Houghton Mifflin Harcourt Company
Q2 2021 Earnings Call Transcript

Published: 7 Aug 2021

[Operator:]

Good day and thank you for standing by. Welcome to the HMH Second Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's is being recorded. I would now like to hand the conference over to your speaker today, Chris Symanoskie, Vice President of Investor Relations. Please go ahead.

[Chris Symanoskie:]

Thank you and good morning everyone. Before we begin, please note that slides referred to on today’s call can be found on the Investor Relations section of our website at hmhco.com. A telephone replay of today’s call will be available until August 15th, 2021 and the webcast will be available on our website for one year. Our 10-Q was filed with the SEC earlier this morning, along with its second quarter 2021 earnings press release. HMH encourages you to review the cautionary statement on slide two for our customary disclosures. Additional information regarding fees and other risk factors can be found in the Risk Factors section and elsewhere in the company's quarterly and annual filings with the SEC. Furthermore, please refer to today's press release and the appendix of our slide presentation for a reconciliation of our non-GAAP measures for the most directly comparable GAAP measures. This morning HMH President and Chief Executive Officer, Jack Lynch and HMH Chief Financial Officer, Joe Abbott, will provide an overview of the company's second quarter 2021 results. Now, I'll turn the call over to Jack. Jack?

[Jack Lynch:]

Thanks Chris. Good morning everyone and thanks for joining the call today. HMH delivered another strong quarter while executing our strategy in a market where demand for teaching and learning solutions is growing. The spending environment is improving and educators are planning for students to return to classrooms this fall. We are pleased that our Q2 performance is positioning us for a strong 2021. We delivered billings growth of 25%. Our margins continue to expand, helping us achieve $101 million in trailing 12 months free cash flow, a 40% improvement compared to Q1 of this year. Annual recurring revenue or ARR from our expanding subscriber base grew 106% as our digital-first connected strategy continues to deliver transformational results. The increase in our net revenue retention rate, or NRR to 154% was a key driver in our ARR growth, reflecting the strength of the relationships we are forging with our subscribers and putting us on track to finish 2021 with ARR in a range of 10% to 15% of our total billings. As you read about in our frequent updates last quarter, we continue to make excellent progress in transforming our capital structure to align with our digital-first connected strategy. Notably, we use the net proceeds from our completed divestiture of HMH Books & Media to pay down $337 million in debt, further enhancing our financial position and ability to invest in growth and efficiency and create shareholder value. In addition, our credit ratings were recently upgraded by both Moody's and Fitch, not only because of the debt paid down, but also due to the strong improvement in our profitability and cash flow. The momentum we have in executing our digital-first connected strategy, combined with strong billings growth year-to-date and the overall strength of our pipeline gives us the confidence to raise our billings and unlevered free cash flow guidance for the year. Joe will walk you through this in more detail shortly. I want to spend a few minutes discussing what we've seen over the past few months in the K-12 spending environment. As educators planner returning students to classrooms this fall and school funding begins to stabilize, we're continuing to see growth in demand for teaching and learning solutions, including intervention solutions that addressed achievement gaps created by interrupted learning last year, arguably the most challenging year in education. Back-to-school purchasing this year also included some catch-up print purchasing. This is not a surprise. Print was not a very useful medium in the remote learning setting. But as districts are now planning for a resumption of in-person learning this fall, they are restocking some of their print resources. One of HMH's key advantages is that we offer our products in digital and print form, in contrast to many of our competitors, who typically focus on one medium or the other. In terms of state and local funding, we saw continued signs of stabilization in Q2, though not uniformly, there are many districts that are receiving stimulus funds and are beginning to use those funds for instructional materials. Conversely, we saw other districts where budgets have not fully recovered, or their stimulus money has not been received and this is still driving a more conservative level of instructional material purchase planning for the 2021-2022 school year, which began last month in July. On a federal level, the outlook remains promising, but the timing impact continues to be uncertain. Factors influencing that include the flexibility and uses of funds, such as the ability of districts to use stimulus dollars to fund prior COVID-19 expenditures. There is also a great deal of flexibility and timing, with some stimulus funds available to be committed into 2024. Looking ahead, it's been encouraging to see the continued emphasis on K-12 funding at the federal level. Now, just a few reminders of why we are incredibly excited about the momentum we are achieving today, and the growth opportunity that lies ahead in our future. First HMH operates in an extremely large and growing market, with 54 million students, 115,000 schools, and $740 billion in annual spending, with more than $10 billion spent on instruction materials and services. Within this market. HMH is the only company that provides a full portfolio of integrated solutions, purpose built for the teaching and learning of all students and competitively, that integrated solution is the most comprehensive in the industry, alleviating a major pain point in the industry today, which is the fragmented nature of the point solutions found in many of today's classrooms that require an exhausting level of work by a teacher to extract insight and improve student outcomes. Demand for this comprehensive solution continues to grow because our solutions are proven to work. They combine the power of evidence based resources, learning analytics services, and a great user experience. How well do they work? Here's a great example. In Newport News, Virginia, at the end of the 2021 school year, more than 11,000 of their students in grades three through nine use HMH reading inventory, system 44, or math 180 to address COVID learning challenges during the 2020-2021 school year. This resulted in 61% of them, achieving gains in their Lexile reading level, 21% achieving double their expected annual growth in reading performance, and more than 120 learners rolling between one and four grade levels. Underpinning our success with advancing student outcomes has been an authentically purpose driven culture, an important differentiator for HMH. Our incredible team continues to find innovative ways to bring learning to students and teachers and to support the communities in which we live and work. Before I turn it over to Joe for our financial review, I'd like to tell you about the increasing confidence educators have in digital solutions and the progress we made this quarter on the three pillars of our digital-first connected strategy. As a result of our approach, we fully expect our billings mix to continue to shift to digital, especially as confidence in digital solutions continues to grow. The result of HMH's just released 2021 educator confidence report highlighted this point. 75% Have educators surveyed believe technology solutions that connect instruction and assessment on one platform will transform teaching and learning in the future. From the use of assessments to growing confidence in Ed-tech , trust and digital solutions is on the rise. 77% of teachers surveyed believe technology will help them be better teachers, and 82% believe adaptive learning will further transform teaching and learning. Furthermore, districts across the nation remain highly committed to maintaining the one to one investments they made to support students through the pandemic. And they're implementing lessons learned about using digital to automate teacher workflows, better track student learning, and personalized learning inside and outside of the classroom. As for digital-first connecting strategy, remember there are three key priorities that guide our team's execution. One, growing our digital-first connected business; two, deepening customer engagement and increasing customer outcomes; and three, optimizing our digital transformation. So, starting with our digital-first connected business, this is our unique value proposition as the breadth of our portfolio allows us to connect our core solutions with supplemental, intervention, and professional services to allow teachers to support the needs of all students across the achievement spectrum regardless of their academic ability, on one engaging and highly effective platform. We continue to see growth in our digital and connected solutions. With our connected sales for the trailing 12 months accounting for 49% of our billings, and digital accounting for 40%, our digital cillings percent is slightly down, which is directly tied to the catch up in print purchasing I mentioned earlier on this call. As students returned to in-person learning towards the end of the school year, and districts restock print materials. As Joe will discuss later, Heinemann's strong rebound this year also contributed. These solutions are predominantly analog in nature. Heinemann's rebound also explains the slight decline in the percentage of our total sales that were connected. We still expect to finish the year with connected sales above 50%. Number two deepen customer engagement and increase outcomes. Usage of our unique proprietary platform, HMH Ed, continues to grow rapidly, with 93% growth in trailing 12 months student assignments compared to the same point last year. While the rate of growth is impressive, it did slow a bit in the quarter, because in the second quarter of 2020, the entire nation transition to remote learning environment. At that time, the principal way for students and teachers to get their work done was on a digital platform. Towards the end of this school year, we saw many schools returning to in-person learning, which slowed usage a bit relative to earlier in the school year. Importantly, we are seeing increased demand for a highly effective learning solutions, while we continue to deepen customer engagement. And this drove an acceleration in our AR our growth rate to 106% in the second quarter, with a net retention rate on our SaaS business of 154%. Our third pillar, optimizing our digital transformation, we continue to make progress, decreasing our variable costs as we deliver more and more of our products digitally. For the trailing 12 months, our adjusted variable costs were 32% of billings. Now, I'd like to hand it over to Joe. Joe?

[Joe Abbott:]

Thanks, Jack and good morning, everyone. Before I walk you through our operating and financial review for the second quarter, I'd like to spend a few minutes updating you on our three financial priorities. Our first priority is maintaining a strong balance sheet. In the quarter, we paid down $337 million in debt using the proceeds from our completed sale of HMH Books & Media and reduced our gross leverage ratio to 1.8 times adjusted EBITDA for the trailing 12 months ended June 30th, 2021. In total, we reduced our outstanding debt balance to $325 million including approximately $22 million under our senior secured term loan facility due 2024 and approximately $303 million in senior secured notes due 2025. We continue to target gross leverage of under 2.0 times trailing 12-month adjusted EBITDA. While we may opportunistically add debt resulting in leverage above our 2.0 times target in support of an acquisition, for example. Our intent is to continue to deliver to below 2.0 times as soon as possible thereafter. As you may have seen, we recently received a ratings upgrade from Fitch, which follows an upgrade from Moody's earlier this year. These service important validations are ongoing work to position HMH as a company with a robust and sustained ability to generate free cash flow. And we continue to look for opportunities to further strengthen our balance sheet and reduce our interest expense. Our $303 million in senior secured notes, which carry a 9% coupon, become callable in February 2022 and we will be monitoring market conditions for the right time to refinance. Finally, we plan to reserve approximately $275 million of our year end cash balance to meet our seasonal working capital needs, which supplements our asset-backed liquidity facility. Our second priority is to invest in growth, we plan to invest a mid-teens percentage of our total billings in development activities to create highly differentiated products that fuel organic growth. We also plan to add to that organic growth with inorganic growth from small tuck-in acquisitions that leverage our business platform, including complimentary products and services, or which provide access to new adjacent customer segments. We added strategic flexibility from our debt paid down positions as well to do this. And our third priority is investing for efficiency. We intend to fund projects that we expect to help us deliver greater customer success, while making us a more effective business. For example, our back office automation project, which is currently ongoing. More on that in the moment. We also intend to fund projects that deliver operational efficiencies. One example of this in our active program to reduce our real estate footprint. In some cases, we will incur one time capital expenditures to make our space available for sublease, but we expect to generate healthy returns on those investments. Most recently, we have vacated or subleased underutilized facilities in both New York and Boston and we will continue to evaluate other facilities as employee preferences shift to remote work. And as our business continues its shift to digital, which requires less physical space in some instances. Given our strong first half results, and robust pipeline, today, we're raising our full year guidance. We now anticipate Billings for the full year to be between $980 million and $1.02 billion, which is a 9% to 14% growth rate versus 2020. up from our prior expectation of $905 million to $955 million. We continue to expect that over 50% of our billings will be derived from connected sales this year. We're also raising our unlevered free cash flow outlook to 12% to 14% of annual billings from our prior nine to 11% range, which reflects the high degree of operating leverage in our business and our increased billings guidance. As our business continues to grow, we expect our unlevered free cash flow margin to expand along with that growth. Our unlevered free cash flow outlook excludes a planned $10 million investment in our back office automation project this year. This is a three-year program focused on modernizing the technology we use to better serve our customers, as well as streamline our operational processes as we continue to scale our digital-first connected business. Finally, we remain on track to deliver annualized recurring revenues of 10 to 15% of 2021 billings up from 6% in 2020. We expect to achieve a net retention rate of over 100%, which will contribute to the growth in our ARR. All-in-all, during the second quarter and first half of 2021, we continue to capitalize on our strengthened financial position to invest in our learning technology strategy. We have a strong balance sheet, discipline capital allocation approach, and continued focus on growth and investing for efficiency, which are fueling our drive to digital and strong financial results. Now, let's turn our attention to our second quarter financials. We've had a strong start to the year as we execute on our digital-first connected strategy. Total billings were $327 million in the second quarter, up 25% over the prior year period. Core solutions billings were up to $7 million or 5% $258 million, driven by strong open territory demand as a result of the market recovery. Extensions billings are up $58 million, or 52% to $168 million, driven by strong demand across all product portfolios. We start off with our particularly strong growth in our Heinemann products, due to the expectation of most of our customers that learning will largely be done in-person in the upcoming school year. Professional Services also grew due to strong customer demand for virtually delivered connected professional development experiences. Turning to our other key financials, our net sales increased to $309 million in the second quarter. Income from continuing operations for the second quarter was $2 million, an improvement of $35 million compared to the same period in 2020. adjusted EBITDA for the second quarter increased to $86 million from $32 million in the same period last year, due to a robust net sales growth and high operating leverage and our business made stronger by the actions we took to reduce costs. Adjusted EBITDA margins expanded by 1,300 basis points to 28%. Free cash flow improved by $29 million in the quarter, bringing our trailing 12 months free cash flow to $101 million at the end of June, up from $72 million at the end of March. As you know, we typically use cash in the first half of the year and generate cash in the second half of this year. Our year-to-date performance is demonstration that our cost structure is scaling well and it's a strong forward-looking indicator of the robust free cash flow we expect to generate this year. Although the market has not fully recovered from the COVID-19 pandemic, we believe our digital-first connected strategy will result in a more stable growing recurring revenue stream with higher margins and increasing free cash flow over time. And with that, I'd like to hand the call back over to Jack for some closing remarks. Jack?

[Jack Lynch:]

Thank you, Joe. Although HMH was founded more than 180 years ago, our learning technology story is just beginning. We are innovating in the market, helping teachers unlock the learning potential of their students with evidence-based solutions powered by digital platform, learning science and artificial intelligence. As an innovator with a student outcome driven approach, we believe HMH is now distinctly different and well-positioned for the next chapter in its history, a completely new chapter, containing four components of value creation. First, HMH has unique opportunity to expand market share in a very large and growing market through innovation, cross-selling, and connections across its portfolio of learning solutions. Second, HMH offers the industry's most comprehensive portfolio of learning solutions, unworn, engaging, and dynamic platform providing critical value to educators and students. As you saw in the case study earlier, our solutions are competitively unique and effective at increasing student outcomes. Third, we have a clear three-point strategy in place that focuses on shifting a revenue mix to digital and building recurring revenue, while expanding margins what we call our digital-first connected strategy. And finally, we're committed to maintaining a strong balance sheet and free cash flow generation to compliment organic growth and enable flexibility for tuck-in acquisitions to further broaden our solutions portfolio. Now, I'd like to take a moment to say how proud I am of our employees. Their hard work and dedication has continued to fuel our momentum. We believe we have a winning formula to create value for students, for teachers, and the communities we serve. And for our shareholders, we've driven growth in all the key indicators of our transformation, annual recurring revenue net retention in digital billings, and we are well-positioned for a great 2021. With that, let's get to your questions.

[Operator:]

Thank you. Our first question comes from Jeff Silber with BMO Capital Markets. Your line is now open.

[Jeff Silber:]

Thanks so much and congratulations on the great results. Jack at the beginning you talked about the flow of funds and how some districts have gotten money, some may have not. Is there any way to quantify that what percentage have gotten the money for this year? What percentage is going to be deferred?

[Jack Lynch:]

Thank you, Jeff. It's difficult to quantify that right now. But as you would call it $200 billion in federal stimulus funding is about 10% of the overall spend or a little bit less than 10%, about 9% of the overall spend each year. And in some states, like for example, Texas, that the state is still holding on to the money or substituting some of the funding that they would ordinarily provide to school districts. So, that's an example of one of the states where the Federal stimulus is flowing directly to the school districts as in other states. So, it's a state-by-state situation right now in terms of the implications of the federal funding, increasing the opportunity for school districts to allocate that funding to instructional materials. The other point I think, to be made, Jeff, is that we expect that this funding will continue on until 2024. And as we said earlier, it's not only for instructional materials, but it's for infrastructure, it's for ventilation systems, it's for teaching assistants. So, there's any number of uses of the funding. So, we like to think of it as a separate -- separating funding from spending on instructional materials. And obviously, one is indirectly related to the other, but not directly related.

[Jeff Silber:]

Okay, that's really helpful. Beyond that, I know, historically, the curriculum adoption calendar was really important to your company. I'm assuming it still is. Can you just remind us in terms of major adoption this year in the next year or two, what should we be expecting?

[Jack Lynch:]

Yes, no, this year, the most significant adoption was Florida, ELA. And next year, the most significant adoption will be Florida math. So, though, that's really the most significant -- what we call the big three adoptions, California, Texas, and Florida. Florida this year and Florida next year. This year for ELA and next year for math. That's the calendar right now, near-term.

[Jeff Silber:]

Have you made any announcements on the Florida ELA side?

[Jack Lynch:]

Yes, I think it's really no change from what we said last quarter, Jeff. We essentially look at that adoption in three categories. So, 6-12, our performance was in line with our expectations; K-5, below our expectations. And then intervention was a part of the ELA adoption in Florida and we completely exceeded our expectations in intervention. So, net-net, I think good performance in Florida.

[Jeff Silber:]

Okay. And then my last question. I think, Jack, when -- when he would talk on the unlevered free cash flow as a percentage of billings guidance for this year, I think you had said that as trends continue to improve, that number can go up. Forgive me, if I misheard you. Can you just confirm that? And is there any way to quantify potentially how large this could be? Thanks.

[Jack Lynch:]

Go ahead.

[Joe Abbott:]

Jeff, this is consistent with what we've talked about in our business, where we have a very high degree of operating leverage. So, as you saw the billings guidance for the year ago up from our prior guidance, you also saw the expansion of our unlevered free cash flow margin commensurate with that. We've talked about in the past, incremental billings flowing through two free cash flow -- that's unlevered, free cash flow or levered free cash flow at a rate of about 65%. And so that should give you a sense for -- the operating leverage in the business and what you can expect as billings continued to grow.

[Jeff Silber:]

Okay, that's really helpful. Joe. Thanks so much.

[Operator:]

Thank you. Our next question comes from George Tong with Goldman Sachs. Your line is open.

[David DeMay:]

Hi, thanks. This is Dave on for George. Prior to COVID, three-year billings guidance was $1.5 billion to $1.6 5 billion covering 2020 through 2022. What are your latest thoughts on billings through 2022?

[Jack Lynch:]

Joe, do you want to take that one?

[Joe Abbott:]

Yes, will do. Hi and good morning. Thanks for the question. So, I think the first thing to remember when you're trying to compare those periods is that you'll want to take a pro forma approach for the recent sale of our Books & Media business, which as you know, was averaging around $190 million to $200 million of annual billings there for the last several years. That's important when you're kind of comparing periods. And look, while we have not put out longer term, billings guidance there, what we can say is that as you look out really no structural reason why pre-pandemic levels of billings aren't achievable, just remember that the timing is not entirely clear as to when the full recovery in spending will occur amongst our customers. And so that's why we've been able to provide you an update on what we think for this year, but not really able to provide you the timing in terms of how ultimately billings grows in subsequent years.

[David DeMay:]

Okay, thank you. That's very helpful. And then just a quick one on margins. Margins should improve its digital increases and mix, what do you see as a long-term EBITDA margin target?

[Joe Abbott:]

Yes, again, not putting any specific targets out there on a long-term basis, but just like Jeff's question earlier, you can think about the flow-through billings to EBITDA in a very similar fashion to the way we've kind of talked about the growth in cash flow as well as you see billings get higher. The operating leverage comments that I was making before are consistent. Additionally, also remember that as our business mix shifts more to digital, which we fully expect, we would also expect the benefits to margins to occur there. So, no specific targets, but certainly the trend supportive of margin expansion is billings rose.

[David DeMay:]

Okay. Thank you.

[Operator:]

Thank you. And at this time, I'm showing no further questions at this time. I'd like to turn the call back over to Mr. Jack Lynch, President and Chief Executive Officer for closing comments.

[Jack Lynch:]

Thank you very much. We appreciate everyone joining us on today's call. Thank you very much for your interest in HMH. And we look forward to speaking with you again on our next call. Have a great day and thank you.

[Operator:]

This concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day.