Houghton Mifflin Harcourt Company
Q1 2018 Earnings Call Transcript

Published: 3 May 2018

[Operator:]

Good day, ladies and gentlemen, and welcome to the Houghton Mifflin Harcourt First Quarter Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. I would now like to introduce your host for today's conference, Mr. Brian Shipman. Mr. Shipman, you may begin.

[Brian S. Shipman:]

Thank you, Sheri, and good morning, everyone. Before we begin, I would like to point out that 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 May 12th, 2018, and the webcast will be available on our website for one year. Our 10-Q was also filed earlier this morning along with our first quarter 2018 earnings press release. Before we discuss our results, I encourage you to review the cautionary statement on slide 2, which explains the risks of forward-looking statements and the use of non-GAAP financial measures in the slide presentation and on today's call. Please also refer to our most recent forms 10-K and 10-Q for a discussion of factors that could cause actual results to differ materially from these forward-looking statements. In addition, please refer to the appendix of the slide presentation for reconciliations of these non-GAAP measures to the most directly comparable GAAP measures. After our prepared remarks, we will open the call to questions from investors. 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. This morning, Jack Lynch, Houghton Mifflin Harcourt's President and Chief Executive Officer; and Joe Abbott, HMHC's Chief Financial Officer, will provide a company update, as well as an overview of the company's first quarter 2018 results. Now, I'll turn the call over to Jack.

[John J. Lynch:]

Thank you, Brian, and thank you, everyone, for joining us on today's first quarter earnings call. We are off to a solid start in 2018 and our first quarter results were in line with our expectations, although the first quarter historically is seasonably light and was a bit of a tough comparison this year versus the same quarter in 2017. Our consolidated net sales and billings each declined by 1% in Q1 2018. After adjusting for a one-time $5 million non-recurring fee we recognized in Q1 2017 in connection with the expiration of the distribution agreement, our consolidated net sales and billings would have grown slightly by 1% in the first quarter of 2018. Importantly, adjusted EBITDA improved $9 million, reflecting the benefit of our 2017 restructuring program. Given the solid start and our continued expectations for the year, today we are reaffirming the guidance we provided you on our fourth quarter 2017 earnings call in February. As I've said before, we are evolving from a publishing company focused on great content to a learning company focused on great outcomes. This evolution is driven by the execution of three strategic pillars. The first is to enhance and extend the core, strengthening our core basal business while investing in faster-growing higher-margin extensions of that business. The second is to develop integrated solutions that deliver successful outcomes for our customers. And finally, the third, is to achieve operational excellence to enhance our overall results. Before going into detail on our first quarter results, I want to highlight two recent announcements that underscore our strategy and demonstrate progress against the transformational goals we'd laid out last quarter. In April, we announced an exclusive strategic partnership with Renaissance, a leader in K-12 learning analytics. This partnership brings together deep data analytics, assessment capabilities and core curricula by integrating Renaissance Flow 360 with HMH's core curriculum programs. Our partnership with Renaissance gives school districts flexibility to choose how they intend to measure student progress. Renaissance's technology will be integrated with our next generation reading and math programs, including in the upcoming Texas and Florida adoptions. We've already heard from several customers that they're extremely excited about the prospect of using this solution. Further, in support of our goal to enhance and extend our Core Solutions, we're pleased to announce today a new partnership with Writable, a SaaS-based, guided-writing program that allows students to strengthen their abilities through purposeful practice and helped educators save time and manage feedback to ultimately build independent and reflective writers. Beginning this fall, HMH will connect Writable's capabilities with our Collections 6-12 English Language Arts program, establishing a single hub for Collections' writing. And providing access to Writable's suite of tools. HMH is investing in the company and will offer Writable solution as a standalone supplemental learning program. Now, onto the highlights of our results from the first quarter. Overall, our education billings were down 2% in the first quarter of 2018, driven by declining Core Solutions, partially offset by growth in Extensions. Core Solutions billings were down approximately $10 million for the quarter driven by the expected reduction in Reading sales into the California ELA adoption, as well as the one-time fee we received last year in connection with the expiration of the distribution agreement. As you will recall, last year was the second year of the California reading adoption which boosted our results somewhat in the first quarter of 2017. We saw a $7 million, or 6% increase in our Extensions billings in the first quarter of 2018 driven by Heinemann and Professional Services somewhat offset by supplemental. Within our Heinemann business, the quality and credibility of Fountas & Pinnell Classroom's has driven strong growth. In addition, READ 180 has shown significant improvement since our last quarterly discussion with conversions now offsetting the declines in older versions. Our Extensions remain a key focus for us as they are less subject to the cyclicality of the core adoption calendar. While we believe we are the largest participant in the Extensions market, we still only garner about 11% share of this $6 billion market and thus have substantial opportunity for growth. Trade continues to see steady growth and billings were up 2% in first quarter compared to Q1 2017 driven by higher licensing income along with print title sales such as the Instant Pot series and the Whole30 series. As I've mentioned before, we continue to look for ways to monetize our strong legacy brands and our deep backlist. You may have heard that Netflix announced they plan to produce an animated television series based on the Carmen Sandiego brand and also intends to produce a feature length for live action Carmen Sandiego film. HMH owns this brand and will be co-producing the series. The Netflix investment in Carmen Sandiego is just one example of how we are monetizing our legacy brands and assets, and finding unique ways to grow our revenues. Carmen Sandiego is also a great demonstration of a brand that crosses (00

[Joseph P. Abbott:]

Thank you, Jack. Good morning, everyone. To echo what Jack said earlier, we were off to a solid start, and with our outlook for the rest of the year, we're reaffirming the guidance for 2018 that we announced on our February earnings call. We're executing on our strategic vision and continue to implement the remaining cost savings opportunities stemming from last year's restructuring plan, which we believe will help drive improved free cash flow in the future. We also believe we're well positioned for the upcoming large adoptions. Turning to the first quarter 2018 results, our consolidated net sales in billings, which we define as net sales plus the net change in deferred revenue were down 1%. Recall that billings grew 10% in last year's first quarter, which included a one-time $5 million non-recurring fee in connection with the expiration of a distribution agreement. So, we're pleased with our billings performance in the first quarter of 2018 in light of that tough comparison. Before I dive into the business segments, I'd like to point out a few changes to how we're categorizing billings and net sales to better align with the way we manage the business. These changes relate to reallocations of product responsibility between Core Solutions, Extensions, and Trade lines of business, as well as our decision to align international Education billings and net sales into Core Solutions and Extensions categories, whereas previously we reported all international Education billings and net sales as part of Core Solutions. We are reporting quarterly 2018 results and 2017 comparable periods consistent with this new approach, and you will see the effect of this re-categorization summarized in the table in the appendix of today's slide presentation. Starting with our Education segment, billings were down 2% to $145 million compared to $148 million during the first quarter of 2017. This decrease was driven by the Core Solutions business partially offset by growth in Extensions. Core Solutions billings were down approximately $10 million for the quarter driven by the expected reduction in Reading sales into the California English Language Arts adoption, as well as non-recurrence of the one-time fee we received last year in connection with the expiration of a distribution agreement. Billings for Extensions grew by $7 million, or 6% in the first quarter of 2018, driven by growth in Heinemann and Professional Services, partially offset by declines in supplemental. Trade segment billings were up 2% to $37 million in the first quarter of 2018 compared to $36 million in the first quarter of 2017. This increase was primarily due to higher licensing income along with print titles such as the Instant Pot series and the Whole30 series. Consolidated net loss for the quarter was $101 million, improving 16% compared to a loss of $121 million during the same period of 2017. This improvement was largely attributed to a decrease in our selling and administrative costs, a decrease in our publishing rights pre-publication and other intangible amortization along with a lower effective tax rate. And adjusted EBITDA improved by $9 million, or 36% in the first quarter of 2018, reflecting the benefit from our 2017 restructuring program. Our free cash flow in the first quarter of 2018 improved to a usage of $134 million compared to a usage of $141 million during the same period in 2017. This was primarily due to lower capital expenditures, primarily due to the timing of property, plant and equipment spent. Operating cash flow was down slightly from the same period last year. As a reminder, given the seasonality of our business, it is typical for us to use cash in the first half of the year. To recap, we're off to a solid start in 2018 and combined with our outlook for the rest of the year, we are reaffirming our guidance for 2018. Additionally, we continue to implement the remaining initiatives related to our 2017 restructuring plan, aimed at improving the company's operational efficiency and rightsizing our cost structure. We believe our new cost structure better aligns with the opportunities we see coming in the market and will allow us to generate a substantial amount of free cash flow in the coming peak adoption years. Jack and I would now be pleased to take any questions you may have. Operator, you may now open the line.

[Operator:]

Thank you. Our first question comes from Peter Appert with Piper Jaffray.

[Peter P. Appert:]

Thank you. Good morning. Jack, I recognize it's probably early in the year, but can you share with us any early read you're seeing in terms of the 2018 adoption cycle and spending trends, customer response to product, et cetera?

[John J. Lynch:]

All right. Yeah. I think you're absolutely right from a phasing perspective that Q1 is our smallest quarter and we're seeing trends that are consistent with our guidance that we provided for the year. So really no news apart from what we've already guided.

[Peter P. Appert:]

Okay. How about specifically on the open territory, any reason for optimism in terms of spending levels in that market this year or next year?

[John J. Lynch:]

We have guided flat on open territory and largely because of the replacement cycle we're in. Right now, open territory is waiting for the new math and reading programs, which make up the lion's share of the addressable market for Core. And so we expect that open territory will be flat in 2018 from 2017.

[Peter P. Appert:]

Okay. Thank you.

[Operator:]

Thank you. Our next question comes from Jason Bazinet with Citi.

[Jason Boisvert Bazinet:]

I noticed a new asset on your balance sheet about $24 million of deferred commissions, which I suspect is related to ASC 606, but can you just remind us what that change is and then did it have any impact on EBITDA at all?

[Joseph P. Abbott:]

Yeah. Hi, Jason, good question. Thanks for that. Yeah, it is related to ASC 606. It does have an impact on adjusted EBITDA, so you would see that in the adjusted EBITDA portion. It wouldn't have an effect ultimately on free cash flow. It's a non-cash change there. Really what that relates to is that you create the asset, you end up paying the commissions effectively in line with the page with which you recognize the revenue, those commissions were earned on.

[Jason Boisvert Bazinet:]

Okay. So how much of that did the accounting change help EBITDA in the quarter?

[Joseph P. Abbott:]

You'll see in the 10-Q that we've broken that out and that in Note 2 of the 10-Q. So about $2.5 million of net impact on EBITDA as a result of the changes related to ASC 606 and the revenue recognition standard.

[Jason Boisvert Bazinet:]

Great. Thank you very much.

[Joseph P. Abbott:]

Yes.

[Operator:]

Thank you. Our next question comes from George Tong with Goldman Sachs.

[George Tong:]

Hi. thanks. Good morning. You've submitted entries for 2019 Texas reading in April and we'll be submitting math for Florida and science for California this quarter. Can you elaborate on when you'll get visibility into the competitive process and the incremental revenue streams (00

[John J. Lynch:]

Yes. I think for the adoption we submitted for earlier in the quarter in Texas, they will go through a evaluation process at the State and then will be adopted in the fall and that will kick off a selling process. So you'll begin to see evidence of our efforts there in Q1 and Q2 of 2019. As it relates to Florida, they have a little bit of a different process. Essentially, what they do is they start with kind of Light House districts who evaluate the program and then they go ahead and they make decisions that you'll see again in Q1 and Q2 of next year. And then the state after districts have made the decisions, we'll go ahead and then officially adopt the program. And in California similar process you're going to see an evaluation at the state level and adoption in the fall and then we'll begin the sales process in the fourth quarter. You'll start to see sales in the first half of 2019.

[George Tong:]

Got it. Very helpful. And then you have anticipated a decline in sales in the California ELA adoption in the quarter. Are there other expected gains or reductions in existing adoptions over the coming quarters?

[John J. Lynch:]

Yeah. No – nothing of any size or note to talk about. Really what we are referring to there, George, is that in the first quarter in California in the second year of their big adoption you'll find that the second year of these adoptions, the purchase decisions are oftentimes earlier in the year. It's because of the districts that have an opportunity to evaluate the program now for approximately a year or so when you're in that second year. And the second year of the California ELA adoption you may recall was actually a pretty sizable opportunity last year. So, now we're in year three of that California ELA adoption that's a smaller overall opportunity. The first quarter wouldn't benefit therefore as much. And that's really what you were seeing for that portion so it's a very state-specific comment having everything to do with the size of the opportunity that presented itself last year in California. So nothing major of note to talk about for the remainder of the year. And our expectation is that we'll be in line with our guidance as we put out in February.

[George Tong:]

Very helpful. Thank you.

[Operator:]

Thank you. Our next question comes from Jeff Goldstein with Morgan Stanley.

[Jeffrey D. Goldstein:]

Hi, guys.

[John J. Lynch:]

Good morning, Jeff.

[Jeffrey D. Goldstein:]

So looking at the Core Solutions – hey. So, just looking at your Core Solutions growth in the quarter, excluding the one-time distribution fee, billings were kind of down low-double digits, while the Extensions billings were up around mid-single. And so I know it's early in the year, but how should we think about growth in these segments for the rest of the year and how it fits to your overall billings guidance?

[John J. Lynch:]

Yeah. Sure. So as we talked about, the declines in Core were due to the factors that we had anticipated when we had put together our guidance for the full year. And while we don't provide annual guidance in the current fiscal year on the various categories of billings, what we have done is lay out the long-term expectation for each of these segments and so what you – in categories of billing. So what you know is that we do expect Extensions to grow in the low to mid-single digits over the long term in line with market growth. And we think actually in the early stages of that growth, we have the opportunity to improve upon that growth rate. First quarter was encouraging and along the lines of that trend in the mid-single-digits area there. Core is going to – if you think about the growth through the cycle, it's going to grow roughly in line with enrollment growth across the country, but it will vary year-to-year on the basis of the adoption cycles that we see there. So we're in a cyclical trough this year. Similarly sized market is what we had last year in total about $2.5 billion. So you shouldn't expect to see too much variance there year-over-year. And then, trade as we've talked about is a low-single digits grower through the long term, although we've had some really nice growth out of that business, both last year and then starting off the year here in the first quarter.

[Jeffrey D. Goldstein:]

Got it. And then I want to ask about your cost structure moving forward. I know you're almost done with the cost restructuring you outlined last year. Your guidance for this year is 47% of billings to be fixed and 38% variable. But just thinking ahead now to the bigger adoption years in 2019 and 2020. Is that cost structure we see this year likely to be the cost structure in those years, or how can that (00

[John J. Lynch:]

Yeah. That's great question. So, fixed cost, as you know, because of the fixed nature is going – that percentage is going to vary over time, but you can think about where we are guiding in terms of the aggregate dollar amount for fixed cost, is it similarly sized fixed-cost base as you move forward. And our task is and our objective is to maintain that fixed-cost base and contain that, offsetting any inflationary pressures in the cost base through our operational improvement initiatives. On the variable cost side, as we've talked about in our additional insight that we provided in February, this year at about 38% of billings is what we would expect that to look like for 2018 just like it looked in 2017. As we move forward, what you should expect is that, especially in the larger adoption years, we have a tendency to see better efficiencies in those larger adoption opportunities, concentrated opportunities in Texas, California and Florida. And so you should see some benefit to the variable cost side of the equation as we move into those bigger adoption opportunities.

[Jeffrey D. Goldstein:]

Great. Thanks.

[Operator:]

Thank you. And our final question will be from Jeff Silber with BMO Capital Market. Mr. Silber, your line is open.

[Jeffrey Marc Silber:]

I'm sorry. Can you hear me now?

[John J. Lynch:]

Yes.

[Joseph P. Abbott:]

Yes. We can.

[Jeffrey Marc Silber:]

Okay. Great. In your press release, you had identified the initiatives, talking about the expected cost savings annualized of $70 million to $80 million by the end of this year. Any of that in the first quarter? I'm just wondering what the cadence is as the year continues? Thanks.

[John J. Lynch:]

Sure. Yeah. Great question. Thanks. So, what you saw in, also in the press release you'll see that in the selling and administrative costs most of that benefit that we saw relative to the first quarter last year had to do with the restructuring initiative, that's about $5 million or so savings year-over-year that we saw in that area. If you'll refer to our fourth quarter earnings call slides, you'll also see the bridge and the amount that we were able to recognize in terms of savings in 2017. So as you're kind of thinking about the remainder of the year, this year we really had taken most of the actions toward the back half of the second quarter last year, so you'll see some year-over-year improvement as a result of the actions we took last year, in this year and really the first half. We still have a few actions to take under the program. Those are predominantly related to facilities consolidation activities. We'll be taking those in and around the midpoint of this year as those projects come to completion. And so we'll get some of that benefit in the back half of the year as well, which will round out the actions on the program, and we're well on track to achieve our $70 million to $80 million target that we talked about at the outset of the program.

[Jeffrey Marc Silber:]

Okay. Great. Thank you very much.

[Operator:]

Ladies and gentlemen, that does conclude our question-and-answer session for today's call. I'd like to turn it back over to management for any closing remarks.

[John J. Lynch:]

Thank you everyone for listening today. We look forward to speaking with you again in our second quarter call in early August. Thank you. Have a great day.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect and have a wonderful day.