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Good morning, everyone, and welcome to Strategic Education, Inc. conference call in which we will discuss third quarter 2018 results. With us today to discuss results are Robert Silberman, Executive Chairman for Strategic Education; Karl McDonnell, President and Chief Executive Officer for Strategic Education; and Daniel Jackson, Executive Vice President and Chief Financial Officer for Strategic Education. [Operator Instructions] Please note this call may include forward-looking statements made pursuant to the safe harbor provision of the Private Securities Litigation Reform Act of 1995. The statements are based on current expectations and are subject to a number of assumptions, uncertainties and risks that Strategic Education has identified in today's press release that could cause actual results to differ materially. Further information about these and other relevant uncertainties may be found in Strategic Education's 10-Q to be filed today and other filings with the Securities and Exchange Commission as well as Strategic Education's future 8-Ks, 10-Qs and 10-Ks. Copies of these filings and the full press release are available for viewing on the website at strategiceducation.com.
And now, I'd like to turn the call over to Robert Silberman, Strategic Education's Executive Chairman. Mr. Silberman, please go ahead.
Thank you, operator, and good morning, ladies and gentlemen. This is our first opportunity to report on SEI's consolidated results since the consummation of our merger between Strayer Education and Capella Education on August 1 of this year, so we have a lot of material to cover this morning.
I'm going to first ask Karl to comment on our operating results for the third quarter as well as provide an update on our merger integration activities. Next, Dan will provide details on both our GAAP and adjusted financial results for the third quarter. And finally, I'll make some brief comments on our capital allocation, after which we'll stay for as long as you have questions. Karl?
Thank you, Rob. Good morning, everyone. As Rob just mentioned, Dan will cover our detailed financial results momentarily so I intend to focus my comments primarily on our operating results and a merger integration update.
And at the outset, I'd like to begin by saying how proud I am of everyone within our organization for generating incredibly strong results while simultaneously first planning and now executing a highly complicated integration. Many of these results are the strongest the universities have generated in many years and speaks directly to the level of talent and professionalism that our team has working on behalf of a nearly 90,000 students and learners.
First, with regard to our operating results. Both Strayer University and Capella University continue to be aided by a very strong U.S. economy, and we continue to see broad increases in overall interest and demand. Strayer University's new student enrollment grew 12% versus the third quarter in 2017, continuing student enrollment increased 8% and the university's total enrollment grew 9% versus the prior year. That's the highest level of total enrollment growth since the fall quarter of 2010.
Strayer University's revenue increased 7% to just under $115 million while Strayer's operating margin increased 290 basis points to 10.4%.
Strayer University opened its second new campus of 2018 during the quarter in Montgomery, Alabama. It is on track to open 2 additional new campuses by the end of the year.
Strayer's preliminary 2019 campus expansion plan calls for an additional 6 to 8 new campuses, pending regulatory approvals. And again, all of these new campuses are in our significantly smaller model, consisting of roughly 3,000 square feet per campus as opposed to more than 20,000 square feet in the model that we used between 2001 and 2012. It also has a significantly smaller staffing requirement and operating breakeven for each campus has been reduced from over 300 students to fewer than 100.
Capella University's new student enrollment increased 13% versus the prior year and their total enrollment increased 2% to just under 38,000 learners.
Capella's FlexPath program, their highly differentiated direct assessment instructional model continues to be a primary driver of overall enrollment growth with new learners within FlexPath growing 34% from the prior year. 26% of all non-doctoral Capella learners are now enrolled in FlexPath and that's up 300 basis points just in the last quarter.
Capella's revenue increased 2.5% to $106 million and Capella's operating margin was unchanged at 15.7%. Capella is also on track to open its first 2 physical locations in Atlanta, Georgia and Orlando, Florida during the first half of 2019.
During the quarter, we also reorganized SEI's non-degree business components into a single management structure and began to organize a single shared service to support all 3 coding boot camps in order to increase productivity and reduce overall operating expenses. And following a strategic review of these non-degreed entities, we've decided to eliminate the New York Code + Design Academy's asset value in its entirety.
Turning now to our integration update. Today marks the 99th day since our merger closed back on August 1 and all key integration-related activities are on track. By the end of 2018, and on a run-rate basis, we will already have implemented just under half of our $50 million synergy target, equating to $22 million in savings of which $9 million will actually be realized in 2018. The remaining $28 million in run rate savings will be implemented in 2019. Realized savings in 2019 are estimated to be $30 million, which, when added to the $9 million saved in 2018, means approximately $40 million of savings will have been realized by the end of 2019 with the full impact of the total $50 million in synergies occurring in 2020.
We continue to forecast the cost to achieve these synergies will be approximately $50 million or $1 for every dollar saved.
In addition to the work on implementing our synergies plans, our teams are also actively working to implement numerous innovations and best practices across the 2 universities, including the deployment of Strayer-developed artificial intelligence tools inside of Capella and evaluating the potential opportunity to seek regulatory approvals to offer FlexPath programs within Strayer University. We also plan to complete our first major systems integration in December of this year, migrating Capella onto Strayer's HRIS system. Lastly, with respect to the overall integration, we continue to place a great deal of emphasis on our new combined culture, which starts by continuing and ultimately deepening our commitment to our students and our learners' success.
So 100 days into our merger, our company has delivered exceptional operating results, is on track to deliver our target synergies and is already beginning to harvest gains as a result of implementing best practices across our organization. And once again, I'd like to thank our team for their incredible efforts over the last quarter.
And now, I'll ask Dan to run through our financials in more detail.
Thank you, Karl, and good morning, everyone. Today, we're reporting consolidated results for Strategic Education, Inc., which now includes 3 reporting segments: the Strayer University segment, consisting of Strayer University and the Jack Welch Management Institute; the Capella University segment, consisting solely of Capella University; and the non-degree program segment, which includes DevMountain, Hackbright Academy, the New York Code + Design Academy and Sophia. Note that our consolidated results will exclude the financial results of Capella Education Company that occurred prior to August 1. Thus, our third quarter revenue expense and cash flow exclude approximately 1/3 of Capella's Q3 results.
For our pro forma view of our Q3 segment level results, including the full quarter results for the Capella segment, please see the third quarter earnings release slide deck posted to the Investor Relations section of our website at strategiceducation.com.
I also want to remind everyone that our earnings release references as-reported or GAAP results and adjusted or non-GAAP results. This format is intended to illustrate the financial performance of the core business as reflected in the adjusted numbers in addition to our GAAP results.
Our adjusted results exclude a number of merger-related items and other noncore adjustments, including purchase accounting related revenue adjustments associated with the valuation of Capella University deferred revenue, amortization expense related to Capella assets acquired in the merger, transaction and integration costs associated with the merger, adjustments to the value of contingent consideration, asset impairment charges and certain discrete tax adjustments. Please refer to the non-GAAP financial information included in the third quarter earnings release we issued this morning for additional information.
Now for a few comments on our consolidated Q3 results. SEI's adjusted income from operations for the third quarter of 2018 was $22.1 million compared to $6.1 million for the same period in 2017. Our adjusted operating margin was 11.8% for the third quarter of 2018 compared to 5.6% in 2017. Third quarter 2018 adjusted results exclude a $26.2 million deferred revenue adjustment associated with the purchase accounting for the Capella merger, a $10.3 million of amortization expense related to intangible assets acquired in the merger, $29.6 million in merger-related costs and a $13.1 million noncash impairment of intangible assets associated with the New York Code + Design Academy.
Third quarter 2017 adjusted results exclude $3.4 million in merger-related costs and a $5.5 million noncash benefit resulting from a fair value adjustment to contingent consideration associated with the New York Code + Design Academy.
On a pro forma basis, which includes Capella Education results prior to August 1, adjusted operating income for the third quarter would have been $26.5 million compared to $19.8 million in 2017.
Third quarter 2018 adjusted net income was $16.9 million compared to adjusted net income of $3.8 million for the same period in 2017 and adjusted earnings per share was $0.92 compared to $0.34 in 2017.
SEI's adjusted effective tax rate for the third quarter was 27.1%, which excludes the impact of the revenue adjustment, amortization of intangible assets, merger costs, impairment of intangible assets and other discrete tax adjustments. We expect our adjusted effective tax rate for the fourth quarter of 2018 to be approximately 27.5%.
Now for a few notes on third quarter segment results. Strayer University segment revenue for the quarter increased 6.7% to $114.5 million from $107.3 million in 2017, driven by higher summer term enrollment offset by lower revenue per student. Revenue per student declined about 2%, which is better than we expected due to the acceleration of about $2 million of deferred revenue from one of our corporate partners.
Moving into the fourth quarter, we expect the year-over-year revenue per student change for the Strayer segment to be about the same as it was for the third quarter.
Strayer University segment income from operations for the third quarter increased to $11.9 million from $8.1 million last year and the operating margin improved to 10.4% for the quarter compared to 7.5% in 2017.
Capella University segment adjusted revenue for the quarter was $70 million, reflecting higher enrollment and a slight increase in revenue per learner. And as Karl mentioned, pro forma Q3 revenue for the Capella University segment was $106.4 million compared to $104 million in the third quarter of 2017.
We expect revenue per learner at Capella University to be roughly flat in the fourth quarter.
Adjusted income from operations for the Capella segment was $11.9 million for the quarter and adjusted operating margin was 17%.
Pro forma adjusted income from operations for Q3 for the Capella segment was $16.7 million compared to $16.3 million in Q3 2017.
Q3 revenue for the non-degree program segment increased to $2.7 million from $1.2 million last year, mainly due to the inclusion of revenue from DevMountain, Hackbright Academy and Sophia. The adjusted loss from operations was $1.7 million compared to an adjusted loss of $1.9 million in the same period in 2017.
Moving to the balance sheet and cash flow. SEI used $14.6 million in cash from operations in the first 9 months of 2018 compared to cash generated from operations of $44.4 million during the same period in 2017 and ended the quarter with $347.8 million of cash, cash equivalents and marketable securities and no debt. The use of cash during the quarter was due to the concentration of merger-related costs that coincided with the close of the transaction on August 1.
Bad debt for the quarter was 5.3% of adjusted revenue, reflecting the incorporation of Capella University bad debt, which has generally been lower than Strayer University due to the higher proportion of graduate students. We expect our consolidated bad debt expense to continue to improve over the next few quarters as the financial aid-related delays and tuition collections at Strayer University have started to subside thus far in the fourth quarter.
Regarding capital expenditures. SEI spent $16 million during the first nine months of 2018 compared to $14.6 million in the same period last year.
For the full year 2018, we're expecting capital expenditures to be between $25 million and $26 million, which does not include any of the CapEx at Capella prior to August 1, 2018.
And finally, we continue to maintain $250 million in available credit on our revolver. Rob?
Thank you, Dan. Just one amplifying comment from my perspective on the financial results. As Dan reported, our financial statements have grown slightly more complicated as a result of the merger and particularly with the impact of the noncash adjustments associated with purchase accounting. But ultimately, when you cut through all the purchase accounting and the merger-related expenses, the figure which I look at each quarter, which I think most closely reflects our owner's economics, is the distributable cash flow per share generated by our business. And for the third quarter, our businesses generated $46.5 million in after-tax cash from operations.
If you think about capital allocation, we invested $8.5 million of those dollars in CapEx during the quarter, leaving $38 million in distributable owner's cash flow or roughly $1.75 per share. This cash flow per share compares very favorably to the $0.92 per share of adjusted EPS that we reported. We paid a $0.50 per share dividend during the quarter or roughly 28% of that distributable cash flow.
And finally, we used, as Dan mentioned, $47 million of our cash during the quarter to fund our merger transaction and integration expenses.
And with that, operator, we'd be pleased to answer any questions.
[Operator Instructions] And our first question comes from Jeff Silber from BMO Capital Markets.
Rob, I just wanted to get, I guess, a segue off the theme that you ended on. Can you talk about your capital allocation strategy going forward? How, if at all, it's changed from before the merger?
Well, it hasn't really changed, Jeff, in that our first and foremost highest return use of capital, we think, is improving the academic outcomes of our students because that generates the highest long-term financial return. And so we're always going to fund as much of that as Karl and his team can find in terms of opportunities. As he mentioned, we've got a quite a bit of work in the area of artificial intelligence, some of which, I think, will be ported over to Capella University as well. So I would guess that our CapEx will be a more fulsome use of capital, but probably analogous to sort of the quarterly numbers that I described for the -- on a pro forma basis for the third quarter. And then we're going to continue to look for opportunities to employ capital outside of the business, if we can't put it into the business, on a high-return basis. I don't think we'd be described as particularly acquisitive, we've done one major acquisition in 15 years. But we'll always look for those opportunities. And then, finally, for that capital which truly is excess of those internal or investment requirements, we want to return it to owners in the most value-enhancing way. We do think that a predictable and reasonable dividend for an entity that owns educational institutions is a positive way to return capital to owners. And we maintain a fairly healthy share repurchase authorization, which we will use in those circumstances in which we feel like the shares are trading at a significant discount to intrinsic value. Because, as we've talked in the past, when we repurchase shares, we're taking that option away from our owners to redeploy that capital and we're essentially giving them a dividend of additional ownership of the company and we only want to do that when we feel a very large discount to intrinsic value.
Okay, got it. Appreciate that. If I could switch back to the core operations. The enrollment numbers that Strayer University has been putting up had been stellar for a while. Capella, we've seen new enrollment improve the past couple of quarters pretty dramatically. What's underlying that? Nobody else in the industry is really putting up those kind of numbers.
Jeff, as I said in my prepared remarks, we continue to see really strong macroeconomic conditions, which is generating large increases on a year-over-year basis and interest in organic demand. The new student growth has been pretty widespread, and by that, I mean, geographically, on the Strayer side, well represented across our campus footprint. But also on the Capella side, they're seeing strong interest and growth across their program portfolio with particular emphasis on FlexPath, particularly in health care. So I would say it's very good macro conditions combined with a diversified portfolio that's generating a lot of interest.
All right, great. And you mentioned the, I guess, it's the learner support center that Capella's going to be opening, I believe it was next year. Can you just tell us a little bit more about that? I know how your new footprint differs from your old footprint, but what do those learning centers look like?
They're essentially going to mimic a Strayer location. We're going to leverage the Strayer design so they'll be roughly the same size, call it, roughly 3,000 square feet. These will be learner support centers, meaning they'll be there for enrollment services, advising services. They will not have any on-ground instruction in the Capella locations, but we're interested in testing those. And we expect that they could open in the middle to latter part of the first quarter, but no later than the second quarter.
[Operator Instructions] And our next question comes from Peter Appert from Piper Jaffray.
This is Kevin Estok in for Peter Appert. My first question has to do with pricing strategy. I was wondering how we should think about this and if you've seen anything industry-wide with pricing?
When we're thinking about pricing, first and foremost, our primary concern is to maintain an eye on overall affordability. You may recall that Strayer University, back in 2013, reduced the cost of their undergraduate programs at that time by about 40%. So we do think affordability is an issue. It's something we want to be constantly focused on. That being said, we think about the overall cost of the degree to be within a range of alternatives that prospective students may have, particularly given local public institutions. And I think both Strayer University and Capella University are within a moderate band where there may be small increases that we may be able to take in any particular year. And in fact, in the fourth quarter of this year, we announced in the prior quarter that Strayer University will have a 1% tuition increase and Capella will have an effective 2% increase, but tuition changes may vary slightly based on the program. So these are relatively modest increases this year, and again, our overall concern is to make sure that we maintain that eye on the overall program's affordability moving forward.
Okay, great. And my second question has to do with the current enrollment mix. So between campus and online, I guess I was wondering how important it was for you to maintain a physical campus network?
Well, over about the last decade, we have seen a strong shift in student preference to more and more online. So 8 to 10 years ago, you might have had close to half of Strayer University classes being taught on ground in a physical location. By the end of this year, fewer than 10% of Strayer University classes will be taught on ground. However, because we also, on the Strayer University side, have about 10% of enrollments that are purely online, meaning there is no optionality to attend at campus, we've always been able to compare academic outcomes for campus students as opposed to out-of-area students. And on the Strayer University side, there continues to be quite a difference in that campus-based students tend to achieve at significantly higher levels than purely out-of-area students. So even in a world where student preference continues to shift more and more online, we think the campus network on the Strayer side helps us attract a more serious student. The analogy we use is banking. Very few people probably would want to bank with a purely online bank. They like the optionality of having a bank branch, and we think that's analogous to the Strayer campus network. We'll see, once we open the Capella learner resource centers, if we see similar trends, but that'll take some time into 2019. So the campuses for Strayer continue to be very important. As I said, we plan to open 2 more this year and up to 8 next year, pending regulatory approvals and we think it helps us generate the types of students that we want to have.
And I'm not showing any further questions from our phone lines. I'd now like to turn the conference back over to Robert Silberman for any closing remarks.
Thank you, operator. Well, we appreciate everyone's participation. As Dan said, we've got some amplifying data on our website that particularly crosswalks between the as-reported and the adjusted results. And if anybody has any other questions, please give us a call directly, and we look forward to talking with you again in the first quarter. Thank you.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a wonderful day.