on the entire contract with the school. However, a school operating loss may reduce the Company's ability to collect its management fees in full and recognized revenues are reduced accordingly to reflect the expected cash collections from such schools. The Company amortizes the estimated school operating loss against revenues based upon the percentage of actual revenues in the period to total estimated revenues for the fiscal year. For turnkey revenue service contracts, a school operating loss may reduce our ability to collect our management fees in full though as noted it does not necessarily mean that we incur a loss during the period with respect to our services to that school. We recognize revenue, net of our estimated portion of school operating losses, to reflect the expected cash collections from such schools. Revenue is recognized based on our performance of services under the contract, which we believe is proportionate to our incurrence of costs. We incur costs directly related to the delivery of services. Most of these costs are recognized throughout the year; however, certain costs related to upfront delivery of printed materials, workbooks, laboratory materials and other items are provided at the beginning of the school year and are recognized as expense when shipped. Each state or school district has variations in the school funding formulas and methodologies that we use to estimate funding for revenue recognition at our respective schools. As we build the funding estimates for each school, we are mindful of the state definition for count dates on which reported enrollment numbers will be used for per pupil funding. The parameters we consider in estimating funding for revenue recognition purposes include school district count definitions, withdrawal rates, average daily attendance, special needs enrollment, student demographics, progress trajectory and historical completion, student location, funding caps and other state specified categorical program funding. The estimates we make each period on a school-by-school basis consider the latest information available to us and consider material relevant information at the time of the estimate. Management periodically reviews its estimates of full-year school revenues and operating expenses and amortizes the net impact of any changes to these estimates over the remainder of the fiscal year. Actual school operating losses may vary from these estimates or revisions, and the impact of these differences could have a material impact on results of operations. Since the end of the school year coincides with the end of our fiscal year, annual revenues are generally based on actual school revenues 68-------------------------------------------------------------------------------- Table of Contents and actual costs incurred (including costs for our services to the schools plus other costs the schools may incur) in the calculation of school operating losses. For the years ended June 30, 2014, 2013 and 2012, the Company's revenue included a reduction for these school operating losses of $49.8 million, $64.5 million and $54.8 million, respectively. A school operating loss may result from a combination of cost increases or funding reductions attributable to the following: º • º costs associated with opening new schools including the initial hiring of teachers, administrators and the establishment of school infrastructure; º • º school requirements to establish contingency reserves; º • º one-time costs, such as legal claims; º • º funding reductions due to the inability to qualify specific students for funding; º • º regulatory or academic performance thresholds that may restrict the ability of a school to fund all expenses; º • º inadequate school funding in particular states; º • º providing services without receiving state funding when enrollments occur after enrollment count dates; and º • º burdensome regulations creating excessive costs. We generate a small percentage of our revenues from the sale of perpetual licenses of curriculum and ongoing support to schools. Under ASC 605, we account for the license and support of separate units of accounting and recognize revenues associated with the license up front and ongoing maintenance and support over the performance period. We also generate a small percentage of our revenues through the sale of our online courses and learning kits directly to consumers, as well as providing hosting services to certain customers. We record revenue for consumer services over the term of the course subscription. For the year ended June 30, 2014, special education students comprise approximately 13% of our student population and approximately 21% of estimated funding for revenue recognition purposes at our schools. We compute revenue at the school level not based on the type of student served; therefore, we are unable to determine the revenue and profitability by student type. For each student enrolled, we receive basic per pupil funds determined by state funding and count definitions, and policies which vary from state-to-state. Additionally, based on the needs of the student population, we may receive supplemental special education state funding grants and federal funding under the Individuals with Disabilities Act. While we do not track profitability at the student level, these supplemental funding programs are intended to offset part of the costs of the education needs of children with learning disabilities through reimbursement of qualifying costs under the programs. Capitalized Curriculum Development Costs Our curriculum is primarily developed by our employees and, to a lesser extent, by independent contractors. Generally, our courses cover traditional subjects and utilize examples and references designed to remain relevant for long periods of time. The online nature of our curriculum allows us to incorporate user feedback rapidly and make ongoing corrections and improvements. For these reasons, we believe that our courses, once developed, have an extended useful life, similar to computer software. We also publish textbooks and other offline materials. Our curriculum is integral to our learning systems. Our customers generally do not acquire our curriculum or future rights to it. Due to the similarity in development stages and long economic life of curriculum to computer software, we capitalize curriculum development costs incurred during the application development stage in 69-------------------------------------------------------------------------------- Table of Contents accordance with ASC 350, Intangibles-Goodwill and Other. ASC 350 provides guidance for the treatment of costs associated with computer software development and defines those costs to be capitalized and those to be expensed. Costs that qualify for capitalization are external direct costs, payroll and payroll-related costs. Costs related to general and administrative functions are not capitalizable and are expensed as incurred. We capitalize curriculum development costs during the design, development and deployment phases of the project. Many of our new courses leverage off of proven delivery platforms and are primarily content, which has no technological hurdles. As a result, a significant portion of our courseware development costs qualify for capitalization due to the concentration of our development efforts on the content of the courseware. Capitalization ends when a course is available for general release to our customers, at which time amortization of the capitalized costs begins. Capitalized costs are recorded in capitalized curriculum development costs. The period of time over which these development costs will be amortized is generally five years. This is consistent with the capitalization period used by others in our industry and corresponds with our product development lifecycle. The Company wrote down approximately $2.2 million of capitalized curriculum development costs due to its decision to discontinue certain curriculum during the fiscal year ended June 30, 2014. There were no material write-downs of capitalized curriculum development costs for the fiscal years ended June 30, 2013 and 2012. Software Developed or Obtained for Internal Use We develop our own proprietary computer software programs to provide specific functionality to support both our unique education offerings and the student and school management services. These programs enable us to develop courses, process student enrollments, meet state documentation requirements, track student academic progress, deliver online courses to students, coordinate and track the delivery of course-specific materials to students and provide teacher support and training. These applications are integral to our learning systems and we continue to enhance existing applications and create new applications. Our customers do not acquire our software or future rights to it. We capitalize software development costs incurred during development in accordance with ASC 350. These capitalized development costs are included in capitalized software development costs and are generally amortized over three years. During the fiscal year ended June 30, 2014, the Company wrote down approximately $3.8 million of capitalized software projects after determining the assets either have no future use or are being sunset. There were no material write-downs of capitalized software projects for the fiscal years ended June 30, 2013 and 2012. Impairment of Long-lived Assets Long-lived assets include property, equipment, capitalized curriculum and software developed or obtained for internal use. In accordance with ASC 360, Property, Plant and Equipment, we review our recorded long-lived assets for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. We determine the extent to which an asset may be impaired based upon our expectation of the asset's future usability as well as on a reasonable assurance that the future cash flows associated with the asset will be in excess of its carrying amount. If the total of the expected undiscounted future cash flows is less than the carrying amount of the asset, a loss is recognized for the difference between fair value and the carrying value of the asset. The Company wrote down approximately $2.2 million of capitalized curriculum development costs due to its decision to discontinue certain curriculum during the fiscal year ended June 30, 2014. During the fiscal year ended June 30, 2014, the Company also wrote down approximately $3.8 million of capitalized software projects after determining the assets either have no future use or are being sunset. There were no material impairment charges for the fiscal years ended June 30, 2013 and 2012. 70-------------------------------------------------------------------------------- Table of Contents Income Taxes We account for income taxes in accordance with ASC 740, Income Taxes. ASC 740 prescribes the use of the asset and liability method to compute the differences between the tax bases of assets and liabilities and the related financial amounts, using currently enacted tax laws. If necessary, a valuation allowance is established, based on the weight of available evidence, to reduce deferred tax assets to the amount that is more likely than not to be realized. Realization of the deferred tax assets, net of deferred tax liabilities, is principally dependent upon achievement of sufficient future taxable income. We exercise significant judgment in determining our provisions for income taxes, our deferred tax assets and liabilities and our future taxable income for purposes of assessing our ability to utilize any future tax benefit from our deferred tax assets. Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgments that could become subject to examination by tax authorities in the ordinary course of business. We periodically assess the likelihood of adverse outcomes resulting from these examinations to determine the impact on our deferred taxes and income tax liabilities and the adequacy of our provision for income taxes. Changes in income tax legislation, statutory income tax rates or future taxable income levels, among other things, could materially impact our valuation of income tax assets and liabilities and could cause our income tax provision to vary significantly among financial reporting periods. We have a valuation allowance on net deferred tax assets of $2.0 million and $1.3 million as of June 30, 2014 and 2013, respectively, for the amount that more likely than not will not be realized. The majority of our remaining net operating loss carryforwards were utilized during fiscal year 2013 and we made more significant federal income tax payments in fiscal year 2014. Accounting for Stock-based Compensation We recognize stock-based compensation expense under the provisions of ASC 718, Compensation-Stock Compensation. We use the Black-Scholes option pricing model to calculate the fair value of stock options at their respective grant date. The use of option valuation models requires the input of highly subjective assumptions, including the expected stock price volatility and the expected term of the option. The fair value of restricted stock awards is the fair market value on the date of grant. We recognize these compensation costs on a straight-line basis over the requisite service period, which is generally the vesting period of the award. During 2012 to 2014, we granted more restricted stock awards than stock options, resulting in increased stock-based compensation that will be recognized over the required service periods. In addition, the vesting period is generally three years for restricted stock compared to four years for stock options. The increase in restricted stock awards and the shorter vesting period has increased our stock-based compensation costs, and this increased cost is expected to continue in future periods. Goodwill and Other Intangible Assets We record as goodwill the excess of purchase price over the fair value of the identifiable net assets acquired. Finite-lived intangible assets acquired in business combinations subject to amortization are recorded at their fair value. Finite-lived intangible assets include the trade names, customer contracts and curriculum and such intangible assets are amortized on a straight-line basis over their estimated useful lives based on third party valuations. We periodically evaluate the remaining useful lives of intangible assets and adjust our amortization period if it is determined that such intangible assets have a shorter useful life. We evaluate the recoverability of our recorded goodwill and other intangible assets annually, or whenever a triggering event of impairment may occur. During fiscal year 2014, we used a qualitative approach to evaluate goodwill for impairment. During the fiscal year ended June 30, 2014, the Company determined that based on rebranding of the Institutional Sales business, the Company fully amortized certain trade names that are no longer going to be used and recorded a $5.2 million impairment charge for the fiscal year ended June 30, 2014. During the fiscal year ended June 30, 2014, the Company also sold 71-------------------------------------------------------------------------------- Table of Contents certain business assets and wrote off approximately $3.4 million of goodwill and $0.4 million of net intangible assets related to the assets of the business that were sold. There were no material impairment charges for the years ended June 30, 2013 and 2012. Consolidation of Noncontrolling Interest Our consolidated financial statements reflect the results of operations of our Middle East and Middlebury Interactive Languages joint ventures. Earnings or losses attributable to our partner are classified as "net loss attributable to noncontrolling interest" in the accompanying consolidated statements of operations. Net income or net loss attributable to noncontrolling interest adjusts our consolidated net results of operations to reflect only our share of the after-tax earnings or losses of an affiliated company. In June 2014, we completed a sale of select businesses to Safanad Education Ventures Limited, including our interest in our Middle East joint venture which we had operated with a Safanad Limited affiliate. Redeemable Noncontrolling Interest In the formation of our joint venture with Middlebury College, at any time after the fifth (5th) anniversary of the agreement (April 2015), Middlebury College may give written notice of its irrevocable election to sell all (but not less than all) of its membership interest (put right) to us. The purchase price for Middlebury College's membership interest shall be its fair market value and we may, in our sole discretion, pay the purchase price in cash or shares of our common stock. At June 30, 2014, MIL had not met certain milestones associated with its Language Academy summer camp programs. As such, Middlebury College may exercise its option to either repurchase the camp programs at fair market value along with other contractual rights. Middlebury College has neither exercised nor expressed an intent to exercise the option. Given the provision of the put right, the redeemable noncontrolling interest is redeemable outside of our control and it is recorded outside of permanent equity at its redemption value, which approximates fair value, in accordance with ASC 480, Distinguishing Liabilities from Equity. We adjust the redeemable noncontrolling interest to redemption value on each balance sheet date with changes in redemption value recognized as an adjustment to retained earnings, or in the absence of retained earnings, by adjustment to additional paid-in-capital. The redeemable value as of the end of each fiscal year is based on a third-party valuation, while the redeemable value during interim periods is based on management updates from the date of the most recent independent valuation. As of June 30, 2014 and 2013, the estimated redeemable noncontrolling interest was $16.8 million and $15.2 million, respectively. Segment Reporting We operate in one operating and reportable business segment: we are a technology-based education company. We offer proprietary curriculum, software systems and educational services designed to facilitate individualized learning for students primarily in kindergarten through 12th grade, or K-12. We have the following three lines of business: Managed Public Schools, Institutional Sales and International and Private Pay Schools. Our Chief Executive Officer is the Chief Operating Decision Maker (the "CODM"). Our CODM manages our business primarily by function and reviews financial information on a consolidated basis, accompanied by disaggregated information on revenues by line of business as well as certain operational data, for purposes of allocating resources and evaluating financial performance. The profitability of our business segments is not produced. The CODM only evaluates profitability based on consolidated results. 72-------------------------------------------------------------------------------- Table of Contents Results of Operations Managed Public Schools The following table sets forth total average enrollment data for students in Managed Public Schools. These figures exclude enrollments from our classroom pilot programs. Growth Growth Year Ended June 30, 2014 / 2013 2013 / 2012 2014 2013 2012 Change Change % Change Change % Average Student Enrollments* 123,259 117,563 104,289 5,696 4.8 % 13,274 12.7 % -------------------------------------------------------------------------------- º * º The Managed Public Schools average student enrollments include enrollments for which we receive no public funding. Additionally, Managed Public Schools enrollments include all programs which have been classified as turn-key programs or where substantial management services are performed in accordance with the contract. International and Private Pay Schools The following table sets forth total data for students in our International and Private Pay Schools. These figures exclude enrollments from our consumer program. Growth Growth Year Ended June 30, 2014 / 2013 2013 / 2012 2014 2013 2012 Change Change % Change Change % Student Enrollments 32,625 31,619 31,830 1,006 3.2 % (211 ) -0.7 % Semester Course Enrollments 89,630 84,642 83,519 4,988 5.9 % 1,123 1.3 % Revenue by Business Lines Revenue is captured by business line based on the underlying customer contractual agreement. Periodically, a customer may change business line classification. For example, a district that purchases a single course (Institutional Sales customer) may decide to convert to a full-time virtual school program (Managed Public School customer). Changes in business line classification occur at the time the contractual agreement is modified. The following represents our revenue for our three lines of business for each of the last three fiscal years. Year Ended June 30, Growth 2014 / 2013 Growth 2013 / 2012 (Dollars in thousands) 2014 2013 2012 Change Change % Change Change % Managed Public Schools $ 804,469 $ 730,800 $ 596,142 $ 73,669 10.1 % $ 134,658 22.6 % Institutional Business 66,765 73,269 73,150 (6,504 ) -8.9 % 119 0.2 % International and Private Pay Business 48,319 44,151 39,115 4,168 9.4 % 5,036 12.9 % Total $ 919,553 $ 848,220 $ 708,407 $ 71,333 8.4 % $ 139,813 19.7 % 73 -------------------------------------------------------------------------------- Table of Contents The following table sets forth statements of operations data and the amounts as a percentage of revenues for each of the periods indicated: Year Ended June 30, 2014 2013 2012 (Dollars in thousands) Revenues $ 919,553 100.0 % $ 848,220 100.0 % $ 708,407 100.0 % Cost and expenses Instructional costs and services 569,219 61.9 % 498,398 58.7 % 408,560 57.7 % Selling, administrative and other operating expenses 313,258 34.1 % 283,032 33.4 % 245,274 34.6 % Product development expenses 14,220 1.5 % 21,084 2.5 % 25,593 3.6 % Total costs and expenses 896,697 97.5 % 802,514 94.6 % 679,427 95.9 % Income from operations 22,856 2.5 % 45,706 5.4 % 28,980 4.1 % Realized gain on sale of assets 6,404 0.7 % - 0.0 % - 0.0 % Interest income (expense), net (69 ) 0.0 % 851 0.1 % (989 ) -0.1 % Income before income tax expense and noncontrolling interest 29,191 3.2 % 46,557 5.5 % 27,991 4.0 % Income tax expense (11,075 ) -1.2 % (20,023 ) -2.4 % (11,882 ) -1.7 % Net income 18,116 2.0 % 26,534 3.1 % 16,109 2.3 % Add net loss attributable to noncontrolling interest 1,484 0.1 % 1,577 0.2 % 1,434 0.2 % Net income attributable to common stockholders, including Series A stockholders $ 19,600 2.1 % $ 28,111 3.3 % $ 17,543 2.5 % Comparison of Years Ended June 30, 2014 and 2013 Revenues. Our revenues for the year ended June 30, 2014 were $919.6 million, representing an increase of $71.4 million or 8.4%, as compared to $848.2 million for the year ended June 30, 2013. Our revenue growth was primarily attributable to an increase of $73.7 million, or 10.1%, in Managed Public Schools revenue, largely due to overall enrollment growth of 4.8% and increases in the per-pupil rate of achieved state funding in some states, other changes in state funding rates and higher utilization in federal and state restricted funding per managed student, and a $4.2 million increase in International and Private Pay revenue, partially as a result of strong growth in iCademy course enrollments. Institutional business revenue decreased $6.5 million, or 8.9%, from the prior year due to decreased volume and rates. Instructional Costs and Services Expenses. Instructional costs and services expenses for the year ended June 30, 2014 were $569.2 million, representing an increase of $70.8 million or 14.2%, as compared to $498.4 million for the prior fiscal year. Of the total increase, $18.6 million relates to accelerated depreciation and amortization during fiscal year 2014 for certain curriculum, learning systems and other fixed assets that will no longer be used or developed, computers that we estimate will not be returned and additional provisions for the decision to discontinue certain products and for excess inventory relative to anticipated demand. The remaining $52.2 million increase between periods related to increased salary and other personnel benefits to teachers, program and material costs due to enrollment growth. Instructional costs and services expenses were 61.9% of revenue during the year ended June 30, 2014; however excluding the impact of the accelerated depreciation and amortization, instructional costs and services were 59.9%, compared to 58.7% for the prior fiscal year. 74 -------------------------------------------------------------------------------- Table of Contents Selling, Administrative and Other Operating Expenses. Selling, administrative and other operating expenses for the year ended June 30, 2014 were $313.3 million, representing an increase of $30.3 million or 10.7%, as compared to $283.0 million for the prior fiscal year. Of the total increase, $7.4 million related to severance and accelerated stock compensation costs for the termination of employment of our former Chief Executive Officer and other employees, and $5.2 million related to an impairment charge on trade names that will no longer be used. The remainder of the increase related to increased headcount, professional fees and marketing costs, offset in part by reduced sales commissions. As a percentage of revenues, selling, administrative and other operating expenses were 34.1% for the year ended June 30, 2014; however excluding severance and accelerated amortization described above, selling, administrative and other expenses were 32.7% as a percentage of revenue, less than the 33.4% for prior fiscal year, reflecting our continued costs savings initiatives. Product Development Expenses. Product development expenses include costs related to new products and associated systems. Product development expenses for the year ended June 30, 2014 were $14.2 million, representing a decrease of $6.9 million or 32.7%, as compared to $21.1 million for the prior fiscal year. As a percentage of revenues, product development expenses decreased to 1.5% for the year ended June 30, 2014, as compared to 2.5% for the prior fiscal year due to a decrease in third-party professional fees supporting product development activities and our costs savings initiatives. Realized Gain on Sale of Assets. Realized gain on sale of assets for the year ended June 30, 2014 was $6.4 million, as compared to zero for the prior fiscal year. In June 2014, we completed a sale of select non-strategic businesses to Safanad Education Ventures Limited, including IS Berne, Capital Education, our post-secondary business, and our interest in our joint venture in the Middle East we operated with a Safanad Limited affliliate. Net Interest Income (Expense). Net interest expense for the year ended June 30, 2014 was $(0.1) million, as compared to net interest income of $0.9 million for the prior fiscal year. The change to net interest expense compared to net interest income in the prior fiscal year related primarily to a decrease of approximately $1.0 million in interest income related to our exercise of the put option on our investment in Web International Education Group, Ltd in fiscal year 2013, partially offset by interest expense related our capital leases and equipment financing arrangements. Income Taxes. Income tax expense for the year ended June 30, 2014 was $11.1 million, or 37.9% of income before taxes, as compared to an income tax expense of $20.0 million, or 43.0% of income before taxes, for the prior fiscal year. Our overall effective tax rate decreased from the prior year due to prior year favorable return to provision true-ups, providing for additional reserves related to the prior year tax positions and additional tax benefits related to research activities of the Company. Net Income. Net income was $18.1 million for the year ended June 30, 2014 compared to net income of $26.5 million for the year ended June 30, 2013, a decrease of $8.4 million, or 31.7%. Net income as a percentage of revenues decreased to 2.0% for the year ended June 30, 2014 as compared to 3.1% for the prior year, as a result of the factors discussed above. Noncontrolling Interest. Net loss attributable to noncontrolling interest for the years ended June 30, 2014 and 2013 was $1.5 million and $1.6 million, respectively. Noncontrolling interest reflects the after-tax losses attributable to shareholders in our joint ventures in the Middle East through the sale date and Middlebury Interactive Languages. Our noncontrolling interest fluctuates in proportion to the operating results of these respective joint ventures. 75-------------------------------------------------------------------------------- Table of Contents Comparison of Years Ended June 30, 2013 and 2012 Revenues. Our revenues for the year ended June 30, 2013 were $848.2 million, representing an increase of $139.8 million or 19.7%, as compared to $708.4 million for the year ended June 30, 2012. Our revenue growth was primarily attributable to an increase of $134.7 million in Managed Public Schools revenue, largely as the result of an increase in per pupil funding rates compared to the previous year; overall enrollment growth; and a $5.0 million increase in International and Private Pay revenue, partially as a result of strong growth in iCademy course enrollments. Revenue for the Managed Public Schools grew 22.6% year-over-year, while total average enrollment growth for Managed Public Schools students grew by 12.7%. Instructional Costs and Services Expenses. Instructional costs and services expenses for the year ended June 30, 2013 were $498.4 million, representing an increase of $89.8 million or 22.0%, as compared to $408.6 million for the prior fiscal year. The increase was primarily attributable to an increase in instructional and administrative costs of $80.2 million; an increase in materials and computers costs of $4.0 million; and an increase in amortization of curriculum and online learning systems of $4.4 million. Our instructional costs and services expenses grew in similar proportion to the growth in revenue as these generally are variable costs directly associated with student enrollments. As a percentage of revenues, instructional costs and services expenses increased slightly to 58.7% for the fiscal year ended June 30, 2013, as compared to 57.7% for the prior fiscal year. Selling, Administrative and Other Operating Expenses. Selling, administrative and other operating expenses for the year ended June 30, 2013 were $283.0 million, representing an increase of $37.7 million or 15.4%, as compared to $245.3 million for the prior fiscal year. This increase was principally attributable to an increase of $29.0 million in personnel costs primarily due to growth in headcount and an increase in marketing and advertising expenses. As a percentage of revenues, selling, administrative and other operating expenses decreased slightly to 33.4% for the year ended June 30, 2013 as compared to 34.6% for the prior fiscal year. Product Development Expenses. Product development expenses include costs related to new products and associated systems. Product development expenses for the year ended June 30, 2013 were $21.1 million, representing a decrease of $4.5 million or 17.6%, as compared to $25.6 million for the prior fiscal year. This decrease was primarily attributable to higher capitalization rates compared to the prior year and a decrease in system maintenance expenses. As a percentage of revenues, product development expenses decreased to 2.5% for the year ended June 30, 2013, as compared to 3.6% for the prior fiscal year. Net Interest Income (Expense). Net interest income for the year ended June 30, 2013 was $0.9 million, as compared to net interest expense of $1.0 million for the prior fiscal year. The change to net interest income compared to net interest expense in the prior fiscal year related to $2.0 million in interest income related to our exercise of the put option on our investment in Web International Education Group, Ltd. The interest income related to this transaction was partially offset by interest expense related our capital leases and equipment financing arrangements. Income Taxes. Income tax expense for the year ended June 30, 2013 was $20.0 million, or 43.0% of income before taxes, as compared to an income tax expense of $11.9 million, or 42.4% of income before taxes, for the prior fiscal year. Our overall effective tax rate increased from the prior year with 2013 reflecting an increase to the rate attributable to foreign operations. Net Income. Net income was $26.5 million for the year ended June 30, 2013 compared to net income of $16.1 million for the year ended June 30, 2012, an increase of $10.4 million, or 64.6%. Net income as a percentage of revenues increased to 3.1% for the year ended June 30, 2013 as compared to 2.3% for the prior year, as a result of the factors discussed above. 76-------------------------------------------------------------------------------- Table of Contents Noncontrolling Interest. Net loss attributable to noncontrolling interest for the years ended June 30, 2013 and 2012 was $1.6 million and $1.4 million, respectively. Noncontrolling interest reflects the after-tax losses attributable to shareholders in our joint ventures in the Middle East and Middlebury Interactive Languages. Our noncontrolling interest fluctuates in proportion to the operating results of these respective joint ventures. Discussion of Seasonality of Financial Condition Certain accounts in our balance sheet are subject to seasonal fluctuations. As our enrollments and revenues grow, we expect these seasonal trends to be amplified. The bulk of our materials are shipped to students prior to the beginning of the school year, usually in July or August. In order to prepare for the upcoming school year, we generally build up inventories during the fourth quarter of our fiscal year. Therefore, inventories tend to be at the highest levels at the end of our fiscal year. In the first quarter of our fiscal year, inventories tend to decline significantly as materials are shipped to students. In our fourth quarter, inventory purchases and the extent to which we utilize early payment discounts will impact the level of accounts payable. Accounts receivable balances tend to be at the highest levels in the first quarter of our fiscal year as we begin billing for all enrolled students and our billing arrangements include upfront fees for many of the elements of our offering. These upfront fees result in seasonal fluctuations to our deferred revenue balances. State education budgets, which remain under pressure due to the current economic environment and public school funding levels, including for the online public schools that we manage, have been reduced in many states over the past few years and even mid-year adjustments have occurred. We routinely monitor state legislative activity and regulatory proceedings that might impact the funding received by the schools we serve and to the extent possible, factor potential outcomes into our business planning decisions. Generally, deferred revenue balances related to the schools tend to be highest in the first quarter, when the majority of students enroll. Since the deferred revenue is amortized over the course of the school year, which typically ends in May or June, the balance is normally at its lowest at the end of our fiscal year. Generally, deferred revenues from virtual and blended public schools have not been a source of liquidity as most schools receive their funding over the course of the school year. The deferred revenue related to our direct-to-consumer business results from advance payments for twelve month subscriptions to our online school. These advance payments are amortized over the life of the subscription and tend to be highest at the end of the fourth quarter and first quarter, when the majority of subscriptions are sold. Liquidity and Capital Resources As of June 30, 2014, we had net working capital, or current assets minus current liabilities, of $351.4 million. Our working capital includes cash and cash equivalents of $196.1 million, including $2.4 million associated with our joint venture, and net accounts receivable of $194.7 million. Our working capital provides a significant source of liquidity for our normal operating needs. Our accounts receivable balance fluctuates throughout the fiscal year based on the timing of customer billings and collections and tends to be highest in the first fiscal quarter as we begin billing for students. In addition, our cash and accounts receivable were significantly in excess of our accounts payable and short-term accrued liabilities at June 30, 2014. We had a $35.0 million unsecured line of credit that expired on December 31, 2013 with PNC Bank, N.A., or PNC, for general corporate operating purposes. On January 31, 2014, we executed a $100.0 million unsecured line of credit to be used for general corporate operating purposes with Bank of America, N.A. ("BOA"). The line has a five-year term, bears interest at the higher of the Bank's prime rate, or the Federal Funds Rates plus 0.50%, or the LIBOR rate plus 1.00% and incorporates customary financial and other covenants, including but not limited to a maximum debt leverage and a minimum fixed 77-------------------------------------------------------------------------------- Table of Contents charge coverage ratio. As of June 30, 2014, we were in compliance with these covenants and we had no borrowings outstanding on the line of credit. We incur capital lease obligations for student computers under a lease line of credit with PNC Equipment Finance, LLC with annual lease availability limits. We have $35.0 million of availability for new leasing during fiscal year 2015. This availability expires in July 2015 and interest rates on the new borrowings are based upon an initial rate of 2.34% modified by changes in the three year interest rate swaps rate as published in the Federal Reserve Statistical Release H.15, "Selected Interest Rates," between June 25, 2014 and the Lease Commencement Date, as defined in the lease line of credit. As of June 30, 2014, the aggregate outstanding balance under the lease lines of credit was $36.9 million. Borrowings bore interest at rates ranging from 2.52% to 3.08% and included a 36-month payment term with a $1 purchase option at the end of the term. We have pledged the assets financed to secure the outstanding leases. We may extend our lease line of credit for additional periods, or consider alternative arrangements for financing student computers. On November 4, 2013, the Board of Directors authorized the repurchase of up to $75.0 million of our outstanding common stock over a two year period. Any purchases under this buyback are dependent upon business and market conditions and other factors. The stock purchases may be made from time to time and may be made through a variety of methods including open market purchases and trading plans that may be adopted in accordance with the Rule 10b5-1 of the Exchange Act. During the fiscal year ended June 30, 2014, cumulative stock repurchases totaled $48.5 million resulting in remaining availability of $26.5 million for shares to be purchased under the plan. Our cash requirements consist primarily of day-to-day operating expenses, capital expenditures and contractual obligations with respect to office facility leases, capital equipment leases and other operating leases. We expect to make future payments on existing leases from cash generated from operations. We believe that the combination of funds to be generated from operations, net working capital on hand and access to our line of credit will be adequate to finance our ongoing operations for the foreseeable future. In addition, to a lesser degree, we continue to explore acquisitions, strategic investments and joint ventures related to our business that we may acquire using cash, stock, debt, contribution of assets or a combination thereof. Operating Activities Net cash provided by operating activities for the years ended June 30, 2014, 2013 and 2012 was $123.5 million, $95.3 million and $33.0 million, respectively. Net cash provided by operating activities for the year ended June 30, 2014 was $123.5 million compared to $95.3 million for the year ended June 30, 2013. The $28.2 million improvement in cash flow from operations between periods was attributable primarily to increased accounts receivable collections and less investment in inventory during the year ended June 30, 2014 than during the prior year. Cash from operations is impacted by the timing of cash collections from products and services provided and payment of operating costs to fund the continued growth and expansion of our business. Net cash provided by operating activities for the year ended June 30, 2013 was $95.3 million compared to $33.0 million for the year ended June 30, 2012. The $62.3 million improvement in cash flow from operations between periods was attributable to higher net income excluding non-cash items, increased cash collections from accounts receivable and less investment in working capital during the year ended June 30, 2013 than during the prior year. These cash collections relate to accounts receivable that increased during fiscal year 2012 from state funding delays to certain of our managed public schools. Cash from operations is impacted by the timing of cash collections from products and services provided and payment of operating costs to fund the continued growth and expansion of our business. 78-------------------------------------------------------------------------------- Table of Contents Investing Activities Net cash used in investing activities for the years ended June 30, 2014, 2013 and 2012 was $45.8 million, $50.3 million and $61.2 million, respectively. Net cash used in investing activities for the year ended June 30, 2014 decreased $4.5 million from 2013. This decrease was a result of cash received of $5.7 million related to a sale of assets and a net decrease of approximately $1.0 million in net capital expenditures for other property and equipment, capitalized software and curriculum development, offset in part by a note made to a managed school partner of $2.1 million. Net cash used in investing activities for the year ended June 30, 2013 decreased $10.9 million from 2012. The year ended June 30, 2012 included the payment of $12.6 million for the purchase of the Kaplan/Insight Assets, which is the primary reason for the net decrease in fiscal year 2013. This decrease was partially offset by a net increase in capital expenditures approximating $1.7 million for capitalized software, curriculum development and other property and equipment. Net cash used in investing activities for the year ended June 30, 2012 was primarily due to investment of $32.5 million in property and equipment, including internally developed and purchased software, investment in capitalized curriculum of $16.1 million, primarily related to the production of high school courses and elementary school math courses and the purchase of the Kaplan/Insight Assets for $12.6 million. Financing Activities Net cash used in financing activities for the years ended June 30, 2014, 2013 and 2012 was $64.0 million, $8.2 million and $19.8 million, respectively. For the year ended June 30, 2014, our primary uses of cash in financing activities were the purchase of treasury stock and the payment of capital lease obligations incurred for the acquisition of student computers. For the year ended June 30, 2014, the Company purchased treasury stock which totaled approximately $48.5 million. The Company made no treasury stock purchases during the year ended June 30, 2013. Our cash payments for capital leases increased approximately $2.4 million due to increased purchases of student computers financed under capital leases. In addition, the year ended June 30, 2014 included a reduction of $7.8 million in the excess tax benefit from stock based compensation. The year ended June 30, 2014 included approximately $3.0 million more in proceeds from the exercise of stock options than the year ended June 30, 2013, which partially offset the increased uses noted above. The timing of cash from the exercise of options impacts our net cash used in financing activities. For the year ended June 30, 2013, net cash used in financing activities consisted primarily of payments on capital leases totaling $21.8 million and the repurchase of restricted stock for income tax withholding of $2.5 million, partially offset by proceeds from the exercise of stock options of $7.3 million and excess tax benefit from stock-based compensation expense of $8.9 million. Our cash payments for capital leases increased $3.7 million between periods resulting from increased purchases of student computers financed under capital leases. The timing of cash from the exercise of options impacts our net cash used in financing activities. For the year ended June 30, 2012, net cash used in financing activities consisted primarily of payments on capital leases and software financing arrangements totaling $18.4 million and excess tax expense from stock-based compensation expense of $3.1 million, partially offset by proceeds from the exercise of stock options of $3.4 million. 79-------------------------------------------------------------------------------- Table of Contents Contractual Obligations Our contractual obligations consist primarily of leases for office space, capital leases for equipment and other operating leases. The following summarizes our long-term contractual obligations as of June 30, 2014, which decreased from $94.4 million as of June 30, 2013: Year Ending June 30, Total 2015 2016 2017 2018 2019 Thereafter (In thousands) Contractual obligations at June 30, 2014 Capital leases(1) $ 38,003 $ 21,217 $ 12,021 $ 4,765 $ - $ - $ - Operating leases 55,186 7,910 7,599 7,291 7,199 7,243 17,944 Total $ 93,189 $ 29,127 $ 19,620 $ 12,056 $ 7,199 $ 7,243 $ 17,944 -------------------------------------------------------------------------------- º (1) º Includes interest expense. For the schools to which we provide turn-key management services, we typically take responsibility for any school operating losses that the school may incur. These individual school operating losses, if they occur, are recorded at the time as a reduction in revenues. Potential school operating losses are not included as a commitment or obligation in the above table as they cannot be determined at this time and many not even occur. Off-Balance Sheet Arrangements We have provided guarantees of approximately $8.5 million related to lease commitments on the buildings for certain of our Flex schools. We contractually guarantee that certain schools under our management will not have annual operating deficits and our management fees from these schools may be reduced accordingly to cover any school operating deficits. Other than these lease and operating deficit guarantees, we do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Impact of Inflation We believe that inflation has not had a material impact on our results of operations for any of the years in the three year period ended June 30, 2014. We cannot be sure that future inflation will not have an adverse impact on our operating results and financial condition. Recent Accounting Pronouncements In February 2013, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2013-02, Reporting of Amounts Reclassified out of Accumulated Other Comprehensive Income, which is included in Accounting Standards Codification ("ASC") 220, Comprehensive Income. This update improves the reporting of reclassifications out of accumulated other comprehensive income. The guidance was effective for the Company's interim and annual reporting periods beginning January 1, 2013, and applied prospectively. The adoption of this guidance in the Company's fiscal year 2014 did not have a material impact on the Company's financial condition, results of operations, cash flows or disclosures. In April 2014, the FASB issued ASU 2014-08, Reporting Discontinued Operations and Disclosures of Components of an Entity, which updates the definition of discontinued operations from current US GAAP. Going forward only those disposals of components of an entity that represent a strategic shift that has (or will have) a major effect on an entity's operations and financial results will be reported as discontinued operations in the financial statements. Currently, a component of an entity that is a reportable segment, an 80-------------------------------------------------------------------------------- Table of Contents operating segment, a reporting unit, a subsidiary, or an asset group is eligible for discontinued operations presentation. Additionally, the existing condition that the entity will not have any significant continuing involvement in the operations of the component after the disposal transaction has been removed. The effective date for the revised standard is for applicable transactions that occur within annual periods beginning on or after December 15, 2014. Early adoption is permitted, but only for disposals (or classifications as held for sale) that have not been reported in financial statements previously issued or available for issuance. The Company adopted this standard in the fourth quarter of fiscal 2014. This resulted in the presentation of historical results of our sold business assets as normal operations in fiscal year 2014, and a one-time gain of $6.4 million being recognized outside of operating income upon the sale of the business in fiscal year 2014. In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which supersedes nearly all existing revenue recognition guidance under US GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The standard is effective for annual periods beginning after December 15, 2016, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). The Company is currently evaluating the impact of our pending adoption of ASU 2014-09 on our consolidated financial statements and has not yet determined the method by which we will adopt the standard in 2017. 81-------------------------------------------------------------------------------- Table of Contents |