We provide supplemental, remedial and enrichment instruction through Sylvan Learning - North America’s largest network of tutoring centers - the best-known and most trusted tutoring brand. We are the leading provider of educational services to public and non-public schools through our school partnership business, Catapult Learning. We also deliver educational products, including the highly regarded Hooked on Phonics early reading, math and study skills programs through our Educate Products business.
We expect that we will continue to benefit from increased national attention on the quality of pre-K-12 education. We believe that parents have become more proactive in seeking education products and services that supplement their children’s education and are willing to pay for these products and services. In addition, over the past ten years, the market for supplemental education services has benefited from increased spending in both public and private schools. Further, increased education spending by governmental authorities has enjoyed continued bipartisan support. We believe these market forces have contributed to our growth.
Merger Agreement
On September 25, 2006 we announced that our Board of Directors had received a nonbinding proposal from a management group led by R. Christopher Hoehn-Saric, our Chairman and Chief Executive Officer, and other investors to acquire all of the Company’s outstanding shares for $8.00 per share in cash.
On January 28, 2007, we entered into a definitive Agreement and Plan of Merger (the “Merger Agreement”) with Edge Acquisition, LLC, a Company affiliated with Sterling Partners and Citigroup Private Equity, and with Mr Hoehn-Saric (the “Merger”). Under the terms of the Merger Agreement, our stockholders will receive $8.00 in cash for each share of Educate common stock they own. Completion of the Merger is subject to customary closing conditions, including, among others, (i) approval by our stockholders, and (ii) the absence of any order or injunction prohibiting the consummation of the Merger. The Company expects the Merger to close in the second quarter of 2007.
The Merger Agreement was filed on a Current Report on Form 8-K filed with the Securities and Exchange Commission on January 29, 2007. The foregoing description of the Merger Agreement is qualified in its entirety by reference to the full text of the Merger Agreement.
Overview of the Sylvan Learning Network
Sylvan is of the most highly recognized brand names in the supplemental education services industry. We develop and deliver trusted, personalized tutoring programs to students in grades pre-K-12 through a network of 912 territories supporting 1,134 franchised and company-owned learning centers primarily in North America operating under the Sylvan brand name.
Sylvan Learning has operated for over 25 years providing supplemental, remedial and enrichment instruction, primarily in reading and mathematics, and to an increasing extent, writing, study skills and test preparation. Our programs feature an extensive series of standardized diagnostic tests, personalized instruction, a student motivational program and ongoing involvement of parents and the students’ regular school teachers. High awareness of the Sylvan brand and our targeted advertising programs motivate parents to inquire about our services on behalf of their children, primarily by telephone or the Internet. Our corporate call center, regional call centers or franchise operators respond to these inquiries and seek to convince parents of the value of our services and to make an appointment for a diagnostic assessment. One of our company-trained educators performs these tests, which include the California Achievement Test, a nationally-recognized diagnostic test, which identifies particular skill gaps of each student. We then use these assessments to create a personalized learning plan for the student.
Our students generally enroll in a 60 to 120 hour program with instruction two to four times per week for one to two hours per visit. In our core reading and math programs, each teacher typically works with up to three students at a U-shaped table designed to facilitate the learning experience. Within this setting, a teacher works with each of the students individually in turn while the other two students
work independently on their own programs. Each teacher is trained in using our proprietary learning systems, which address the particular skill gaps identified in the diagnostic testing. Students generally work with multiple teachers throughout their course of instruction. We also incorporate a motivational program using tokens redeemable for novelties and toys to inspire students to achieve their objectives, build self-confidence and strengthen their enthusiasm for learning. We measure and evaluate each student’s progress after every 36 hours of instruction, hold parent conferences after every 12 hours of a student’s program, and schedule periodic updates with the student’s regular school teachers during the program. Our Sylvan Learning Centers guarantee that each math and reading student will achieve at least one grade level equivalent of improvement within the first 36 hours of instruction or the student will receive 12 hours of additional instruction for free.
The cost of an education program is dependent upon the student’s individual needs. The program costs approximately $3,200 to $4,400, with the actual amount dependent upon the price per hour for tutoring and the number of hours of tutoring provided. Consumers may pay for the full program upon enrollment or prepay on a monthly basis using cash or a credit or debit card. Many of our customers also use third-party financing programs offered by recommended vendors.
We also provide tutoring services for the Scholastic Aptitude Test (“SAT”) and other standardized tests in our Sylvan Learning Centers using materials developed by our subsidiary, Ivy West Educational Services, Inc. Ivy West instructors also provide one-on-one tutoring and test preparation services to students in their homes through a staff averaging 500 instructors for a year.
Our company-owned and franchise learning centers deliver tutoring services under the Ace it! brand to students that are institutionally funded through the supplemental education services provision of the No Child Left Behind legislation.
Our Sylvan Learning Centers are staffed by trained teachers who deliver high quality education programs that are personalized for each student based upon the results of extensive diagnostic testing. These centers are leading a significant shift in the provision of pre-K-12 supplemental education services, away from the traditional model in which individual tutors provide in-home homework help to students. We seek to instill in each student our “Learning Feels Good” philosophy through a motivational program that inspires students to achieve their objectives, builds self-confidence and strengthens each student’s enthusiasm for learning.
Based on our market research, we believe that 98% of women within our target demographic recognize the Sylvan brand name. Our long history of successfully providing tutoring services and our substantial investments in advertising and direct marketing on national, regional and local levels have contributed to consumers’ recognition of the Sylvan brand. We have found an integrated marketing strategy, including television and Web advertising, to be effective at delivering a compelling message to consumers.
Our Learning Center operations are comprised of franchised and company-owned territories. A territory reflects the geographically-specified area where an operator controls rights to provision of services under the Sylvan license agreement. Due to changes in demographics over time and levels of demand, territories often support more than one Sylvan Learning Center. As of December 31, 2006, there were 178 Company-owned territories and 734 franchised Sylvan territories.
Continuing our focus on maximizing service delivery throughout the entire Sylvan network, management has evaluated all Company-owned territories and has concluded that greater focus in specifically targeted geographical areas is necessary to maximize system revenue potential and to efficiently manage Company-owned operations. Therefore, we anticipate that selected Company-owned territories in targeted markets will be re-franchised to franchisees that will apply best practices in center operations. Current expectations are that this multi-year re-franchising program will eventually result in increasing franchised centers to approximately 85% of the total network.
Business Segments
We operate through seven business segments that served more than 430,000 students in 2006. During the fourth quarter of 2006, management changed the manner in which it reviews segment operating performance, and increased the number of reporting segments to include Franchise Services, Catapult Learning, European, Company-Owned Centers, Educate Products, Progressus, and Educate Online. Additionally, Franchise Services, Catapult Learning and European businesses are also reviewed together as “Educate Services” for financial analysis purposes due to common executive management. Segment revenues and operating income are presented on this basis for all periods.
Franchise Services
Franchising is a core element of our business strategy. Our Franchise Services segment manages our system of franchised Sylvan Learning territories. We generate income in our Franchise Services segment from franchising activities primarily through royalties, which are calculated as a fixed percentage of franchisee cash receipts. We generate additional licensing fees from the
sale of new franchise territories, within which a franchisee is allowed to open learning centers, and from sales of learning materials and other materials to franchisees. Our Franchise Services segment also provides SAT preparation services in California under the Ivy West brand name.
Our franchise agreements grant the franchisee a license to operate Sylvan Learning Centers and to use Sylvan’s trademarks within a specified geographical territory. Our franchise agreements generally have an initial term of ten years, subject to unlimited additional ten-year extensions at the franchisee’s option under the same terms and conditions. The license fees and royalty rates vary depending upon the demographics of the territory. If a franchisee proposes to sell a franchised center, we have the right to acquire the franchised center on the same terms as the proposed buyer.
We actively manage our franchise system to enhance our brand and maintain a consistent, high quality of service. Franchisees must obtain our approval for the location and design of learning centers and for all advertising. Franchisees must also operate their learning centers in accordance with our methods, standards and specifications. We monitor educational quality at our franchised centers through a variety of procedures, including access to pre- and post-diagnostic test data for students of our franchisees. Each franchisee is required to purchase from us certain diagnostic and instructional materials, student record forms, parental information booklets and explanatory and promotional brochures developed by us. We specify requirements for other items necessary for operation of a learning center, such as computers, instructional materials and furniture, and we offer our franchisees the opportunity to purchase these items from preferred vendors. Generally franchisees provide us with periodic business updates and must submit monthly financial and operating data to us. We require franchisees and their employees to attend a one-week initial training program and to pass a certification examination in our learning center operations and educational programs. We also offer franchisees continuing training each year through a number of different methods. We employ franchise business consultants to provide assistance to franchisees in marketing, education and operations, technology implementation and business development. These employees also facilitate regular communications between franchisees and us and assist us in assuring a consistently high quality of service in each Sylvan Learning Center.
Our franchisees are true owner-operators, as evidenced by the fact that 80% of our franchisees own only one or two centers and no franchisee owns more than 14 centers. We believe that this allows franchise owners to remain focused and committed to the success of their centers.
As of December 31, 2006, there were 734 territories, which supported franchised Sylvan Learning Centers located primarily in North America, including 794 in the United States and 83 in Canada. During 2006, we expanded our franchised network by 9 territories. Our Franchise Services segment generated revenues of $59.7 million during 2006, representing 17% of our total revenues. Of this amount, $11.4 million represented intercompany royalty from our Company-Owned Centers segment.
Catapult Learning
Our Catapult Learning segment, formerly referred to as Institutional Services, provides tutoring and other supplemental education services, to eligible students in public and private schools through government-funded contracts under the Catapult Learning and other brand names.
Since 1993, Catapult Learning has provided supplemental instruction programs primarily in reading and math to students in schools, school districts and private educational entities (primarily parochial schools) across the country. These programs encompass a wide variety of education services that supplement and expand those provided by these institutions. Our services are typically provided on location at the client school or a conveniently located community organization’s facility. These services are funded by federal, state and local governments. While funding for our programs comes from a variety of sources, there are two federal government programs that are significant sources of funds for the services that we offer: Title I of the Elementary and Secondary Education Act and the Individuals with Disabilities Education Act (IDEA). Title I funds are provided by the Federal government to address the needs of educationally and economically disadvantaged students in public and private schools. IDEA funds are provided by the Federal government to address the needs of students identified for special education. We also provide professional development services through federal funding under Title IIa. This includes providing workshops and other training materials to teachers in public and private schools.
The largest component of our Catapult Learning business is small group instruction to non-public school, pre-K-12 students who have been identified by their school as requiring these services. Additionally, we offer a variety of supplemental programs and services that cater to the specific needs of our institutional partners, such as summer school programs, early childhood development programs and special education services. The services that we provide to institutions are typically governed by school-year contracts subject to annual renewal that have had and continue to have high rates of repeat business.
In 2006, our Catapult Learning segment generated revenues of $73.5 million, representing 21% of our total revenues. We believe that the increasing willingness of school districts and private schools to utilize third parties to provide supplemental education and specialized support services to the students in their schools, the increases in Title I spending, and access to IDEA funding and state education funds provide us with opportunities for continued growth.
During 2006, we completed the sale of our Education Station business, which delivered site-based NCLB services to public schools. Education Station was a component unit within the Catapult Learning operating segment. The operations of Education Station are classified as discontinued operations for all periods presented.
European
Our European segment operates a network of company-owned and franchised centers under the Schülerhilfe brand name. Schülerhilfe has provided after school tutoring, consisting primarily of homework support, to primary and secondary students in Germany and Austria for over 30 years.
Our European segment generates revenue primarily from the operation of company-owned centers and the receipt of monthly fixed fees from franchisees. As in our Sylvan Learning Centers, the aim of Schülerhilfe’s center-based tutoring is for students to improve their grades and develop their self-confidence. Schülerhilfe provides tutoring in a number of subjects, including German, math, English, Latin, and French, using the child’s own textbooks and Schülerhilfe material. After an initial consultation, students visit a Schülerhilfe center after school an average of twice per week for 90 minutes. Students work with teachers on addressing their skill gaps using a combination of schoolwork, homework, and Schülerhilfe curriculum. Sessions are taught in small groups of five or fewer students per teacher. On average, parents pay €125 per month for eight sessions.
As of December 31, 2006, Schülerhilfe operated 264 company-owned learning centers and 755 franchised centers in Germany, and 61 franchised centers in Austria. Our European segment generated revenues of $35.1 million during 2006, representing 10% of our total revenues.
Company-Owned Centers
Our Company-Owned Centers segment manages our network of company-owned Sylvan Learning territories. Our Company-owned centers enable us to test and refine new educational programs, marketing plans and learning center management procedures before offering these programs and procedures to our franchisees. Our company-owned territories serve as best practice models where significant operational and educational improvements can be developed and implemented quickly. On average, company-owned territories have higher sales than franchised territories primarily due to higher average revenue per student. In 2006, our company-owned territories generated average sales per territory of $780,000 and we received royalties from our franchisees that imply average cash receipts per franchised territory of $510,000.
As of December 31, 2006, we operated 178 company-owned territories including 251 company-owned Sylvan Learning Centers in 33 markets in North America. During 2006, we increased the number of company-owned territories by 6, primarily through opening centers in previously undeveloped territories. Our Company-Owned Centers segment generated revenues of $143.8 million during 2006, representing 41% of our total revenues.
Educate Products
Our Educate Products business creates, manufactures, and sells educational products that are fun, easy to use, and effective, including the highly regarded Hooked on Phonics early reading, math and study skills programs. Since the launch of the first product in 1987, more than two million families and thousands of schools have turned to the Hooked on Phonics library of award-winning programs. We work with educators, interactive designers, writers, artists and parents to develop step-by-step learning programs that help teach children critical reading, math and study skills. Our line of educational programs and products are distributed through national retailers such as Wal-Mart, Target, K-mart, Costco, Sam’s Club and Amazon, directly to consumers through catalogs and our web site www.hookedonphonics.com, and internationally through international distributors. Our Educate Products segment derives a significant portion of revenue from a small number of customers in the club channel. Customers in our Products segment are granted payment terms customary in the industry, which typically range from 90 to 120 days. This segment also sells Reading Rainbow branded products.
Our Educate Products segment generated revenues of $18.2 million during 2006, representing 5% of our total revenues.
Progressus
Our Progressus segment provides certified occupational therapists, physical therapists and speech-language pathologists to public and non-public school districts, community-based centers, early intervention programs, State Departments of Education and State
Departments of Health and Human Services. We are one of the largest, most experienced providers of contracted educational services in the country. Progressus operates in 18 states throughout the United States and in the District of Columbia.
School districts are experiencing significant pressure to provide quality special education and related services programs for children with a broad range of learning needs and disabilities. Their challenge is complicated by persistent shortages of speech-language pathologists, occupational therapists and physical therapists.
Our Progressus segment supplies full-time and part-time qualified occupational therapists, physical therapists and speech-language pathologists who provide therapy and early intervention programs under Parts B & C of IDEA. Our therapists provide services that are designed to help meet the educational and developmental needs of eligible children with disabilities. Our Progressus segment (including predecessor companies) has over 15 years of educational therapy experience.
Our Progressus segment generated revenues of $22.0 million during 2006, representing 6% of our total revenues.
Educate Online
Our Educate Online segment is a leading provider of online tutoring to students with functional grade levels of third through ninth grades, under the Sylvan Online and Catapult Online brand names. Through Sylvan Online we deliver trusted diagnostic, prescriptive tutoring programs utilizing the Sylvan Learning Center network of franchised and company-owned learning centers. Through Catapult Online we provide tutoring to eligible students in public and private schools through government-funded contracts. (Catapult Online operates independently from Catapult Learning.) Our programs are staffed by trained, state certified teachers who deliver high quality education programs that are personalized for each student based upon the results of extensive diagnostic testing.
Our Educate Online segment generated revenues of $14.3 million during 2006, representing 4% of our total revenues.
Segment and geographic area information for the three years ended December 31, 2006 is incorporated by reference to Note 15 to our consolidated financial statements included in Item 8 of this Form 10-K.
Sales and Marketing
Learning Center
Philosophy
We have positioned ourselves as a provider of tutoring services that inspire students to achieve their objectives, build self-confidence and strengthen each student’s enthusiasm for learning by instilling our “Learning Feels Good™” philosophy. We developed our philosophy through qualitative and quantitative consumer research of women within our target audience. We have used consumer research to identify the most compelling message as well as the benefits and features that are most relevant and believable to our target audience.
Marketing
We believe our multi-year investment in advertising has driven a high level of brand awareness and favorable consumer perceptions about our brand. Our marketing strategy relies primarily on direct response marketing using an integrated, multi-channel approach. Our marketing materials are designed to generate a response from consumers, usually in the form of a call or email to one of our learning centers. This direct marketing strategy allows us to quantitatively and qualitatively test the effectiveness of various aspects of our marketing campaigns by measuring consumer response and making appropriate modifications to the campaign to improve consumer response.
We have found television advertising, such as our “We have a Tutor for that” campaign, to be effective at delivering a compelling message to consumers. Accordingly, we commit a majority of our advertising funds to television and Internet advertising. Other important marketing strategies include public relations, word of mouth marketing, educator relations and direct mail/conversion marketing. As part of our quantitative and qualitative analysis, each year we test the performance of our newly developed advertising materials and compare the results to the benchmarks set by the best performing advertising materials in our previous campaigns to determine if the new material will be used throughout the system.
Our marketing is coordinated across three tiers, the national marketing fund, regional cooperative marketing funds, and local marketing. Substantially all franchised and company-owned centers pay a monthly fee into the national marketing fund, which is jointly managed by representatives of the company and the franchise community, while regional cooperative marketing funds are managed by members of the region, and local funds are managed individually by franchisees or company-owned territory management. These three tiers use a combination of marketing channels, including television, internet, print, direct mail and grassroots public and community relations, such as appearances at public school parent assemblies, local street fairs and festivals, and other community events sponsored by local civic and religious groups. We maintain a consistent and targeted advertising message across each of these tiers and in each of the marketing channels through the centralized development and distribution of all advertising material used, including the materials used by franchisees and company-owned centers in local markets, and through specific recommendations to our franchisees of the appropriate mix of marketing channels.
In 2006, we launched Sylvan branded products and pre-packaged services available through Costco and QVC. These new distribution channels have opened the opportunity to enhance brand affinity for Sylvan through retail channels.
Catapult Learning and Progressus
Our Catapult Learning and Progressus segments seek to understand the needs of a particular institution and develop specific programs to address those needs within the scope of available funding. Our institutional services are marketed primarily through direct, personal contact with superintendents of school districts, school principals and other key decision makers at targeted institutions by our relationship managers and sales force. Through these sales efforts, we seek to maintain and expand our relationships with existing institutional customers. This focus on our existing relationship allows us to market additional supplemental services to them, which is less expensive than new client development efforts.
European
We believe Schülerhilfe has a high level of brand awareness in the German market. We have developed our brand awareness through effective marketing in multiple channels. We have experienced success in our nationwide advertising campaigns including television, online, and print advertising.
Educate Products
We market our Educate Products brand to both trade and consumer audiences including club and retailers. Our trade customers are typically decision makers that we reach through a variety of methods including direct mail, trade shows and advertising in targeted trade publications. Our consumer target consists primarily of parents of children ages 3 to 12. We reach these consumers through a variety of means including print, online, and television advertising as well as direct mail and public relations programs.
Industry Overview
We believe the pre-K-12 education services industry is large, growing and fragmented and that the overall size of this industry has significant potential to grow as a result of a number of factors. These factors include favorable demographics, increasing parental dissatisfaction with the quality of public education, an increasingly competitive educational system and the heightened focus on school performance due to the continued failure of many students to achieve basic skills. According to the U.S. Department of Education, enrollment in elementary and secondary schools rose 22% between 1985 and 2005 to 54.7 million students and is expected to rise by an additional two million students between 2005 and 2014. We believe these trends will drive demand in both the public and private sectors for the types of supplemental education services that we provide.
Private Sector Demand . Demand for supplemental education services is growing due to parents’ dissatisfaction with the quality of public pre-K-12 education. We believe that the demand for private pre-K-12 tutoring services has grown, and will continue to grow, as children face additional federally-mandated standardized tests throughout their pre-K-12 years, and a growing number of qualified students vie for positions at top colleges. At the same time, the monetary value of a college degree is increasing, as evidenced by U.S. Census Bureau data. In 2004, holders of a bachelor’s degree earned 80% more on average than those with only a high school diploma, as compared with 66% more on average in 1984. In addition, many schools have ended the practice of social promotion and now require students to pass end-of-year exams to advance to the next grade. These high stakes tests create additional pressures on students’ school performance. We believe that all of these factors will increase private sector demand for supplemental education services.
Public Sector Demand . According to data published by the U.S. Department of Education in the 2002-2003 school year, the total K-12 expenditures by U.S. governmental entities for purchased instructional services was approximately $7 billion. The size of that market has increased since the 2000-2001 school year due in part to the adoption of federal legislation. The most recent major federal legislation, NCLB, increased federal funding for addressing the needs of low income students by 3% from $12.3 billion in 2004 to $12.7 billion in 2005.
NCLB also provides for more alternatives to public schools, and a heightened focus on results and school accountability. Funding for outsourced programs and services comes from a variety of sources, including federal, state and local governments. The federal
government provides funds through two main programs, Title I of the Elementary and Secondary Education Act and IDEA. Title I funding has grown 3% from $14.4 billion in 2004 to $14.8 billion in 2005, and IDEA funding has grown 6% from 10.0 billion in 2004 to $10.6 billion in 2005.
European Demand . According to the German Institute for Statistics, parents spend approximately €4.6 billion a year on tutoring. Approximately one third of German students receive private tutoring outside of school. German students primarily utilize private tutors to remain on grade level, however, approximately 25% of students utilize tutors to improve their grades. The majority of students who seek private tutoring are in their 7 th to 10 th school year.
Competition
While we face competition in each of our business segments, the markets in which our segments operate are very fragmented and penetrations are low.
We are aware of only six direct national corporate competitors in our Sylan Learning business: Huntington Learning Centers, Inc., Kumon Educational Institutes, The Princeton Review, Kaplan Educational Centers, SCORE! Education Centers, and Club Z!. With the exception of Kumon Educational Institutes, which is comprised of a large number of locations mostly operated in facilities primarily used by other organizations, we believe these competitors operate fewer learning centers and provide services within a smaller geographic area than we do. In most areas served by our Sylvan Learning network, competition also exists from individual tutors and local learning centers. Sylvan Learning competition focuses on education quality, convenient locations and price.
In our Catapult Learning segment, competition is primarily based on education quality, reputation and price. We compete with individuals that provide tutoring services to institutional customers, state and local education agencies that provide supplemental education services and national providers of supplemental education services, such as Kaplan K12 Services and The Princeton Review. We also compete with several other entities that currently provide Title I and state-based programs on a contract basis for students attending parochial and private schools.
In our European segment, our primary competition consists of Studienkries, a slightly-larger national provider of tutoring services in Germany, smaller regional tutoring chains and individual local tutors.
In our Products segment, we compete primarily in the preschool and early elementary categories of educational products. Our products compete with a variety of brands in both the toy and publishing industries. In the toy industry we compete with electronic learning aid products including those produced by LeapFrog and VTech Corporation. In the publishing industry we compete with companies, including School Zone and Scholastic, whose products are designed to teach children basic phonics, reading and math skills. We believe the principal competitive factors impacting the market for our products in retail stores are brand, design, overall educational efficacy, quality and price.
In our Progressus segment, our primary competition comes from several national providers, such as EBS Healthcare Columbus Organization, Solient Health, CompHealth and Career Staff. We also compete with some well established regional therapy businesses, including PediaStaff, Bilingual Therapy and Cobb Therapy, as well as many local providers.
The No Child Left Behind Supplemental Education Services (SES) industry in which Educate Online competes is highly fragmented featuring few companies with national scope and hundreds of regional and local companies with limited ability to scale beyond their current geographic area. The majority of SES companies deliver face to face, facility-based services. While there are a handful of companies that provide online services across the country, we are the only company operating nationally in this industry and we are the only company that provides the combination of live, individualized, in home instruction with U.S.-based, state-certified teachers. SES competition focuses on academic quality and parental and student convenience.
Employees
The following table sets forth information regarding the numbers of employees as of December 31, 2006 by segment:
| Full Time Employees |
Part Time Employees |
Total | ||||
| Segment: |
||||||
| Franchise Services |
172 | 431 | 603 | |||
| Catapult Learning |
939 | 1,178 | 2,117 | |||
| European |
84 | 728 | 812 | |||
| Company-Owned Centers |
730 | 4,564 | 5,294 | |||
| Educate Products |
70 | 1 | 71 | |||
| Progressus |
281 | 41 | 322 | |||
| Educate Online |
62 | 756 | 818 | |||
| Corporate services |
123 | 1 | 124 | |||
| Total |
2,461 | 7,700 | 10,161 | |||
Approximately 135 employees in our European segment are represented by a Works Council. We consider our relationship with the Council to be good. During December 2006, 17 employees in Lakewood, New Jersey who work in the Catapult Learning segment became members of the American Federation of Teachers, AFL-CIO (the “Union”). We have begun negotiating a collective bargaining agreement with the Union, but have not finalized an agreement. None of our other employees is party to any collective bargaining agreement with us and we consider our relationships with employees to be good.
Government Regulation
Franchise Regulation . Various state authorities as well as the Federal Trade Commission (“FTC”) regulate the sales of franchises in the United States. The FTC requires that franchisors make extensive disclosures to prospective franchisees but does not require registration. A number of states require registration and prior approval of the franchise-offering document. In addition, many states have “franchise relationship laws” or “business opportunity laws” that limit the ability of a franchisor to terminate franchise agreements or to withhold consent to the renewal or transfer of these agreements. While our franchising operations have not been materially adversely affected by existing regulation, we cannot assure you that we will not be adversely affected in the future nor can we predict the effect of any future legislation or regulation.
Our international franchise agreements and franchise operations are regulated by various foreign laws, rules and regulations. To date, these laws have not precluded us from selling franchise licenses in any given territory and have not had a material adverse effect on our operations.
Title I . Title I eligible school districts are responsible for implementing Title I and carrying out their educational programs. Title I provisions and regulations direct eligible districts to satisfy obligations including, among others, involving parents in their children’s education, evaluating and reporting on student progress, providing equitable services and other benefits to eligible non-public school students in the district and other fiscal requirements. In contracting with school districts to provide Title I services, we are, and will continue to be, subject to various Title I requirements and may become responsible to the school district for carrying out specific functions required by law. For example, we have responsibility for introducing program content adequate to achieve certain educational gains and maintaining the confidentiality of student records. Our failure to adhere to Title I requirements or to carry out regulatory responsibilities undertaken by contract may result in contract termination, financial liability or other sanctions.
Intellectual Property
We have federal trademark registrations for the words “Sylvan,” “Sylvan Learning Center,” “eSylvan”, “Hooked on Phonics”, “Hooked on Reading” and distinctive logos, along with various other trademarks, patents and service marks and have applications pending for a number of other distinctive phrases, including “Ace it!,” “Catapult Learning,” “Hooked on,” “Progressus,” and “Progressus Therapy, Inc.” We cannot predict whether our trademark and service mark applications will be approved. We cannot assure you that our existing or future trademarks, patents or service marks will provide meaningful protection. We also have obtained foreign registrations of Sylvan in over 50 countries. Our License Agreement grants our franchisees the right to use certain of our trademarks and service marks in connection with operation of a franchised learning center subject to certain quality control and other provisions.
Corporate Information
Educate was formed by an investor group led by affiliates of Apollo Advisors, L.P. (“Apollo”), a private equity investment company and certain management stockholders on June 30, 2003 to acquire the pre-K-12 educational services business of Laureate Education, Inc. (formerly known as Sylvan Learning Systems, Inc.) (“Laureate”). Apollo is Educate’s controlling stockholder.
As of December 31, 2006, affiliates of Apollo owned 52% of our outstanding shares of common stock. Apollo was founded in 1990 and is among the most active private investment firms in the United States in terms of both number of investment transactions completed and aggregate dollars invested. Since its inception, Apollo has managed the investment of an aggregate of approximately $16 billion in equity capital in a wide variety of industries, both domestically and internationally.
We are a holding company and all of our operations are conducted through our operating subsidiaries. Our principal executive offices are located at 1001 Fleet Street, Baltimore, Maryland 21202. Our telephone number is 410-843-8000. Our website is www.educate-inc.com . Information on our website is not a part of and is not incorporated by reference into this Annual Report on Form 10-K. Our filings with the Securities and Exchange Commission are available without charge on our website as soon as reasonably practicable after filing. Copies of our Form 10-K are available free of charge by writing to 1001 Fleet Street, Attn: Investor Relations, Baltimore, Maryland 21202.
Item 1A. Risk Factors.
Our inability to adequately manage our growth could have an adverse effect on our operations.
We have increased the number of our company-owned Sylvan Learning Center territories from 49 as of January 1, 2000 to 178 as of December 31, 2006. We may not be able to integrate the territories we acquired from franchisees in 2005 and 2006 into our other operations without substantial costs, delays or other operational or financial problems. In particular, in 2006 we experienced higher than expected integration costs and lower than expected revenues from many of our acquired territories. In addition, as our business grows, more resources will be required to support our operations, including hiring teachers, directors of education, center directors and area managers, particularly if this growth occurs outside of the 33 markets in which we now operate company-owned territories. In our products business, our inability to effectively open new distribution channels for Educate Products and our inability to determine and predict consumer sell-through could have an adverse effect on our operations. Requirements to fund the start-up of Educate Products including product development, inventory build and extended terms on distribution partner receivable balances may also be a significant harm to our products business. Our inability to manage our anticipated growth may adversely affect the quality and consistency of our programs, our ability to integrate new personnel and our ability to capitalize on new business opportunities.
In response to our same territory revenue growth in 2006, we implemented a new strategy to restore growth, but we cannot assure you that our new strategy will be effective.
In 2006, our same territory revenues declined compared to the prior year in our Company-Owned Centers segment. While segment revenues grew by 7% over 2005 due primarily to acquisitions we made in 2005, same territory revenues declined by 8%. Inquiries declined from the prior year, and we did not achieve expected levels of revenue growth.
Our refranchising plan may not be effective in improving our financial results.
The plan to refranchise some of our Company-owned centers will have two impacts on our business. The costs of operating centers that are sold and the profits or losses associated with each center will become the responsibility of the buyer. Our Learning Center business will receive ongoing royalties and other fees from the buyer of the center. We cannot be sure that royalties and fees received will be more profitable than operating income from each center had it remained a Company owned-center.
Actions of teachers, instructors and other personnel could lead to liability claims and damage to our reputation, which could cause us to incur substantial costs and strain our relationships with franchisees.
We could become liable for the actions of teachers and other personnel in our company-owned learning territories or in other areas in which we provide services, including schools and students’ homes. In the event of accidents or injuries or other harm to students, we could face claims alleging that we were negligent, provided inadequate supervision or were otherwise liable for the injuries. A liability claim against us or any of our employees could adversely affect our reputation with our customers, which could adversely affect our enrollment and revenue. Even if unsuccessful, such a claim could create unfavorable publicity, cause us to incur substantial expenses and divert the time and attention of management. Unfavorable publicity resulting from a liability claim against us or any of our employees may also adversely affect our franchisees’ businesses, which could strain our relationships with franchisees.
Actions taken by our franchisees may harm our business.
Our business is dependent upon our franchisees and the manner in which they operate their franchised territories under our licensed brand. If a franchisee were to engage in unauthorized or unlawful conduct, the general public may associate this conduct with our brand, and negative publicity associated with this conduct could affect the reputation and success of all of our centers. Our business may also be adversely affected if our franchisees do not operate their territories and provide tutoring services in a manner consistent with our standards and requirements or do not hire and train qualified teachers. Our license agreements with our franchisees do not require them to conduct background checks on prospective employees. In addition, a liability claim against a franchised center or any center personnel may result in unfavorable publicity for all of our learning centers, whether or not the claim is successful.
Our ability to grow may be hindered and our business may suffer if our franchisees do not adopt and effectively implement improved programs and business practices we develop.
We are dependent on the willingness of our franchisees to adopt and effectively implement improved programs and business practices we develop in order to increase franchised center-based revenues and resulting royalties paid to us. However, franchisees often are not required to adopt these practices and they may adopt and implement our programs and business practices more slowly than we anticipate, or not at all. Any of these delays or failures could result in lower franchised center-based revenues and royalties paid to us, thus limiting our growth.
Our failure to maintain good relationships with our franchisees could significantly reduce our revenue and income.
We derive significant revenue from franchised operations, which comprised 17% and 19% of our revenue in 2006 and 2005, respectively. Our relationships with our franchisees may deteriorate in the future. Any deterioration in our relationship with our franchisees could significantly reduce our revenue and require management to direct their time and effort to rebuild strained relationships with franchisees. If management’s attention is focused on repairing relationships with franchisees instead of developing new programs and processes to increase revenue and income, our business and prospects may be adversely affected.
If we fail to sell licenses for new franchise territories, our financial performance and growth prospects may be adversely affected.
The growth of our business is dependent upon increasing the number of our franchised centers by selling licenses for new territories. Damage to our reputation and competition from other franchised supplemental education service providers may adversely affect our ability to sell licenses for additional franchise territories. If this were to occur, continued expansion would require the opening of a larger number of company-owned centers than we currently have planned which would require significantly more time and capital expenditures by us and could hinder or prevent our expansion.
The sale of licenses for new franchise territories could harm our relationship with existing franchisees.
Some or our franchisees presently benefit from being located adjacent to unlicensed territories. If we sell licenses for those unlicensed territories, the existing franchisees may have an adverse reaction, potentially straining our relationship with them.
New programs, services, and products may not be accepted and purchased by institutional customers and consumers.
As part of our growth strategy, we intend to implement, offer, and sell new programs, services, and products. There can be no guarantee that the new programs, services, and products will be successful or that our institutional customers and consumers will accept and purchase them.
Our ability to grow may be hindered by product-related problems.
A source of growth of our business will be in the creation, manufacture and sale of educational products that are fun, easy to use, and effective. We may experience manufacturing problems, distribution problems, and inventory management problems. In particular, during 2006 our products business experienced a negative $19 million operating income swing due to increased operating costs incurred to prepare the segment for future growth. Increased infrastructure costs to expand production and distribution as well as a dramatic increase in the development cost for new products combined to result in a significant decline in operating performance for the Product business. If we continue to incur similar levels of necessary infrastructure and development costs without an increase in revenue through expansion of our distribution channels, our ability to grow or maintain our other businesses may be adversely effected. In addition, there are risks due to the seasonal nature of the product business and we may experience problems as we sell the products internationally.
We rely on the accuracy of the unaudited financial information we receive from our franchisees, over which we do not have direct supervision or control and which we do not routinely audit.
Under their license agreements with us, our franchisees are required to report financial and other data to us, including their learning center revenues and results of operations. We rely on franchisee data to make important business decisions. However, we do not routinely audit the information that our franchisees report to us, and we do not have direct supervision over the reporting of our franchisees. Therefore, we are unable to ensure that the data reported by our franchisees is accurate. If the data reported by our franchisees is not accurate, it may result in less informed business decisions by management.
Franchise regulations could limit our ability to terminate or replace unproductive franchises, which could result in lower franchise royalties.
Applicable laws may delay or prevent us from terminating an unproductive franchise or withholding our consent to renew or transfer a franchise, which could result in lower franchise royalties. As a franchisor, we are subject to federal, state and international laws regulating the offer and sale of franchises. These laws also frequently apply substantive standards to the relationship between franchisor and franchisee and limit the ability of a franchisor to terminate or refuse to renew a franchise. Compliance with federal, state and international franchise laws can be costly and time consuming, and we cannot be certain that we will not encounter delays, expenses or other difficulties in this area. Further, we cannot predict the nature and effect of any future legislation or regulation of our franchise operations.
Economic, political and other risks associated with our European and Canadian centers could adversely affect our business.
Our European and Canadian centers are subject to a number of risks inherent to operating in foreign countries. For example, risks affecting our European and Canadian centers include:
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fluctuations in foreign currency exchange rates; •
differences or unexpected changes in regulatory requirements; •
foreign governments’ restrictive trade policies; •
the imposition of, or increase in, duties, taxes, government royalties or non-tariff trade barriers; •
exchange controls; •
challenges of operating in international markets with different cultural bases and consumer preferences; and •
increased dependence on local country managers. Most of these risks are beyond our control. We cannot predict the nature or likelihood of any such events. However, if such an event should occur, it could adversely affect our business, financial condition and results of operations.
Our Catapult Learning segment conducts business largely with local education authorities, which change from time to time. As a result of these changes, our relationship can be adversely affected, leading to reductions in business and harm to our reputation.
A substantial portion of our revenue, 21% and 20% in 2006 and 2005, respectively, is generated by our Catapult Learning segment. This segment provides services to government agencies, primarily to school districts, and therefore is exposed to the risks associated with government contracting. Many of our contracts with school districts are school-year contracts subject to annual renewal at the option of the school district, and in many instances the school district can terminate or modify the contracts at their convenience. Any negative publicity, whether or not the reason for such publicity is within our control, could cause a school district to terminate or fail to renew a contract. Changes in the composition of local school boards or changes in school district administration may adversely affect a school district’s willingness to contract with us. In addition, any termination or non-renewal of a contract with a school district could have an adverse effect on our results of operations, and a termination or non-renewal caused by our failure to improve the poor academic performance of students enrolled in our programs could adversely affect our ability to secure contracts with other school districts.
Changes in Federal and state laws reducing or eliminating funding for third-party suppliers of supplemental education services could adversely affect our business.
Our Catapult Learning segment relies almost exclusively on government-funded programs. The federal government and state governments may, at any time, reduce, or lower the rate of growth of, funding under the Elementary and Secondary Education Act (ESEA), the Individuals with Disabilities Education Act (IDEA) or similar programs. The U.S. Congress may modify or repeal the ESEA (currently reauthorized as the No Child Left Behind Act) or modify the IDEA, thus reducing the amount of federal money available to fund our programs. The Federal and state governments may eliminate or specifically limit the amount of funds spent on third-party supplemental education services. Any such reduction, limitation or elimination of funding could adversely affect our revenue.
If we fail to comply with applicable state and federal regulations, we may face government sanctions.
As a result of providing services funded by government programs, we are subject to state and federal regulations. Compliance with state and federal regulations can be costly and time consuming, and we cannot be sure that we will not encounter delays, expenses or other difficulties. Further, our failure to comply with these regulations could result in financial penalties or restrictions on our operations.
Additional Risks Relating to Our Business and Industry
Our operating results may vary significantly from quarter to quarter as a result of seasonal and other variations to which our business is subject. This may result in volatility or adversely affect our stock price.
We experience seasonality in results of operations primarily as a result of changes in the level of student enrollments during the course of the school year and the duration of the school year. Also, we recognize franchise royalty revenue based upon our cash receipts from franchisees, in accordance with the terms of our franchise agreements. Because many customers prepay for programs at the time of enrollment, the timing of our franchise royalty revenues tends to correspond to student enrollment dates. In our company-owned center and other businesses, however, we recognize revenue as we deliver services. We typically generate the largest portion of our
revenue in our Franchise Services, Company-Owned Centers and Catapult Learning segments in the second quarter, and we experience lower revenues from franchise royalties in the fourth quarter as a result of prepayments by customers to our franchisees in other quarters. As a result, we believe that quarter-to-quarter comparisons of our results of operations may not be a fair indicator and should not be relied upon as a measure of future performance.
Our historical results of operations may not be indicative of future performance, which is difficult to forecast. We expect our results to vary from quarter to quarter.
We expect results of operations to fluctuate in response to factors in addition to seasonal fluctuations. These factors include customer issuance of purchase orders and acceptance of product, the timing of receipt of payment from our customers, including those under government contracts funded under Title I and other legislation, changes in the percentage of customers prepaying in our franchised centers and the timing of revenue recognition of franchise license fees. Changes in the pattern of customer prepayments in our franchised centers would cause fluctuations of operating results because these changes impact our franchise royalty revenues. In our Catapult Learning and Educate Online segments, we often experience significant delays in payment by the school districts.
We make substantial investments in advertising campaigns, which may not be effective.
Our business is dependent upon inquiry calls from potential customers. Most of these calls are generated in response to television and internet advertising. In January 2007 we began airing new television advertisement. We cannot be certain this new advertisement will generate more inquiries per dollar spent on media than in prior years. Additionally, in October 2006 we launched a revision of our Educate.com website intended to improve responsiveness from customers. We cannot be certain this new website will be more responsive than the site it replaced.
In 2007, we modified our mix of television, radio and web media purchases. We cannot be sure this new mix of media will be more effective than our prior strategy.
We have a limited operating history as an independent company, which may make our business difficult to evaluate.
We commenced operations as an independent company in 2003. As a result, we have only a limited operating history as an independent company upon which you can evaluate our business and prospects. We will encounter risks, uncertainties and difficulties frequently experienced by other similarly situated companies, such as maintaining adequate internal controls and procedures and managing the expansion of our operations. If we do not successfully manage these risks, our business, financial condition and results of operations will be adversely affected.
We expect that new products and programs we develop will expose us to risks that may be difficult to identify until such products or programs are implemented.
We are currently developing, and in the future will continue to develop, new products and programs, the risks of which will be difficult to ascertain until these future programs are implemented. For example, in February 2005, we acquired the Hooked on Phonics brand of educational programs. These new products and programs differ significantly from the services our Sylvan Learning Center franchisees currently provide in their learning centers. Any negative events or results that may arise as we develop new products or programs may adversely affect our reputation, business, financial condition and results of operations.
New products and programs we develop may compete with our current programs.
We are presently developing, and will likely in the future develop, products and programs that compete with our existing programs. For example, we are currently piloting programs to address homework assistance and premium tutoring opportunities to complement our traditional center-based diagnostic, prescriptive learning programs. Our Hooked on Phonics brand, to some extent, also competed with our existing programs.
Our success depends on our ability to recruit and retain necessary personnel.
Our success also depends, in large part, upon our ability to attract and retain highly qualified personnel. For example, our Progressus Therapy business must recruit qualified occupational therapists, physical therapists and speech language pathologists to administer the specialized services we provide. A shortage of qualified therapists and pathologists currently exists, which may inhibit us from satisfying demand and could limit our growth. In addition, as a result of higher elementary school enrollment and the retirement of veteran teachers, a shortage of teachers may develop over the next decade. Similar shortages have occurred in the past. We may have difficulty locating and hiring qualified teachers and retaining such personnel once hired. We depend on key personnel, including
R. Christopher Hoehn-Saric, Peter Cohen, Donna Dixon, Christopher Paucek and Kevin Shaffer, to effectively operate our business. If any of our key personnel left our company and we failed to effectively manage a transition to new personnel, or if we fail to attract and retain qualified and experienced personnel on acceptable terms, our business, financial condition and results of operations could adversely be affected.
Our substantial indebtedness could adversely affect our financial condition and impact our business and growth prospects.
As of December 31, 2006, our total indebtedness was approximately $178.4 million. Our substantial indebtedness could have important consequences. For example, it could:
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require the use of all or a large portion of our cash to pay principal and interest on our operating company’s secured credit facility, which could reduce the availability of cash to fund working capital, capital expenditures and other business activities; •
increase our vulnerability to general adverse economic and industry conditions; •
limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; •
restrict us from making strategic acquisitions or exploiting business opportunities; •
place us at a competitive disadvantage compared to our competitors that have less debt; and •
limit our ability to borrow additional funds, dispose of assets or pay cash dividends, if we choose to pay dividends in the future. Furthermore, all of our indebtedness under our operating company’s secured credit facility bears interest at variable rates. If these rates were to increase significantly, our interest expense would increase, our ability to borrow additional funds may be reduced and the risks related to our substantial indebtedness would intensify.
The terms of our secured credit facility restrict us from engaging in many activities and require us to satisfy various financial tests. We expect that any credit facilities that we obtain in the future will contain similar restrictions and requirements.
Our secured credit facility contains covenants that restrict, among other things, our ability to incur additional debt, pay cash dividends, create liens, change our fundamental organization or lines of business, make investments and engage in transactions with affiliates and that contains events of default that are triggered, among other things, if there is a change of control of us or our subsidiaries and for certain changes in the composition of our Board of Directors, all of which may adversely affect our ability to grow and to pursue new business opportunities. The secured credit facility also requires us to maintain specific financial ratios. Events beyond our control could affect our ability to meet those financial ratios, and we cannot assure you that we will meet them. A breach of any of the covenants contained in our secured credit facility could allow the lenders to declare all amounts outstanding under the secured credit facility to be immediately due and payable. We have pledged substantially all of our assets to the lenders as collateral under our secured credit facility. The lenders could proceed against the collateral granted to them if we are unable to meet our debt service obligations. If the amounts outstanding under our secured credit facility are accelerated, we may be forced to restructure or refinance our obligations, obtain equity financing or sell assets, which we may be unable to accomplish in a timely manner, on terms satisfactory to us or at all. If we are unable to restructure or refinance our obligations, we may default under our obligations. In order to replace our existing secured credit facility or raise additional capital, we may seek to obtain one or more credit facilities in the future. We expect that any credit facilities we enter into in the future will contain restrictions and requirements similar to those described above.
As discussed more fully in the Notes to the Consolidated Financial Statements as of December 31, 2006, on March 15, 2007, we obtained a waiver of certain violations of these financial covenants as of December 31, 2006 and March 31, 2007 from our bank syndicate. We believe we will fail to comply with these same financial covenants at subsequent quarterly reporting dates in 2007, and accordingly, will need to obtain waivers or amend the terms of the credit facility to avoid triggering the facility’s demand repayment provisions. As a result, we classified the $175.8 million of outstanding borrowings under the credit facility at December 31, 2006 as a current liability in the accompanying 2006 consolidated balance sheet, resulting in a working capital deficit of $170.0 million.
We considered attempting to negotiate revised financial covenants to allow for compliance in 2007 based on projected operating results. However, because we have entered into a definitive merger agreement for the sale of the Company and expect to close that transaction by June 30, 2007, we determined it was not prudent to negotiate new terms and incur additional costs to amend our credit facility. However, we cannot assure you that lenders will waive their right to demand repayment of outstanding borrowings upon the likely default of the credit facility’s provisions in the June 30, 2007 and subsequent quarterly reporting periods, and in the event of demanded repayment, that we can refinance the loans on acceptable terms. If we are unable to refinance the indebtedness or obtain a waiver of a default, then we may be unable to continue as a going concern. In addition, we cannot assure you that the Merger will be completed within this timeframe, or at all.
Business uncertainties and contractual restrictions while the proposed merger is pending may have an adverse effect on us.
Uncertainty about the effect of the Merger on employees, suppliers and partners may have an adverse effect on us. These uncertainties may impair our ability to attract, retain and motivate key personnel until the Merger is consummated, and could cause others that deal with us to defer decisions concerning us, or seek to change existing business relationships with us. Employee retention may be particularly challenging while the Merger is pending, as employees may experience uncertainty about their future roles with the post-merger entity. In addition, the Merger Agreement restricts us from taking specified actions without the buyer’s approval. These restrictions could prevent us from pursuing attractive business opportunities that may arise prior to the completion of the Merger.
Failure to complete the Merger may negatively impact on our ongoing business.
If the Merger is not approved by our stockholders or if the Merger is not completed for any other reason, we will remain an independent public company and our common stock will continue to be listed and traded on the NASDAQ Global Select Market. While we expect that management will operate the business in a manner similar to that in which it is being operated today, if the merger is not completed, we may suffer negative financial ramifications, including as a result of paying the $16 million termination fee if such termination fee is required to be paid and the expenses incurred as a result of the proposed merger and the decline of the market price of our shares of common stock to the extent that the current market price reflects a market assumption that the proposed merger will be completed. In addition, a failed merger may result in negative publicity and/or a negative impression of us in the investment community. As a result, our business, prospects, results of operations or stock price could be adversely impacted.
Natural or manmade disasters could interrupt our business.
Natural disasters, fire, power shortages, terrorist attacks and other hostile acts, labor disputes, public health issues, and other events beyond our control could interrupt our business operations. We cannot predict the occurrences or consequences of these events, which could decrease demand for our products and services, or make it difficult or impossible for us to deliver products and services to our customers. These events have adversely affected our operating results and financial condition in the past, and may adversely affect us in the future. For example, during 2005 Hurricane Katrina adversely affected the delivery of services in the Catapult Learning segment in the Gulf Coast region, thus adversely affecting our operating results.
Item 1B. Unresolved Staff Comments.
None.
