Grand Canyon Education, Inc. — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018. Financial statements are unaudited. Amounts below are in millions of dollars except per-share data and enrollment.
Business context
On July 1, 2018, GCE completed a transaction transferring Grand Canyon University’s campus and academic operations to GCU, a separate nonprofit entity. GCE now provides services to GCU under a 15-year Master Services Agreement (MSA), receiving 60% of GCU tuition and fee revenue. GCE also received a $870.1 million senior secured note, bearing 6% annual interest, with principal and unpaid interest due at maturity on June 30, 2025. GCU is GCE’s sole university client.
Financial results and liquidity
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Net revenue | $155.5 | $236.2 | $668.0 | $702.7 |
| Operating income | $29.4 | $59.7 | $178.0 | $191.4 |
| Net income | $33.8 | $39.3 | $153.5 | $135.1 |
| Diluted EPS | $0.70 | $0.81 | $3.17 | $2.80 |
| Operating cash flow | Not provided for quarter | Not provided for quarter | $96.5 | $269.9 |
- Period comparability: Q3 2018 revenue is service revenue after the transaction; Q3 2017 revenue reflects university operations. GCE’s comparable service-fee revenue, using 60% of pre-transaction university revenue, increased 9.7% in Q3 and 9.8% for the nine-month comparison. GCU enrollment rose 8.2% year over year to 98,715.
- Reported operating margin was approximately 18.9% in Q3 2018 versus 25.3% in Q3 2017; the periods are not directly comparable because of the transaction and changed revenue base. Nine-month reported margins were approximately 26.6% and 27.2%, respectively.
- Q3 2018 included $15.6 million of transaction loss and $6.6 million of university-related expenses. The transaction loss for the nine months was $17.6 million, including transaction costs, impairment, and funding for a deferred compensation plan. University-related expense included $7.9 million of accelerated share-based compensation.
- Effective tax rates were 20.5% for Q3 and 20.6% for the first nine months of 2018, versus 35.1% and 29.6%, respectively, in 2017. Management cited federal tax reform and contributions to school-sponsoring organizations; nine-month results also included $7.9 million of excess tax benefits from share-based compensation.
- Nine-month operating cash flow fell to $96.5 million from $269.9 million, which management attributed mainly to income-tax payment timing and working-capital changes, including GCU receivables. Investing cash outflow was $215.7 million, including $90.2 million of capital expenditures and transaction-related cash transfers.
- At September 30, cash and cash equivalents were $44.9 million, investments were $68.8 million, and restricted cash was $61.7 million. Restricted cash represented collateral under GCE’s amended credit agreement. Notes payable totaled $61.5 million; the $882.9 million note receivable is a distinct asset, not cash or available liquidity.
Outlook, risks, and unusual items
- Management said operating cash flow and other liquidity sources were expected to be adequate for operations, planned capital expenditures, and working capital needs for at least 24 months. GCE expected to fund approximately $30 million of GCU capital expenditures in Q4 2018 and $100 million during 2019 under the note arrangements.
- The GCU note requires interest-only payments during its term, with principal and accrued unpaid interest due at maturity. GCE agreed to fund approved GCU capital expenditures during the first three years. GCE’s own term loan maturity remains December 2019.
- Key risks include dependence on GCU as the sole customer; GCU’s ability to grow and retain enrollment; potential divergence of GCU’s interests from GCE’s; termination or non-renewal of the MSA; regulatory and Title IV requirements; competition; and GCU’s ability to meet obligations under the secured note. GCE noted that it has limited experience operating as a third-party service provider.
- The MSA has an initial 15-year term. GCU may terminate early after the later of seven years or repayment in full of the note; an early termination fee equals 100% of trailing 12-month fees. Non-renewal after the initial term triggers a fee equal to 50% of trailing 12-month fees.
- Management reported no material adverse effect expected from pending litigation, while noting that outcomes and potential losses for most matters could not be estimated with certainty. No quantified revenue or earnings guidance was provided.
Most important facts to verify
- Whether GCU’s enrollment, tuition and fee revenue, and collections support the MSA fee stream and timely payment of the $870.1 million secured note.
- The status and terms of Department of Education approval referenced in connection with GCE’s restricted cash collateral and amended credit agreement.
- Actual timing and amount of GCE’s planned GCU capital-expenditure funding, and the impact on unrestricted liquidity and cash flows.
- How post-transaction results should be compared with prior periods, including the company’s use of adjusted “Non-GAAP” revenue comparisons.
- Progress on diversifying beyond GCU, given the single-customer concentration and GCE’s limited third-party service-provider track record.