You should read the following discussion together with the consolidated financial statements and the related notes included elsewhere in this report.

Overview
Executive Overview
We are an online postsecondary education services company. As of December 31,
2012, our wholly owned subsidiaries included the following:
•        Capella University (the University) is a regionally accredited
         university offering a variety of undergraduate and graduate degree
         programs primarily for working adults.


•        Resource Development International Limited (RDI) is an independent
         provider of United Kingdom (UK) university distance learning
         qualifications and markets, develops and delivers these programs
         worldwide via its offices and partners across Asia, North America,
         Africa and Europe.


•        Sophia Learning, LLC (Sophia) is a social teaching and learning platform
         that integrates education with technology.

We believe we have the right operating strategies in place to continually differentiate ourselves in our markets and drive growth by supporting learner success, producing affordable degrees, expanding our comprehensive marketing strategy, and serving a broader set of our learner's professional needs and establishing new growth platforms. Technology and the talent of our faculty and employees enable these strategies. We believe these strategies and enablers will allow us to continue to deliver high quality, affordable education, resulting in continued growth over the long-term. We will continue to invest in these enablers to strengthen the foundation and future of our business.

Key Trends, Developments and Challenges
The following developments and trends present opportunities, challenges and risks toward achieving our goal of providing attractive returns to our shareholders:

•         Initiatives to improve learner success. As we continue to position
          Capella to drive sustainable growth, we are focused on improving
          learner success rates particularly in the first four quarters of
          enrollment, while maintaining a high standard of academic quality and
          rigor. We have implemented various measures likely to affect our growth

•             Investing in our actionable analytics capabilities to further
              leverage data, refine our models and accurately predict the
              likelihood of a prospective and new learner persisting to critical
              thresholds of success in the learner's first four quarters of
              enrollment;


•             Piloting programs to create personalized pathways for different
              learner groups which focus on transitioning learners into the
              online environment, creating a supportive community, and providing
              a proactive support structure;


•             Providing clear information near-real-time to our learners,
              faculty, advisors and staff to help learners persist and
              successfully complete their programs;

•             Transitioning our marketing approaches to increase emphasis on
              attracting learners who are more likely to persist in our programs;


•             Promoting affordability and encouraging learners to remain enrolled
              by offering learner success grants to new learners who meet
              admissions requirements, enroll, and apply within certain
              timeframes; and,


•             Diversifying outside of Capella University by creating innovative
              new learning technologies that have potential to increase
              affordability, and better serve the life-long learning needs of
              working adult professionals and therefore increase learner success.

As a result of these initiatives, early cohort persistence improved by approximately four percent over the prior year. Early cohort persistence measures the four-quarter weighted moving average new cohort persistence rate, since that is where our learner success strategy is primarily focused. Although these early results have been positive, we expect some of these initiatives will adversely impact our new and active enrollment, revenue, and operating margins in the near term. We believe these efforts are in the best interest of our learners and over the long-term will improve learner success and lifetime revenue, which, in turn, positions us for more sustainable long-term growth.

•        Comprehensive marketing strategy. Our strategic shift from a demand
         driven strategy towards a comprehensive marketing strategy which is
         focused on building relationships with prospective learners early in the

•             Introducing prospective learners to Capella through channels such
              as mass media and strategic relationships with employers,


•             Connecting with prospective learners by generating and nurturing
              inquiries through direct media such as natural search, our website,
              and display media, and


•             Engaging with prospective learners by developing meaningful
              relationships such as through social media or direct engagement.

According to our research, we believe the awareness and consideration of Capella University as an educational option has increased compared to the prior year. This shift has also resulted in improved conversion rates of prospective learners. However, inquiry volume has not yet fully replaced previous levels.

We believe our comprehensive marketing strategy will produce long-term efficiencies and increase our ability to attract high-quality learners on a long-term sustainable basis. However, some of these initiatives may adversely impact our new enrollment, revenues, and operating margins in the near term.

•        Current market and regulatory environment. The market continues to
         present challenging conditions and competition is strong; however, we
         remain focused on attracting the right learners and learner success. We
         believe our initiatives to improve learner success through innovation
         will position us to be a leader in the online postsecondary education
         market and to more closely align with employers. In addition, many
         states have become more active in regulating on-line education and
         enforcing consumer protection laws, especially with proprietary
         institutions. While we have a strong track record of regulatory
         compliance, such actions, even if not directed at Capella University,
         serve to make our operating environment more challenging.



•        Establishing new growth platforms. We seek to drive long-term growth
         that is an extension of our core competencies into new markets. We are
         pursuing this extension through a small business development team that
         is exploring early stage opportunities. This may result in increased new
         business development costs focused on researching, identifying, and
         cultivating these new opportunities.

In July 2011, we acquired RDI to access the fast-growing international higher education market. RDI has a presence in the UK and certain other countries. Although we believe the acquisition will have a positive impact on our revenue growth, RDI was dilutive to our earnings in 2012, and is expected to be dilutive to our earnings throughout 2013.

•        New enrollment growth. Overall, new enrollments grew approximately 0.5
         percent in 2012 compared to a decline of approximately 32 percent in
         2011. New enrollment growth in the second half of 2012 was led by our
         master's and certificate programs. The certificate programs were
         designed with the intent of offering an additional credential

or creating a pathway for the learner to ultimately participate in master's or doctoral programs. Certificate programs are shorter in length and generate less revenue per learner than our master's or doctoral programs. Thus, if these learners do not matriculate into a degree program, this may result in a lower learner lifetime value, impacting revenue and operating margins.

•        Redesign of programs and specializations. In our continued efforts to
         drive affordability and speed to competency, we are focused on
         maximizing efficiencies in our existing programs while delivering the
         same learning outcomes. Our curriculum is based on competency mappings,
         which we are able to leverage as we redesign existing offerings. We
         believe these types of redesigns have the potential to increase
         persistence rates, learner success, and affordability.

Regulatory Environment

•        U.S. Pending Legislation and Congressional Hearings. In recent years,
         there has been increased focus by members of the U.S. Congress on the
         role that proprietary educational institutions play in higher education.
         Congressional hearings and roundtable discussions have been held, and
         more are expected to be held in the future, regarding various aspects of
         the education industry including federal financial aid and military
         education funding that may result in regulatory changes that affect our
         business. We have voluntarily provided substantial amounts of
         information about our business at the request of various Congressional
         committees and individual members, and we intend to continue being
         responsive to Congress in this regard. In September 2010, the HELP
         Committee held a third hearing and Sen. Harkin's staff released its
         initial report entitled, "The Return on the Federal Investment in
         For-Profit Education: Debt Without a Diploma." After additional hearings
         and roundtable discussions and review of the information provided by
         proprietary institutions, Senator Harkin's staff released its final
         report in July 2012 entitled, "For Profit Higher Education: The Failure
         to Safeguard the Federal Investment and Ensure Student Success." The
         final report was not adopted by the full committee and the minority
         committee staff criticized it for relying on discredited sources and
         refusing to examine similar concerns in the non-profit education sector.
         Nonetheless, the report may be influential as Congress begins the
         process of reauthorizing the Higher Education Act, which currently
         expires in September 2013. The report advocates significant changes in
         the requirements governing participation by for profit educational
         institutions in Title IV student financial aid programs, including the

• Tie access to federal aid to meeting minimum student outcome thresholds;

•            Prohibit institutions from funding marketing, advertising and
             recruiting activities with federal financial aid dollars;


•            Improve cohort default rate tracking by expanding the default
             reporting rate period beyond 3 years;


•            Require that proprietary colleges receive at least 15 percent of
             revenues from sources other than federal funds; and


•            Use criteria beyond accreditation and state authorization for
             determining institutions' access to federal financial aid.

In addition, other Congressional hearings and roundtable discussions may be held regarding various aspects of the education industry that may affect our business. We cannot predict what legislation, if any, may emanate from these Congressional committee hearings or what impact any such legislation might have on proprietary institutions and our business in particular. Congressional scrutiny of proprietary institutions combined with federal budget deficits increases the likelihood of legislation that will adversely impact our business. As Congress addresses the historic U.S. budget deficit, whether through across-the-board funding reductions, sequestration or otherwise, financial aid programs are a potential target for reduction.

If Congress significantly reduced the amount of available Title IV program funding, we would attempt to arrange for alternative sources of financial aid for our students; however, private sources would not be able to provide as much funding to our students on as favorable terms as is currently provided by Title
IV. In addition, private organizations could require us to guarantee all or part of this assistance and we might incur other additional costs. For these reasons, private, alternative sources of student financial aid would only partly offset the impact on our business of reduced Title IV program funding.

•        Recent legislation. The Budget Control Act of 2011 (BCA; P.L. 112-25)
         eliminated the availability of Subsidized Stafford Loans to graduate and
         professional students for periods of instruction beginning on or after
         July 1, 2012;

and terminated the availability of certain repayment incentives for loans made on or after July 1, 2012. Without access to subsidized loans, graduate students could see higher debt balances and subsequently higher debt payments when they graduate or leave the institution. While difficult to determine if these changes in the law directly impacted or continue to impact enrollment, any changes to the terms by which the Department makes loans available to graduate students could impact our business.

•        The Improving Transparency of Education Opportunities for Veterans Act
         of 2012. This veterans' education initiative was signed into law on
         January 10, 2013. The purpose of the bill is to require the Department
         of Veterans Affairs (VA) to develop a comprehensive policy to improve
         outreach and transparency for veterans and member of the Armed Forces
         with respect to higher education. The details of this policy will be
         developed through rulemaking. Additional provisions include:


•            Creation of a centralized mechanism for tracking and publishing
             feedback from students and state authorizing agencies on the quality
             of instruction, recruiting practices and post-graduation
             employment.


•            A description of the different types of accreditation available to
             institutions and an explanation of Federal Financial Aid.


•            For each institution, the VA will list the tax status, accreditation
             type, state approving agency information, if the institution
             participates in Title IV, tuition and fees, median debt, the cohort
             default rate, enrollment/graduation/retention rate, transfer credit
             policies, and support services available.


•            The bill also contains an incentive compensation provision as it
             relates to VA tuition benefits. The VA will not approve courses or
             programs for VA tuition benefits if a school participates in
             incentive compensation practices.


•        Rulemaking by the U.S. Department of Education. In 2010, the DOE issued
         new Title IV program integrity rules that address numerous topics. The

•            Adoption of a definition of "gainful employment" for purposes of the
             requirement for Title IV student financial aid that a program of
             study offered by a proprietary institution prepare learners for
             gainful employment in a recognized occupation;


•            Implementation of standards for state authorization of institutions
             of higher education;


•            Implementation of standards around the new program approval section
             of gainful employment; and


•            Expansion of the definition of misrepresentation, relating to the
             Department's authority to suspend or terminate an institution's
             participation in Title IV programs if the institution engages in
             substantial misrepresentation about the nature of its educational
             program, its financial charges, or the employability of its
             graduates, and expansion of the sanctions that the Department may
             impose for engaging in a substantial misrepresentation.

The Department published final regulations on October 29, 2010, including disclosure and reporting provisions related to gainful employment metrics. Most of the October 29, 2010 final rules were effective July 1, 2011; however, the Department published final gainful employment debt and repayment metrics, and new program approval requirements on June 2, 2011, with an effective date of July 1, 2012. On June 21, 2012, the DOE released data to educational institutions showing the calculation of gainful employment metrics for 2011 for each of the institution's covered programs. This gainful employment information was released to the public on June 26, 2012. An institution's programs must pass a loan repayment rate test or meet debt-to-discretionary income or debt-to-annual earnings ratios in order to remain eligible for federal financial aid. These 2011 metrics were released for informational purposes only, and as pursuant to the Department's final rule published in June 2011, the standards to determine whether a program prepares students for gainful employment went into effect on July 1, 2012. The informational metrics for 2011 are generally based on data reported for Capella University learners and programs from federal Fiscal Years 2007 and 2008.

As a result of a data transmission issue, there is an error in the debt data that the Department used to calculate Capella University's debt-to-discretionary income and debt-to-annual earnings ratios. The error produced more favorable debt-to-earnings metrics than we had anticipated. We thus are unable to rely on the accuracy of the informational debt-to-earnings metrics provided by the Department and have engaged with the Department on this issue. We are not aware of any similar data issues with respect to the loan repayment rate. Six of Capella University's programs did not satisfy the loan repayment rate standard, of which three programs do not have a

sufficient number of graduates within the pertinent timeframe to be evaluated. The size of the remaining three programs is not material to the total number of Capella University learners.

On June 30, 2012, one day before the regulation was scheduled to take legal effect, the U.S. District Court for the District of Columbia vacated the Gainful Employment "debt measures" regulation in its entirety, largely on grounds that the loan repayment rate aspect of the regulations was arbitrary and capricious. Although the District Court vacated the debt measures regulation - including the loan repayment and debt-to-income metrics promulgated by the Department to assess whether a program prepared students for gainful employment - and the related institutional reporting requirements and new program approval regulations, the Gainful Employment program disclosure requirements that took effect July 1, 2011 were left intact. On July 30, 2012 the Department filed a motion with the District Court to reinstate the requirement that institutions report information used to calculate student loan-repayment rates and debt-to-income ratios. The Department's motion is still pending.

Because of the significance of this regulation, and the basis on which the District Court made its decision, we believe the Department may appeal the full decision to the U.S. Court of Appeals for the District of Columbia Circuit. Further, the District Court found that the Department did possess statutory authority to define "gainful employment" by regulation and to develop specific metrics as part of such regulations. The court's decision, however, means that the Gainful Employment Debt Measures regulation did not take effect on July 1, 2012.

•        Minnesota Office of Higher Education Student Debt Information
         Request. The Minnesota Office of Higher Education (MOHE) is developing
         state level metrics related to Average Student Loan Debt. The data
         request was sent to all schools located within the state. The final
         report will be published by institution and sector (public 2-year,
         public 4-year, private not-for-profit, and private for-profit) covering
         average educational loan debt (excluding PLUS loans) of degree
         recipients by award level for 2009-2010. The student loan debt is debt
         from all sources (federal, state, institution, private) known to the
         institution. We are working with MOHE on this request. The date for the
         report to be published has not been determined.



•        Student Loan Cohort Default Rates. To remain eligible to participate in
         Title IV programs, an educational institution's student loan cohort
         default rates must remain below certain specified levels. Under current
         regulations, an educational institution will lose its eligibility to
         participate in Title IV programs if its two-year measuring period
         student loan cohort default rate equals or exceeds 25% for three
         consecutive cohort years, or 40% for any given year. Capella
         University's two-year cohort default rates for the 2010 and 2009 cohorts
         are 7.0% and 6.6%, respectively.

The cohort default rate requirements were modified by the Higher Education Opportunity Act enacted in August 2008 to increase by one year the measuring period for each cohort. Starting in September 2012, the Department will publish the official three-year cohort default rates in addition to the two-year rates, beginning with the 2009 cohort. If an institution's three-year cohort default rate exceeds 30% for three consecutive years (compared to 25% under the current two-year standard), it must establish a default prevention task force and develop a default prevention plan with measurable objectives for improving the cohort default rate. We believe that our current repayment management efforts meet these requirements.

If an institution's three-year cohort default rates for the 2009 and 2010 cohorts exceed 30%, the institution may be subject to provisional certification imposing various additional requirements for participation in Title IV programs. Beginning with the three-year cohort default rate for the 2011 cohort published in September 2014, the three-year rates will be applied for purposes of measuring compliance with the requirements. If the three-year cohort default rate for the 2011 cohort exceeds 40%, the institution will cease to be eligible to participate in Title IV programs, and if the institution's three-year cohort default rate exceeds 30% for three consecutive years, beginning with the 2009 cohort, the institution will cease to be eligible to participate in Title IV programs. The Department has published, for informational purposes, "trial rates" to assist institutions in understanding the impact of the new three-year cohort default rate calculation. Capella University's three-year cohort default rate for the 2009 cohort is 9.7%, and its trial three-year cohort default rate for the 2008 cohort is 6.5%. This increase is primarily due to the overall economic environment, and an increased percentage of Capella University learners enrolled in a bachelor's program, who generally have a higher default rate compared to graduate learners.

Overview of Revenues and Expenses
Revenues. Revenues consist principally of tuition, application fees, and commissions we earn from bookstore and publication sales. During each of 2012, 2011, and 2010 tuition represented approximately 99.1%, 99.4%, and 98.9% of our revenues,

respectively. Factors affecting our revenues include: (i) the number of enrollments; (ii) the number of courses per learner; (iii) our degree and program mix; (iv) the number of programs and specializations we offer;
(v) annual tuition adjustments; (vi) the number of colloquia events and learners at each event; and (vii) the amount of scholarships, tuition discounts, and leaner success grants offered to learners.

Enrollments for a particular time period are defined as the number of learners registered in a course on the last day of classes within that period. We offer monthly start options for newly enrolled learners. Learners who start their program in the second or third month of a quarter transition to a quarterly schedule beginning in their second quarter. Enrollments are a function of the number of continuing learners at the beginning of each period and new enrollments during the period, which are offset by graduations, withdrawals and inactive learners during the period. Inactive learners for a particular period include learners who are not registered in a class and, therefore, are not generating revenues for that period, but who have not withdrawn from Capella University. We believe that our enrollments are influenced by the attractiveness of our program offerings and learning experience, the effectiveness of our marketing and recruiting efforts, the quality of our faculty, the number of programs and specializations we offer, the availability of federal and other funding, the length of our educational programs, the seasonality of our enrollments, general economic conditions, and the regulatory environment.

The following is a summary of our Capella University learners as of the last day of classes for the years ended December 31, 2012, 2011, and 2010:

            2012        2011      2010
Doctoral   11,023      11,619    12,058
Master's   15,596      17,049    18,740
Bachelor's 8,800        8,489     8,435
Other      910            547       244
Total      36,329      37,704    39,477

Tuition and fees. Our tuition rates vary by type and length of program and by degree level, such as doctoral, master's or bachelor's. For all learners in master's and bachelor's programs, tuition is charged on a per course basis. Prices per course ranged from approximately $1,400 to $2,500 for the 2012-2013 academic year (beginning in July 2012) and from $1,300 to $2,364 for the 2011-2012 academic year (beginning in July 2011). The price of the course varies based upon the number of credit hours, the degree level of the program and the discipline.

The majority of doctoral programs are priced at a fixed quarterly amount ranging from approximately $3,500 to $4,600 per learner for the 2012-2013 academic year . . .