UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

Commission File Number: 001-33883

 

K12 Inc.

(Exact name of registrant as specified in its charter)

 

 

(703) 483-7000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

As of February 4, 2010, the Registrant had 31,296,158 shares of Common Stock, $0.0001 par value outstanding.

 

 

K12 Inc.

 

Form 10-Q

 

For the Quarterly Period Ended December 31, 2010

 

Index

 

 

 

K12 INC.

 

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

 

 

See notes to unaudited condensed consolidated financial statements.

K12 INC.

 

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

See notes to unaudited condensed consolidated financial statements.

K12 INC.

 

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF EQUITY

 

 

 

 

See notes to unaudited condensed consolidated financial statements.

K12 INC.

 

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

See notes to unaudited condensed consolidated financial statements.

K12 Inc.

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

 

K12 Inc. and its subsidiaries (K12 or the Company) are technology-based education companies. The Company offers proprietary curriculum and educational services created for individualized learning for students in kindergarten through 12th grade, or K-12. The K12 proprietary curriculum is research-based and combines content with innovative technology to allow students with a wide spectrum of learning styles to receive an effective and engaging education regardless of geographic location or socio-economic background. This learning system combines a cognitive research-based curriculum with an individualized learning approach well-suited for virtual public schools, online school district-wide programs, public charter schools, hybrid programs and private schools that combine varying degrees of online and traditional classroom instruction, and other educational applications.

 

The Company delivers its learning system to students primarily through virtual public schools and is building an institutional business with sales directly to school districts. The Company offers its proprietary curriculum, learning kits, use of a personal computer, online learning platform and varying levels of academic and management services, which can range from targeted programs to complete turnkey solutions.

 

As of December 31, 2010, the Company served virtual public schools or hybrid schools in 27 states and the District of Columbia. The Company expanded into two new states in fiscal year 2011, Massachusetts and Michigan. In addition, the Company operates an online private school, the K12 International Academy, and also sells access to its on-line curriculum and learning kits directly to individual consumers.

 

In April 2010, the Company formed a joint venture with Middlebury College known as Middlebury Interactive Languages LLC (MIL) to develop online foreign language courses. This new venture will create online language programs for pre-college students and will leverage Middlebury’s recognized experience in foreign language instruction and K12’s expertise in online education. In July 2010, the Company acquired all of the stock of KC Distance Learning, Inc. (KCDL), a provider of online curriculum and public and private virtual education. On December 1, 2010, the Company acquired American Education Corporation (AEC), a leading provider of research-based core curriculum instructional software for kindergarten through adult learners. These acquisitions and the formation of MIL increase K12’s portfolio of innovative, high quality instructional and curriculum offerings.

 

 

The accompanying condensed consolidated balance sheet as of December 31, 2010, the condensed consolidated statements of operations for the three and six months ended December 31, 2010 and 2009, the condensed consolidated statements of cash flows for the six months ended December 31, 2010 and 2009, and the condensed consolidated statements of equity for the six months ended December 31, 2010 are unaudited. The unaudited interim financial statements have been prepared on the same basis as the annual financial statements and in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position as of December 31, 2010, the results of operations for the three and six months ended December 31, 2010 and 2009, cash flows for the six months ended December 31, 2010 and 2009 and the condensed consolidated statements of equity for the six months ended December 31, 2010. The results of the three and six month period ended December 31, 2010 are not necessarily indicative of the results to be expected for the year ending June 30, 2011 or for any other interim period or for any other future fiscal year. The consolidated balance sheet as of June 30, 2010 has been derived from the audited consolidated financial statements at that date.

 

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X of the Securities Exchange Act of 1934, as amended (“Exchange Act”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, these statements include all adjustments (consisting of normal recurring adjustments) considered necessary to present a fair statement of our consolidated results of operations, financial position and cash flows. Preparation of the Company’s financial

K12 Inc.

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts in the financial statements and footnotes. Actual results could differ from those estimates. This quarterly report on Form 10-Q should be read in conjunction with the financial statements and the notes thereto included in the Company’s latest annual report on Form 10-K filed on September 13, 2010, which contains the Company’s audited financial statements for the fiscal year ended June 30, 2010.

 

 

Revenue Recognition

 

Revenues are principally earned from long-term contractual agreements to provide on-line curriculum, books, materials, computers and management services to public charter schools and school districts. In addition to providing the curriculum, books and materials, under most contracts, the Company is responsible to the virtual public schools for all aspects of school management, including monitoring academic achievement, teacher hiring and training, compensation of school personnel, financial management, enrollment processing and procurement of curriculum, equipment and required services. The schools generally receive funding on a per student basis from the state in which the public school or school district is located.

 

Where the Company has determined that it is the primary obligor for substantially all expenses under these contracts, it records the associated per student revenue received by the school from its state funding up to the expenses incurred in accordance with ASC 605 (formerly Emerging Issues Task Force (EITF) 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent). For contracts in which the Company is not the primary obligor, the Company records revenue based on its net fees earned per the contractual agreement.

 

The Company generates revenues under contracts with virtual public schools which include multiple elements. These elements include: providing each of a school’s students with access to the Company’s on-line school and the on-line component of lessons; learning kits which include books and materials designed to complement and supplement the on-line lessons; use of a personal computer and associated reclamation services; internet access and technology support services; instruction from a state-certified teacher and; all management and technology services required to operate a virtual public school.

 

The Company has determined that the elements of our contracts are valuable to schools in combination, but do not have standalone value. While we have sold some of these elements in various combinations or bundles to schools and school districts, the value of each element across these combinations is indeterminable and we have concluded that we do not have sufficient objective and reliable evidence of fair value for each element. As a result, the elements within our multiple-element contracts do not qualify for treatment as separate units of accounting. Accordingly, the Company accounts for revenues received under multiple element arrangements as a single unit of accounting and recognizes the entire arrangement based upon the approximate rate at which we incur the costs associated with each element. In certain schools where the Company has a direct relationship with the state funding school district, the Company recognizes the associated per student revenue on a pro-rata basis over the school year.

 

Under the contracts with the schools where the Company provides turnkey management services, 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 over revenues incurred by the virtual public schools as reflected on their financial statements. The costs include Company charges to the schools. These school operating losses may reduce the Company’s ability to collect invoices in full. Accordingly, the Company’s amount of recognized revenue reflects this reduction.

 

Other revenues are generated from individual customers who prepay and have access for 12 or 24 months to curriculum via the Company’s online learning system. The Company recognizes these revenues pro rata over the maximum term of the customer contract, which is either 12 or 24 months. Revenues from associated learning kits are recognized upon shipment.

K12 Inc.

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

Consolidation

 

The condensed consolidated financial statements include the accounts of the Company, its wholly-owned and affiliated companies, either owned directly or indirectly, and all controlled subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.

 

Reclassifications

 

Certain prior year amounts related to capitalized software development costs and other long term liabilities have been reclassified to conform to the current year presentation.

 

Series A Special Stock

 

Equity that is redeemable upon occurrence of an event outside the Company’s control should be classified outside of permanent equity per ASC 480, Distinguishing Liabilities from Equity. The Series A Special Stock as described further in Note 11, is considered redeemable outside of the Company’s control and classified separately outside of permanent equity. At a Special Meeting of Shareholders held on January 27, 2011, the right to convert the Series A Special Stock to Common Stock was approved by shareholders. As a consequence, the right of redemption is no longer effective and the shares will be classified within stockholders’ equity in the consolidated balance sheet in subsequent financial statements.

 

Goodwill and Intangibles

 

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 in accordance with ASU Topic 350. Finite-lived intangible assets include trade names, customer relationships and non-compete agreements. Such intangible assets are amortized on a straight-line basis over their estimated useful lives.

 

In accordance with ASC 360 Accounting for the Impairment or Disposal of Long-Lived Assets, the Company reviews its recorded finite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. 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.

 

ASC 350 Goodwill and Other Intangible Assets, prescribes a two-step process for impairment testing of goodwill and intangibles with indefinite lives, which is performed annually, as well as when an event triggering impairment may have occurred. The first step tests for impairment, while the second step, if necessary, measures the impairment. Goodwill and intangible assets deemed to have an indefinite life are tested for impairment on an annual basis, or earlier when events or changes in circumstances suggest the carrying amount may not be fully recoverable. The Company has elected to perform its annual assessment on May 31st.

 

Fair Value Measurements

 

The carrying values reflected in our consolidated balance sheets for cash and cash equivalents, receivables, and short and long term debt approximate their fair values.

 

The following table summarizes certain fair value information at June 30, 2010 for assets and liabilities measured at fair value on a recurring basis. The redeemable noncontrolling interest is a result of the Company’s venture with Middlebury College to form a new entity, Middlebury Interactive Languages. Under the agreement, Middlebury College has an irrevocable election to sell all (but not less than all) of its Membership Interest to the

K12 Inc.

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

Company (“put right”) after May 1, 2015.  The fair value of the redeemable noncontrolling interest reflects management’s best estimate of the redemption value of the put right.

 

 

The following table summarizes certain fair value information at December 31, 2010 for assets and liabilities measured at fair value on a recurring basis.

 

 

The following table presents activity related to our fair value measurements categorized as Level 3 of the valuation hierarchy, valued on a recurring basis, for the six months ended December 31, 2010. There have been no transfers in or out of Level 3 of the hierarchy for the period presented.

 

 

The fair value of the redeemable noncontrolling interest as of December 31, 2010 was estimated to be $20.8 million. The fair value was measured in accordance with ASC 480, Distinguishing Liabilities from Equity, and initial valuations were determined by a third party valuation firm and updated by management for the current period. In determining the fair value of the redeemable noncontrolling interest, the Company incorporated a number of assumptions and estimates including utilizing various valuation methodologies including an income-based approach.

 

Net Income Per Common Share

 

Basic earnings per share is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock outstanding during the period. The weighted average number of shares of common stock outstanding includes vested restricted stock awards. Diluted earnings per share reflects the potential dilution that could occur assuming conversion or exercise of all dilutive unexercised stock options, unvested restricted stock awards and warrants. The dilutive effect of stock options, restricted stock awards, and warrants was determined using the treasury stock method. Under the treasury stock method, the proceeds received

K12 Inc.

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

from the exercise of stock options and restricted stock awards, the amount of compensation cost for future service not yet recognized by the Company, and the amount of tax benefits that would be recorded in additional paid-in capital when the stock options and restricted stock awards become deductible for income tax purposes are all assumed to be used to repurchase shares of the Company’s common stock. Stock options and restricted stock awards are not included in the computation of diluted earnings per share when they are antidilutive. Common stock outstanding reflected in our condensed consolidated balance sheet includes restricted stock awards outstanding.

 

Securities that may participate in undistributed earnings with common stock are considered participating securities. Since the Series A Shares participate in all dividends and distributions declared or paid on or with respect to common stock of the Company (as if a holder of common stock), the Series A Shares meet the definition of participating security under ASC 260, Participating Securities and the Two-Class Method under FASB Statement No. 128. All securities that meet the definition of a participating security, regardless of whether the securities are convertible, non-convertible, or potential common stock securities, are included in the computation of both basic and diluted EPS (as a reduction of the numerator) using the two-class method. Under the two-class method all undistributed earnings in a period are to be allocated to common stock and participating securities to the extent that each security may share in earnings as if all of the earnings for the period had been distributed.

K12 Inc.

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

The following schedule presents the calculation of basic and diluted net income per share:

 

 

Recent Accounting Pronouncements

 

In June 2009, the FASB issued an amendment to ASC 810, Consolidation, which modifies how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. ASC 810 clarifies that the determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. ASC 810 requires an ongoing reassessment of whether a company is the primary beneficiary of a variable interest entity. ASC 810 also requires additional disclosures about a company’s involvement in variable interest entities and any significant changes in risk exposure due to that involvement. ASC 810 is effective for fiscal years beginning after November 15, 2009 and is effective for the Company on July 1, 2010. The adoption of the policy did not have a material impact on our condensed consolidated financial statements.

 

In October 2009, the FASB issued ASU 2009-13, Multiple-Deliverable Revenue Arrangements, a consensus of the FASB Emerging Issues Task Force. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration and the use of the relative selling price

K12 Inc.

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

method is required. The new guidance eliminated the residual method of allocating arrangement consideration to deliverables and includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. ASU 2009-13 is effective for revenue arrangements entered into or materially modified in fiscal years beginning after June 15, 2010. ASU 2009-13 is effective for the Company on July 1, 2010. The adoption did not have a material impact on our condensed consolidated financial statements.

 

In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures, which requires new disclosures for transfers in and out of Level 1 and Level 2 and activity in Level 3 of the fair value hierarchy. ASU 2010-06 requires separate disclosure of the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and a description of the reasons for the transfers. In the reconciliation for fair value measurements using Level 3 inputs, a reporting entity should present separately information about purchases, sales, issuances and settlements. ASU 2010-06 is effective for new disclosures and clarification of existing disclosures for interim and annual periods beginning after December 15, 2009 except for disclosures about purchases, sales, issuances and settlements in the Level 3 activity rollfoward. The provisions of ASU 2010-06 related to new disclosures and clarification of existing disclosures was adopted by the Company beginning January 1, 2010. As ASU 2010-06 relates only to disclosure, the adoption of these provisions did not have a material impact on its financial condition, results of operations, and disclosures. The provisions of ASU 2010-06 related to Level 3 rollforward activity are effective for fiscal years beginning after December 31, 2010 and will be effective for the Company on July 1, 2011. The Company is currently evaluating the impact that the adoption of ASU 2010-06 will have on our financial condition, results of operations, and disclosures.

 

 

The provision for income taxes is based on earnings reported in the condensed consolidated financial statements. A deferred income tax asset or liability is determined by applying currently enacted tax laws and rates to the expected reversal of the cumulative temporary differences between the carrying value of assets and liabilities for financial statement and income tax purposes. Deferred income tax expense is measured by the change in the deferred income tax asset or liability during the year.

 

 

Capital Leases

 

As of December 31 and June 30, 2010, computer equipment and software under capital leases are recorded at a cost of $44.3 million and $38.8 million, respectively and accumulated depreciation of $21.6 million and $22.9 million, respectively. The Company’s equipment lease line of credit with Hewlett-Packard Financial Services Company (“HPFSC”) expired on August 31, 2010. Prior borrowings under the HPFSC equipment lease line had interest rates ranging from 4.96% to 7.7% and included a 36-month payment term with a $1 purchase option at the end of the term. The Company had pledged the assets financed with the HPFSC equipment lease line to secure the amounts outstanding. The Company entered into a guaranty agreement with HPFSC to guarantee the obligations under this equipment lease and financing agreement.

 

The Company has an equipment lease line of credit with PNC Equipment Finance, LLC effective August 2010 for new purchases. Availability for additional purchases terminates on March 31, 2011. We expect to renew this line of credit, obtain additional financing from other providers or use cash on hand for future purchases. The interest rate on new advances under the PNC equipment lease line is set at the time the funds are advanced based upon interest rates in the Federal Reserve Statistical Release H.15. Borrowings under the equipment lease line had interest rates of 3.0% and include a 36-month payment term with a $1 purchase option at the end of the term.

K12 Inc.

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

Notes Payable

 

The Company has purchased computer software licenses and maintenance services through notes payable arrangements with various vendors at interest rates ranging up to 6.1% and payment terms of three years. The balance of notes payable at December 31, and June 30, 2010 was $1.0 million and $1.9 million, respectively.

 

The following is a summary as of December 31, 2010 of the present value of the net minimum payments on capital leases and notes payable under the Company’s commitments:

 

 

 

The Company has a $35 million line of credit with PNC Bank that expires in December 2012. As of December 31, 2010 and June 30, 2010, there was $15 million and zero outstanding on the line of credit, respectively. As of December 31, 2010, borrowings on the line of credit had an interest rate of 1.8%.

 

 

Stock Options

 

Stock option activity during the six months ended December 31, 2010 was as follows:

 

 

The total intrinsic value of options exercised during the six months ended December 31, 2010 was $5.1 million or $16.65 per share.

K12 Inc.

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

The following table summarizes the option grant activity for the six months ended December 31, 2010. There were no new grants during the second quarter.

 

 

As of December 31, 2010, there was $6.4 million of total unrecognized compensation expense related to unvested stock options granted. The cost is expected to be recognized over a weighted average period of 2.65 years. During the six months ended December 31, 2010 and December 31, 2009, the Company recognized $2.6 million and $3.1 million, respectively of stock based compensation expense related to stock options.

 

Restricted Stock Awards

 

Restricted stock award activity during the six months ended December 31, 2010 was as follows:

 

 

As of December 31, 2010, there was $8.6 million of total unrecognized compensation expense related to unvested restricted stock awards granted. The cost is expected to be recognized over a weighted average period of 2.79 years. The total fair value of shares vested during the six months ended December 31, 2010 was $2.2 million. During the six months ended December 31, 2010 and December 31, 2009, the Company recognized $2.8 million and $0.4 million, respectively of stock based compensation expense related to restricted stock awards.

 

 

In the second quarter, the Company purchased services and assets in the amount $0.4 million from Knowledge Universe Technologies (KUT). KUT is an affiliate of the Learning Group, LLC a related party. Additionally, KC Distance Learning has capital leases with an outstanding balance due to KCDL Holdings Inc. in the amount of $0.9 million as of December 31, 2010.

 

 

Litigation

 

In the ordinary conduct of business, the Company is subject to lawsuits, arbitrations and administrative proceedings from time to time. The Company expenses legal costs as incurred.

 

Aventa Learning

 

In June 2010, the shareholders of Aventa Learning, Inc. (Aventa) filed a lawsuit against KC Distance Learning, Inc. which is currently pending in the U.S. District Court for the Western District of Washington, Axtman et al. v. KC Distance Learning, Inc. (Case No. 2:10-cv-01022-JLR). The lawsuit alleges, among other things, that KCDL did not honor the terms of an earn-out provision contained in an asset purchase agreement after certain assets of Aventa

K12 Inc.

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

were acquired by KCDL in 2007. In addition, the plaintiffs allege breach of contract and misrepresentation claims, and seek the remedy of rescission for alleged violation of the Securities Act of Washington. On July 23, 2010, the Company acquired all of the shares of KCDL, which is now a wholly-owned subsidiary. On August 31, 2010, the plaintiffs amended their complaint to add K12 Inc. as a co-defendant in this matter, reflecting the change in ownership. On October 4, 2010, defendants filed a motion to dismiss plaintiff’s amended complaint. Pursuant to the Agreement and Plan of Merger between K12 Inc. and KCDL Holdings LLC (Seller), Seller agreed to assume responsibility to defend this lawsuit and to fully indemnify K12 Inc. for any liability, including rescission. In addition, K12 Inc. obtained a guarantee from Seller’s parent company, Learning Group LLC, from any losses related to this litigation. In our view, the outcome of this litigation will not have a material adverse effect on the financial condition or results of operations of K12 Inc. or any of our subsidiaries.

 

 

During the six months ended December 31, 2010, the Company’s goodwill increased by approximately $51.7 million due primarily to the acquisitions of KC Distance Learning, Inc. and American Education Corporation (see Note 11). The Company did not experience a significant adverse change in its business climate and therefore does not believe a triggering event occurred that would require a detailed test of goodwill for impairment as of an interim date. Consequently, the first step of the goodwill impairment test will not be performed during the second quarter of 2011. The Company will complete its annual goodwill impairment test as of May 31, 2011.

 

 

KC Distance Learning, Inc.

 

On July 23, 2010, the Company acquired all of the stock of KCDL, a provider of online curriculum and public and private virtual education, by issuing to its parent company, KCDL Holdings LLC, 2,750,000 shares of a new class of stock designated as Series A Special Stock, which had a value at closing of $63.1 million. KCDL Holdings, Inc. is an affiliate of the Learning Group, LLC, a related party. The holders of the Series A Special Stock initially had no voting rights and no rights of conversion with respect to those shares; however, the holders had and continue to have participating rights in all dividends and distributions declared or paid on or with respects to common stock of the Company.

 

On December 23, 2010, the Company filed a definitive proxy statement with the Securities and Exchange Commission (SEC) for the stockholder vote. On January 27, 2011, the Company held a Special Meeting at which the stockholders approved conversion and voting rights for the holders of the Series A Special Stock. The holders of the Series A Special Stock now have the right to convert those shares into common stock on a one-for-one basis and for the right to vote on all matters presented to K12 shareholders, other than for the election and removal of directors, for which holders of the Series A Special Stock shall have no voting rights. The redemption right of the holders of the Series A Special Stock terminated upon shareholder approval of their conversion and voting rights.

 

The KCDL businesses include: Aventa Learning (online curriculum and instruction), the iQ Academies (statewide virtual public charter schools for middle and high school); and The Keystone School (international online private school). K12 believes the acquisition of KCDL to be an important strategic step in the Company’s efforts to expand its presence in a number of end markets. The operating results of KCDL have been included in the Company’s condensed consolidated financial statements commencing as of the acquisition date of July 23, 2010. The acquisition of KCDL has been accounted for under the acquisition method of accounting which requires the total purchase price to be allocated to the assets acquired and liabilities assumed based on their estimated fair values. The fair values assigned to the assets acquired and liabilities assumed are based on valuations using management’s best estimates and assumptions. The allocation of the estimated consideration to the identifiable tangible and

K12 Inc.

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

intangible assets and liabilities assumed under the purchase method of accounting, is preliminary and based on their estimated fair values as of the acquisition date and summarized in the following table (in thousands):

 

 

 

The following unaudited pro forma combined results of operations give effect to the acquisition of KCDL as if it had occurred at the beginning of the periods presented. The unaudited pro forma combined results of operations are provided for informational purposes only and do not purport to represent K12’s actual consolidated results of operations had the acquisition occurred on the dates assumed, nor are these financial statements necessarily indicative of K12’s future consolidated results of operations . K12 expects to incur costs and realize benefits associated with integrating the operations of K12 and KCDL. The unaudited pro forma combined results of operations do not reflect the costs of any integration activities or any benefits that may result from operating efficiencies or revenue synergies.

 

K12 Inc.

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

American Education Corporation

 

On December 1, 2010, the Company acquired American Education Corporation (AEC), a leading provider of research-based core curriculum instructional software for kindergarten through adult learners, headquartered in Oklahoma City, OK, for a total cash purchase price of $35.2 million, including certain amounts held in escrow. The escrow amounts include $6.8 million for the achievement of specified financial targets for quarter-ended December 31, 2010. As of the current date, the Company does not expect any of this contingent consideration to be distributed to the selling AEC shareholders. Consequently, this escrow amount is recorded in other current assets. In connection with the acquisition, the Company recorded net Working Capital accounts of $2.9 million, net long term assets of $8.3 million, goodwill of approximately $15.8 million, intangible assets of approximately $4.5 million, and other long term liabilities and taxes payable of $3.1 million. The acquisition of AEC has been included in the Company’s results since the acquisition date of December 1, 2010. The allocation of the estimated consideration to the identifiable tangible and intangible assets and liabilities assumed under the purchase method of accounting is preliminary and based on their estimated fair values as of the acquisition date.

 

An additional amount of approximately $6.8 million is held in escrow and, if specified claims against AEC arise for which the Company is indemnified, such amounts may be used to satisfy those claims but not to exceed it. K12 is not entitled to any claims against the indemnification escrow amount unless and until the aggregate claim amount exceeds $250,000, at which time K12 is only entitled to reimbursement for any claims exceeding the $250,000 up to a maximum of $6.8 million. Any amounts remaining in escrow after the satisfaction of any such claims are to be paid to the selling AEC shareholders in two fifty percent installments of the remaining balance of the $6.8 million in the indemnification escrow, at 6 and 12 months after closing. At closing, the Company recognized a liability of $1 million relating to potential claims offset by a receivable from the escrow account of $750,000.

K12 Inc.

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

 

 

 

On January 3, 2011, K12 invested $10 million in Web International Education Group, Ltd. (Web). This strategic investment gives the Company a 20% minority interest in Web, with the option to acquire the remainder of Web within a period of five years. Web is a leader in English language training for learners of all ages throughout China, including university students, government workers, and employees of international companies. Web has a network of 72 learning centers in 47 cities. It currently serves more than 35,000 students. The proceeds of the investment will primarily be used to expand Web’s learning center network into more Chinese cities. As of December 31, 2010, the $10 million cash investment was in transit and recorded in long-term other assets.

 

On January 13, 2011, K12 announced a partnership with the George Washington University to launch an online private high school, the George Washington University Online High School (GWUOHS). The private school will serve students in the U.S. and in countries around the world. The program offers K12’s college preparatory curriculum and is designed for high school students who are seeking a challenging academic experience and aspire to attend top colleges and universities.

 

On January 27, 2011, shareholders approved the right of the holders of the Series A Special Stock to convert those shares into common stock on a one-for-one basis and for the right to vote on all matters presented to K12 shareholders, other than for the election and removal of directors, for which holders of the Series A Special Stock shall have no voting rights unless converted to common. In addition, the right of redemption is no longer effective.

 

Certain statements in Management’s Discussion and Analysis (MD&A), other than purely historical information, including estimates, projections, statements relating to our business plans, objectives, and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended (the Securities Act), and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act). These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. 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 our Annual Report on Form 10-K (Annual Report), including any updates found in Part II, Item 1A, “Risk Factors,” of this quarterly 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 condensed consolidated financial statements and related notes included in this report, as well as the consolidated financial statements and MD&A of our Annual Report. The following overview provides a summary of the sections included in our MD&A:

 

 

Executive Summary

 

We are a technology-based education company. We offer proprietary curriculum and educational services designed to facilitate individualized learning for students 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. Since our inception, we have invested more than $200 million to develop curriculum and an online learning platform that promotes mastery of core concepts and skills for students of all abilities. This learning system combines a cognitive research-based curriculum with an individualized learning approach well-suited for virtual public schools, online school district-wide programs, public charter schools, hybrid programs and private schools that combine varying degrees of online and traditional classroom instruction, and other educational applications.

 

We deliver our learning system to students primarily through virtual public schools and are building an institutional business with sales directly to school districts. Many states have embraced virtual public schools as a means to provide families with a publicly funded alternative to a traditional classroom-based education. We offer virtual schools our proprietary curriculum, online learning platform and varying levels of academic and management services, which can range from targeted programs to complete turnkey solutions. Additionally, without the requirement of a physical classroom, virtual schools can be scaled quickly to accommodate a large dispersed student population, and allow more capital resources to be allocated towards teaching, curriculum and technology rather than towards a physical infrastructure.

For the 2010-11 school year, we manage virtual public schools or hybrid schools in 27 states and the District of Columbia, including new schools in two new states, Massachusetts and Michigan. For the most part, these schools are able to enroll students on a statewide basis. Most of these enrollments are in virtual public schools. We are serving a growing number of hybrid schools the first of which opened in Chicago in 2006. A hybrid school is a virtual public school that combines the benefits of one or two days a week of face-to-face time for students and teachers in a traditional classroom setting along with the flexibility and individualized learning advantages of online instruction. In July 2010, we extended our involvement with traditional classroom settings to the full operational management of a brick and mortar school. Specifically, the Delaware Department of Education contracted with us to assume responsibility for all aspects of the operation of the Moyer Charter School, and authorized us to serve up to 460 students in grades 6-12. This contract furthers the use of our learning systems and instructional methods in a traditional classroom setting.

 

For the three months ended December 31, 2010, we served 98,296 total average enrollments, including the recently acquired Aventa, iQ, and Keystone programs, as compared to 68,519 for the same period in the prior year, a growth rate of 43.5%. For the three months ended December 31, 2010, excluding the newly acquired programs, total average enrollments in K12 programs increased to 83,318, as compared to 68,519 for the same period in the prior year, a growth rate of 21.6%. These enrollments include public and private school enrollments as well as those in the K12 International Academy. Enrollments from the Aventa, iQ, and Keystone for the three months ended December 31, 2010 were 14,978 and contributed 21.9% to enrollment growth. Enrollments exclude students in our direct-to-consumer and pilot programs and enrollments acquired with AEC.

 

We executed on our acquisition strategy this fiscal year and acquired KC Distance Learning and American Education Corporation and invested in Web International. With these additions, along with the recent formation of Middlebury Interactive Languages, we believe we have improved our growth potential and the ability to scale our business even further.

 

For the three months ended December 31, 2010, we increased revenues to $129.0 million from $93.3 million in the same period in the prior year, a growth rate of 38.4%. Over the same period, operating income declined to $14.2 million from operating income of $14.3 million, a decrease of 0.7%, and net income to shareholders declined to $7.8 million from net income to shareholders of $9.6 million, a decrease of 18.7%. The decline in operating income and net income was primarily attributable to: several new growth initiatives; increased depreciation and amortization including the impact of new curriculum releases, systems enhancements and the effects of purchase accounting; merger integration, financial systems and process improvement costs; and M&A transaction expenses.

 

Middlebury Interactive languages

 

In April 2010, we formed a joint venture with Middlebury College known as Middlebury Interactive Languages LLC (MIL) to develop online foreign language courses. This new venture will create innovative, online language programs for pre-college students and will leverage Middlebury’s recognized experience in foreign language instruction and K12’s expertise in online education. Language faculty from Middlebury will work with K12 to develop and manage the academic content of the Web-based language courses, which K12 will offer through its online education programs. The new courses will use features such as animation, music, videos and other elements that immerse students in new languages. The joint venture will also expand the Middlebury-Monterey Language Academy (MMLA), a language immersion summer program for middle and high school students. Our results for the six months ending December 31, 2010 include the summer 2010 four week residential session that offered Arabic, Chinese, French, German and Spanish at four college campuses. MMLA intends to expand to eight campuses for summer 2011.

 

Acquisition of KC Distance Learning

 

On July 23, 2010, we acquired all of the stock of KCDL, a provider of online curriculum and public and private virtual education, by issuing to its parent company, KCDL Holdings LLC, 2,750,000 shares of a new class of stock designated as Series A Special Stock, which had a value at closing of $63.1 million. KCDL Holdings, Inc. is an affiliate of the Learning Group, LLC, a related party. The holders of the Series A Special Stock initially had no

voting rights and no rights of conversion with respect to those shares; however, the holders had and still have participating rights in all dividends and distributions declared or paid on or with respects to our common stock.

 

On December 23, 2010, we filed a definitive proxy statement with the Securities and Exchange Commission (SEC) for the stockholder vote. On January 27, 2011, we held a Special Meeting at which the stockholders approved conversion and voting rights for the holders of the Series A Special Stock. The holders of the Series A Special Stock now have the right to convert those shares into common stock on a one-for-one basis and for the right to vote on all matters presented to K12 shareholders, other than for the election and removal of directors, for which the holders shall have no voting rights unless converted to common.

 

The KCDL businesses include: Aventa Learning (online curriculum and instruction), the iQ Academies (statewide virtual public charter schools for middle and high school); and The Keystone School (international online private school). Aventa Learning offers to schools and school districts over 140 core, elective and AP courses in grades 6-12, from credit recovery courses to full-scale virtual school programs, as well as instructional services. Aventa Learning is accredited by the Northwest Association of Accredited Schools (NAAS). The Keystone School is an online private school for middle and high school students, which is also accredited by the NAAS. It was established in 1974 and has served over 250,000 students from 84 countries. The school enrolls both full-time and part-time students and its course offerings are supported by certified teachers. The iQ Academies are statewide online public schools that partner with school districts or public charter schools to serve middle and high school students. iQ Academies currently operate in California, Kansas, Minnesota, Nevada, Texas, Washington, and Wisconsin.

 

Acquisition of American Education Corporation

 

On December 1, 2010, we acquired the operating assets and liabilities of American Education Corporation (AEC), a leading provider of research-based core curriculum instructional software for kindergarten through adult learners, headquartered in Oklahoma City, OK, for a total cash purchase price of $35.2 million, subject to certain adjustments. The acquisition increases our portfolio of innovative, high quality instructional and curriculum offerings to school districts all over the country. The purchase price includes $6.8 million held in escrow that selling AEC shareholders may receive based upon achievement of specified financial targets for the three months ended December 31, 2010. As of the current date, we do not expect any of this contingent consideration will be distributed to the selling AEC shareholders.

 

Web International

 

On January 3, 2011, we invested $10 million in cash in Web International Education Group Ltd. (“Web”). This strategic investment gives us a 20% minority interest in Web, with the option to acquire the remainder of the company within a period of five years. Web is a leader in English language training for learners of all ages throughout China, including university students, government workers, and employees of international companies. Web has a network of 72 learning centers in 47 cities. It currently serves more than 35,000 students. The proceeds of the investment will primarily be used to expand Web’s learning center network into more Chinese cities.

 

The George Washington University Online High School

 

On January 13, 2011, K12 announced a partnership with the George Washington University to launch an online private high school, the George Washington University Online High School (GWUOHS). The private school will serve students in the U.S. and in countries around the world. The program offers K12’s college preparatory curriculum and is designed for high school students who are seeking a challenging academic experience and aspire to attend top colleges and universities.

 

Developments in Education Funding

 

Our annual revenue growth is impacted by changes in federal, state and district per enrollment funding levels. Due to the budgetary problems arising from the economic recession, many states reduced per enrollment funding for public education affecting many of the virtual public schools we serve. While the American Recovery and

Reinvestment Act of 2009 (ARRA) has provided additional funds to states, it has not fully offset the state funding reductions. Thus, the net impact to funding was negative and had a negative effect on both revenue and income for our fiscal years 2009 and 2010. Our financial results reflect these reductions, ARRA funds, and expense reductions that we undertook in order to mitigate the impact of the funding reductions. In August 2010, the Education Jobs and Medicaid Assistance Act was enacted into law, providing $10 billion in federal aid for schools. This assistance will reach some of the schools we serve, although we cannot be certain of the aggregate impact. At this time, many states still have budget issues. The specific level of federal, state and district funding for the coming years is not yet known, and taken as a whole, it is possible the public schools we serve could experience lower per enrollment funding in the future.

 

Strategic Marketing and Student Recruiting Initiatives

 

We continue to pursue opportunities to open virtual public schools, hybrid schools, and classroom-based programs in additional states and are marketing our post-secondary curriculum offering under Capital Education. Our follow-on marketing and student recruiting spending plans to support the success of these business development efforts are based upon historical trends. If we are more successful than anticipated, we will invest incrementally in marketing and student recruiting to support future revenue growth. The nature and timing of these events may result in higher fourth fiscal quarter marketing expenses with the corresponding increase in revenue occurring in future periods.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions about future events that affect the amounts reported in our consolidated financial statements and accompanying notes. Future events and their effects cannot be determined with certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates, and any such differences may be material to our consolidated financial statements. Critical accounting policies are disclosed in our fiscal year 2010 audited consolidated financial statements, which are included in our Annual Report. Other than those described in the condensed consolidated financial statements, there have been no significant updates to our critical accounting policies disclosed in our Annual Report.

 

Results of Operations

 

Enrollment

 

Due to growth in our private school and institutional sales business, including the increasing number of students who enroll part-time or take a single course in these programs, we are including additional enrollment information for fiscal year 2011. We believe this information, combined with the existing virtual public school enrollment data, provides a more complete picture of the drivers of revenue.

 

Total average enrollments in public schools for the three months ended December 31, 2010, the metric previously reported, increased to 81,083, or 20.4%, as compared to 67,354 for the same period in the prior year. High school students comprised 25.9% of public school enrollment as compared to 21.6% in the same period in the prior year. New schools in Delaware, Massachusetts and Michigan contributed 1.2% to total average enrollment in public schools. With the acquisition of KCDL, we added 14,978 enrollments to the total.

 

Enrollment growth in K12 managed virtual public schools was 20.0%. Enrollment growth in online curriculum sales to public schools, school districts and other schools (institutional sales) was 22.5%. These enrollments exclude students in our direct-to-consumer and pilot programs.

 

Enrollments in K12 private schools for the three months ended December 31, 2010 increased 91.9% to 2,235 from 1,165 for the same period in the prior year. Private schools include the K12 International Academy as well as private brick and mortar schools. These private schools offer educational services on a full and part-time basis. For better comparability, enrollments reported are converted to full-time equivalents (FTEs).

 

For the three months ended December 31, 2010, enrollments in the Aventa, iQ, and Keystone School brands obtained through our acquisition of KC Distance Learning were 5,830, 3,128, and 6,020, respectively. These

programs serve students in grades 6-12 on a full and part-time basis. For better comparability, enrollments reported are converted to full-time equivalents (FTEs).

 

The following tables set forth average enrollment data for each of the periods indicated:

 

Total Average Enrollment (FTEs)

 

 

The above enrollments exclude those in our direct-to-consumer and pilot programs, and enrollments acquired with AEC.

The following table sets forth statements of operations data for each of the periods indicated: