Houghton Mifflin Harcourt Company
Q2 2020 Earnings Call Transcript

Published: 9 Aug 2020

[Operator:]

Ladies and gentlemen, thank you for standing by, and welcome to the Houghton Mifflin Harcourt Second Quarter 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. [Operator Instructions] I would now like to hand the conference over to Brian Shipman, Senior Vice President, Investor Relations. Thank you. And please go ahead, sir.

[Brian Shipman:]

Thank you, and good morning, everyone. Before we begin, I would like to point out the slides referred to on today's call can be found on the Investor Relations section of our website at hmhco.com. A replay of today's call will be available until August 15, 2020, and the webcast will be available on our website for one year. A 10-Q was also filed earlier this morning, along with our second quarter 2020 earnings press release. Before we discuss our results, I encourage you to review the cautionary statement on Slide 2 for our customary disclosures. Further information can be found in our regular SEC filings. In addition, please refer to the appendix in our slide presentation for a reconciliation of our non-GAAP measures to the most directly comparable GAAP measures, which is also posted to the HMH Investor Relations website. This morning, Jack Lynch, HMH's President and Chief Executive Officer; and Joe Abbott, HMH's Chief Financial Officer, will provide a Company update as well as an overview of the Company's second quarter 2020 results. After our prepared remarks, we will open the call to questions. During the Q&A, please limit yourself to one question plus one follow-up. You may get back into the queue if you have additional questions. Now I'll turn the call over to Jack.

[John Lynch:]

Thank you, Brian, and good morning, everyone. Today, I'd like to start by sharing with you our perspective on COVID-19's continued disruption in education and how that is driving increasing demand for HMH's digital solutions and accelerating our digital-first connected strategy. First, I'd like to share my thanks to our HMH employees for being solutions-oriented and customer focused during this extraordinary period. Our fantastic team has enabled us to continue providing vital resources to educators, students and teachers when they need it the most. Clearly, this has been an extraordinary time for the world, for education and for HMH. We've continued to navigate the COVID-19 environment by supporting the increasing growth in digital demand, while streamlining our operations and capital structure. Last quarter, we shared with you six drivers as to why we're so confident in our strong position for the future. Let me repeat them again today. First, our financial strength, namely our ample capital liquidity and strong balance sheet. As Joe will point out later, we paid off our revolver. And in addition, the decisive actions we took in March strengthened our liquidity position during our seasonal trough in cash inflows. Second, we remain resilient and well positioned to support all of our stakeholders, ending furlough for employees, and restoring 100% of their pay. And we focus on their safety with all employees working virtually, save our warehouse personnel. Third, HMH remains a trusted partner for customers. We've continued our comprehensive support efforts, including a number of summer school solutions as well as resources for teachers as they plan for the fall. The back-to-school period, the fourth point, will drive market demand, whether a school district goes back-to-school remotely or in person. We will have the resources required to support them. Fifth, the market's move to digital has been and will continue to be accelerated. The pandemic has placed a spotlight on the digital divide, and districts are rushing to ensure all students have a computing device and internet connectivity. The result is greater demand for digital solutions. Finally, HMH will emerge even stronger post pandemic with a digital-first connected offering. While near-term, we are seeing funding pressures driven by a downturn in the economy, we're also seeing teachers embrace technology as the primary means through which they are educating their students. For a company that is focused on providing all of its products and services in one connected digital platform, the pandemic has actually served to accelerate our strategy. Why has the pandemic accelerated our digital-first connected strategy? Two reasons, first, COVID-19 has pushed our industry to a 1

[Joseph Abbott:]

Thanks, Jack, and good morning, everyone. In the second quarter, we began to see our markets stabilize after the impacts of the pandemic in Q1. As Jack said, while students, teachers and district administrators are still getting a handle on what the upcoming school year will look like, we fully expect and are preparing for back-to-school to be an important demand driver as it is each and every year. Let me share with you how we've seen the market begin to stabilize over the last few months. In April, school closings were still affecting the market with administrators focused on quickly getting their students transitioned to a remote learning environment. By May, we saw the market beginning to improve as our customers began to acclimate to their new routines. Focus began to return to planning for the next school year. In June, we saw the sequential month-over-month billings growth that we expect every year as ordering for next fall begins to ramp up. June purchasing activity was more concentrated around our digital solutions that enable remote learning, a trend we fully anticipate accelerating. For example, we've already seen a number of school districts, including Los Angeles and San Diego; two of the largest districts in the country announce that their students will return to school this fall in an online-only format. In fact, according to an Education Week survey sampling U.S. school districts, over 50% have already announced they will be going back-to-school in online-only or hybrid environments. Sequential month-over-month billings growth continued in July, again, consistent with our historical seasonal billings pattern and demand for digital solutions has increased as well. As Jack mentioned, we launched HMH Anywhere, another important way we're meeting that demand by helping to de-risk the difficult decisions our customers are facing in an uncertain back-to-school environment. Though the pandemic has impacted our results year-to-date, we have not let up on executing our strategy and have made great progress this quarter. As Jack mentioned, we extended our market-leading share in Texas Literature with a strong connected solution, featuring Into Literature, Writable and Literacy solutions. As of now, we have taken about 34% market share, with about 95% of the market having made their decisions in Texas. More importantly, as Jack mentioned, our attachment rate of writeable into Literature sales in Texas this year was an impressive 98%, which demonstrates the power of our single platform to deliver learning outcomes across the entire spectrum of student needs. We delivered very strong digital growth, increasing both our SaaS billings and Ed platform usage for the trailing 12 months ended June 30. He we have flipped 99% of in-person professional development events to higher-margin virtual sessions. We reduced our costs in the second quarter, which enabled us to mitigate the temporary pressures on our billings and enabled us to deliver strong adjusted EBITDA margins. And our actions in March this year, building on our transformation efforts we commenced in October 2019, helped reduce our seasonal use of cash. We have fully repaid our revolving credit facility now that we have moved into the cash flow generative portion of our year. So let's move now to an overview of our financial results for the quarter. Our total company billings for the quarter were $297 million, down $192 million from last year's quarter. Note that even before the impact of the COVID-19 pandemic, we faced a difficult comparable this year as we transitioned from the peak adoption year of 2019 to our expectation for a mid-cycle year in 2020. To better illustrate the impact of the pandemic on our results, I'll also point out that our billings were only down $75 million compared to the second quarter of 2018, which was a trough year in the adoption market. Despite the decline in billings, however, we generated positive free cash flow in the month of June, resulting from our cost reduction and containment actions over the last nine months. Our Education segment delivered billings of $262 million in Q2. This was driven by core solutions billings of $151 million. We expect the majority of billings from this year's Texas Literature adoption to occur in Q3. Extension billings were $111 million. Strong growth in supplemental and intervention was offset by Heinemann and services billings. For HMH Books & Media, billings in Q2 were $35 million. And this segment showed impressive resiliency and was down just 10% for the quarter. While sales of print books have been impacted by bookstore closures nationwide, we are pleased that our eBook sales were up 19% in the second quarter. Moving to the consolidated financial results, our net sales were $251 million in the second quarter and $441 million for the first half. Net loss from continuing operations for the second quarter was $38 million, an improvement of 6% compared to Q2 of 2019. Adjusted EBITDA for the second quarter declined to $36 million, but notably, our adjusted EBITDA margin improved compared to the second quarter a year ago despite the decline in net sales this year. Given the operating leverage in our business, this is a remarkable result that was driven by the cost reduction and containment actions we've taken over the last nine months. Our free cash flow in the second quarter was a usage of $61 million, a 52% improvement compared to the second quarter of last year. Our year-to-date cash usage of $248 million was a 27% improvement compared to the same period last year, again, due to our October restructuring and the decisive actions we took in March. Partially offsetting an increase in networking capital was a reduction in total capital expenditures. Content development spending was $35 million in the first half of 2020 compared to $56 million for the same period last year. Total capital expenditures were $59 million for the first half of 2020 compared to $74 million for the first half of last year, down 20%. We've made progress in key areas that give us great confidence in our financial position as we approach the back half of the year in a more stable market environment. First, as I mentioned, we've generated positive free cash flow in the month of June as our billings began to stabilize in light of resuming purchase activity. Second, regarding our liquidity, we have repaid the $150 million that we preemptively drew earlier this year. Now as you know, in past years, we've drawn liquidity from our asset-backed revolving credit facility during the second quarter and paid it back in mere months. This year proved to be no exception. Throughout our seasonal liquidity trough this year, however, we maintained our cash balance above the $150 million drawn from our revolver, demonstrating that the entire amount we drew was precautionary. Third, we've lifted our furlough, which indicates our comfort with our current liquidity position. At the same time, and this is the fourth takeaway, we also know that realizing our digital-first connected vision requires further operational streamlining and acceleration of our ongoing transformation. One of the steps we have already initiated is an early retirement offer to certain qualifying employees. We're also deep into the next leg of our value innovation analysis, following the same framework we utilized and shared with you in our Investor Day last October. We'll update you on the results of this analysis by the fourth quarter. Fifth, as we look to the remainder of the year, we feel optimistic about demand recovery, and we are seeing the resumption of the usual seasonal billings pattern with sequential month-over-month growth in both June and July. And finally, that we lifted the furlough in July. We continue to estimate that our breakeven level of billings in 2020 is in the range of $1.23 billion to $1.28 billion. Now as we said before, this scenario range does not constitute billings guidance on our part. But we think it may be helpful in quantifying the significant improvement in our cash flow generation capability, resulting from our work so far, and we will be looking to improve upon that capability through our continued value innovation approach. So taken together, what all this means is that from a capital, liquidity and balance sheet perspective, we are in very good shape. And we're making the necessary moves now that will ensure we can capitalize on the emerging opportunity afforded by our digital-first connected vision that you've heard so much about today. And with that, I'll hand it back over to Jack for some closing remarks before we move into Q&A.

[John Lynch:]

Thanks, Joe. Before we move to Q&A, I'd like to leave you with these key points. We're in a strong financial position that enables us to navigate the near-term challenge environment and to capture even longer-term opportunities. We are supporting all our stakeholders and remain a trusted partner to our customers, as they wrestle with new found challenges and realities in education. The market is improving, and we see back-to-school driving greater demand and recovery. Finally, the pandemic has accelerated the market shift to digital with long-term benefits despite near-term pressures, and HMH will emerge even stronger with a digital-first connected offering, well positioned to capitalize on our accelerated market opportunity. We look forward to updating you on our continued progress next quarter. With that, let's get right to your questions.

[Operator:]

[Operator Instructions] Our first question comes from Bill Warmington with Wells Fargo. Your line is open.

[William Warmington:]

Good morning, everyone.

[John Lynch:]

Hi, Bill.

[Joseph Abbott:]

Hi, Bill.

[William Warmington:]

So first question I wanted to ask about was billings. So historically, 70%, 75% of billings would come in, in the June and July range. And this year, it sounds like because of the shutdown around COVID, you're potentially seeing the shift of billings from Q2 into Q3. Plus, you also have some it sounds like higher demand for digital. So I was going to ask some thoughts around Q3 billings. Potentially, could they be flat with Q3 billings in 2019?

[Joseph Abbott:]

Hey, Bill. It's Joe. It's difficult for us at this stage to make that call. And as you know, we typically don't provide guidance on the quarters, and we're not putting guidance for the year. What you said though about the shift from Q2 to Q3 is accurate. And I think the question about the possibility of a flat year-over-year, just keep in mind there, as you're thinking about that, last year was a peak of the state adoption market with some outstanding performance in the state of Texas that we had. That sets up a pretty difficult comparable for us, even ex-pandemic. But I think you're right to think about it in terms of a general timing shift to the latter part of the year.

[William Warmington:]

Got it. And then I'm also trying to understand the connection between the increased demand for digital, the greater SaaS billings, and how that's going to play out ultimately in billings? I mean, when does it actually start to move the billings needle, so to speak?

[John Lynch:]

Yes. Bill. This is Jack. Joe, do you want me to take that?

[Joseph Abbott:]

Yes. Go ahead, Jack.

[John Lynch:]

Yes. I think the important thing that we're highlighting, Bill, is the tremendous growth that we're seeing demand for SaaS-based solutions, which as you know is a recurring revenue, and it goes without saying that still the SaaS-based billings represent a relatively small percentage of our overall mix. But I think a really good kind of leading indicator as to where the business is moving as more and more of our business is digital and more and more of it becomes recurring. So that's kind of the way we think about it from an investment standpoint is moving more and more of our business model to recurring over time. And so we're very excited about the growth that we're achieving with the SaaS-based solutions right now.

[William Warmington:]

And it looked like share continued to be very strong in the Texas ELA. I just wanted to ask there, if you could remind me, what is the share going to be for the entire adoption? And then are you finding that that's helping to drive adoption in either other adoption states or in open territory?

[John Lynch:]

Yes. I think the good news for the first half of this year is, overall while the market is down, our share is holding really well. And as you point out, in Texas we have a leading share in the Texas adoption. What's most significant to us is the proof point of our strategy. The 100% attach rate of the core solution to services, 96% to the extensions product Writeable. And I think that's a good kind of encapsulation of the strategy that we're executing nationwide to leverage that core installed base to cross-sell into extensions and capture a greater share of that $276 per student per year spend. So we feel really good about that. The other thing about share is that if you look at open territory, AAP has reported that it's about down 15% year-to-date. We're actually down less than that, which suggests a gain in share in open territory. So I think despite the top line pressures that we're seeing as a result of the pandemic, we're faring pretty well from a share perspective.

[William Warmington:]

Okay. And then in the extensions market, we were surprised to see the extensions down more than the core, and I wanted to ask, especially with the high attach rates, and then I wanted to ask whether it was really a year-over-year comp issue or whether there was something else going on within extensions?

[John Lynch:]

Yes. Joe, do you want to take that?

[Joseph Abbott:]

Yes, I will. So there is a comparable issue there, certainly, Heinemann had a record year last year and very, very strong performance also in that Texas adoption, which of course didn't recur. The products, the Heinemann products that we were selling in that adoption, of course, were focused more on the lower grade levels and they wouldn't have had that opportunity for Texas this year. So there is a bit of comparable on that. But I would say, generally, what you've seen in the extensions is very, very strong performance in our supplemental and intervention product lines. You've seen much of that growth in the SaaS billings in those areas. In fact, all of it is. And second, I'd just point out that generally speaking, we see the third quarter as a much more important overall quarter in a normal year for our extensions, this year would be no exception. And in fact, due to some of the later decision-making that we've seen out there in the market, I would expect that that third quarter dynamic is going to be more important for our extensions as well this year.

[William Warmington:]

Got it. So one more question on the digital side. You mentioned 50% of schools returning to class this fall in a remote format. Are you seeing any type of unusually late surge in demand for the digital products, especially from schools that normally wouldn't be buying at this point in the cycle?

[Joseph Abbott:]

Yes. Great question, Bill. I mean, as you know we've been providing our products in both print and digital form for some time now. I think this new solution we offered last week was really in response to the very topic you're raising, that is what do we do in a remote learning environment versus an in-person environment? And the approach we took is use the same platform. Whether you're in remote learning and you're doing video conferencing where we're going to actually integrate with Zoom, and we'll integrate our platform with Microsoft Teams, Google Meet, so you can do the video conferencing. But if you go back-to-school where you start in-person, use that very same platform. So you don't have the discontinuity of trying to do something virtually and then find yourself in a different mode of instruction using a different set of solutions. So we are seeing, obviously as you can see in the growth in usage on our platform, we are seeing increased demand for digital solutions. And I would say that when we talk to our sales organization, most of the discussions they're having right now with customers are about outfitting them with our digital solutions for an uncertain school year. I think 50% actually starting remote is probably a low number now. I think given where we are right now, we'll probably see something north of 50% of the school districts starting remotely.

[William Warmington:]

Got it. All right. I know I went long on the questions. Appreciate your patience. Thank you very much.

[Joseph Abbott:]

Thank you, Bill.

[John Lynch:]

Thanks, Bill.

[Operator:]

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

[George Tong:]

Hi. Thanks. Good morning. You indicated that you're starting to see a resumption of seasonal purchasing behaviors. Can you elaborate on purchasing activity a bit more in the quarter and exiting the quarter in both California and Texas?

[Joseph Abbott:]

Yes, George. It's Joe. In Texas, as I pointed out in the remarks there, we're about 95% of the way through that adoption. And so most, the lion's share, of those decisions have been made so far. We're expecting the billings to come through in the third quarter for that adoption. And certainly, those orders that are going to come later or those wins that come later, we would expect to be a bit later in the year as well. As it relates to California, we have seen some of the typical pilots and some of the scheduled pilots push to the latter parts of the year, get delayed a bit. We're expecting that some of that demand and some of those purchase decisions in California do get pushed out into year three of the California science adoption. Typically, as you know, the year two, which we're in right now in the California adoption, is the largest. I would expect that that's still the case. We don't know what the full impact is going to be of some of this delayed purchase decision making, but we would expect the third quarter probably to be a bit bigger than we would normally see in the California adoption and therefore, the second quarter a bit smaller.

[George Tong:]

Got it. That's helpful. And then looking between core solutions and extensions, can you perhaps talk about where you expect the revenue recovery to be faster over the remainder of the year?

[John Lynch:]

Yes. It's a good question, George. As Joe mentioned a few moments ago, typically if you look at the phasing of our business, extensions lag a little bit. Usually, you get your core solutions in place first half of the year into July. And then as you go back-to-school and you assess your kids, you can determine how many of them are requiring intervention solutions, how many are going to require supplemental solutions. So there is a bit of a lag in intervention, supplemental and professional development. So as we kind of go into the third and fourth quarter, you'll see a greater percentage of the mix in extension than you would see in core.

[George Tong:]

Got it. That's helpful. Thank you.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from David Pang of Stifel. Your line is open.

[David Pang:]

Hey, good morning, everyone.

[John Lynch:]

Hi, David.

[David Pang:]

Jack, I think you touched on this earlier, but I was hoping you could provide more of an update on the funding environment at the state and local level. And then secondly, for Joe, can you talk about how the billings might differ under the different school reopening plans? Thanks.

[John Lynch:]

Yes. Yes, a really good question in terms of the funding environment. Let me take it in two parts. One is current versus future. If you look at K-12 funding, 90% of it is state and local funding. And obviously, economies and tax receipts, budgets are going to be constrained, especially at the state level. So that's a bit of what we're experiencing right now, budgetary pressures that schools are experiencing because of the amount of funding that comes from state and local. Federal funding, as you may recall, we had with the CARES Act about $13.5 billion of federal funding to K-12 schools. So that's kind of the current environment. In terms of future, obviously as the economy picks up, then we'll see less funding pressure in K-12. But importantly, right now, the federal government is looking at additional funding for education. The Senate and the White House had proposed about $70 billion in additional funding for K-12. That goes to the House now, which is obviously an education friendly institution. So we kind of feel that that $70 billion may even be added to as we go forward. That is, for a half a trillion-dollar industry, K-12 education, that's a material amount of money. And obviously, would be flowing into budgets at the end of this year and beginning of next year. So I think the future funding environment will be improved by the stimulus steps program that we've provided.

[Joseph Abbott:]

And David, I think your second question was related to the impact on billings, depending on the scenario that plays out in a particular district, whether it's remote or hybrid or in-person. And it's a difficult question to really pinpoint, but I would say that because we offer a solution that is useful and actually solves a lot of challenges, in any one of those environments, we really wouldn't expect that there's much difference with any particular customer in terms of if they have a particular need, we can solve it or we can help them solve it. And so we wouldn't expect much of a difference there in billings. Clearly, if you have districts that were unprepared for a return to school in a remote environment and now have stimulus funds or other funds that they need to deploy or to make sure that they are prepared for that environment, that can act as a spur for demand. We are seeing a lot of interest right now, having just launched the HMH Anywhere in the last two weeks, and we're starting to see demand build quite a bit for that because of its unique ability to offer a solution for really any eventuality there. But as a general matter, we wouldn't expect that there is a tremendous amount of difference in our billings even if the extremes of full in-person versus full remote.

[Operator:]

Thank you. At this time, we have no further questions. I'd like to hand the conference back over to Mr. Jack Lynch for closing remarks.

[John Lynch:]

Great. Thank you. Thanks everyone for joining us on today's second quarter earnings call. We look forward to updating you again on the third quarter earnings call in early November. Have a great day. Thank you.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. You may now disconnect. Everyone, have a wonderful day.