Houghton Mifflin Harcourt Company
Q2 2018 Earnings Call Transcript

Published: 2 Aug 2018

[Operator:]

Good day, ladies and gentlemen, and welcome to our Houghton Mifflin Harcourt Second Quarter and Year-To-Date 2018 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 . As a reminder this conference call is being recorded. I would now like to turn the conference over to Brian Shipman, Senior Vice President, Investor Relations. Sir, you may begin.

[Brian S. Shipman:]

Thank you Brian, 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 August 12, 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 second quarter 2018 earnings press release. Before we discuss the 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, HMH's Chief Financial Officer, will provide a company update, as well as an overview of the company's second quarter and year-to-date 2018 results. Now, I'll turn the time over to Jack.

[John J. Lynch:]

Thank you Brian, and thank you everyone for joining us on today's second quarter 2018 earnings call. Our second quarter and year-to-date results demonstrate that we have sustained our solid start to the year. Additionally, our results illustrate the potential extensions we can have on the growth of our portfolio as Extensions billings grew 10% year-to-date. As we have discussed previously, 2018 is a cyclical trough year in our industry, with fewer large state adoptions taking place and many open territory districts deferring purchases of Core Reading and Math programs until they have new programs to evaluate for purchase. Despite this market backdrop, our Education segment billings and net sales were only slightly lower on a year-to-date basis. While we still have the important second half ahead of us, which typically contributes around 60% of our annual billings, we're encouraged by this performance. Given these results, coupled with our outlook for the year, we are reaffirming the guidance we provided on our fourth quarter 2017 earnings call in February. As we mentioned last quarter, the three largest adoption states California, Texas, and Florida, are buying new Science, Reading, and Math programs respectively in 2019. We have new product offerings in each of these disciplines that will strengthen our core, and we are very excited about these new programs which are branded into learning. Now that we have submitted to California, Florida, and Texas for 2019 adoptions, the review process by each state is underway. In Texas, we're pleased to report that the Texas Education Agency has given the HMH Into Reading and Into Literature programs a 100% alignment rating for grades K through 8. Additionally, California review panels have recommended HMH Science Dimensions program for approval in next year's science adoption. School districts in Florida are also now in the process of reviewing our next generation Into Math submission. These approvals are part of a multi-step adoption process and we expect final word on approvals to come sometime in the fourth quarter. Importantly, recall that because of the size of these large adoptions, we estimate our addressable market will reach approximately $3.2 billion in 2019. Looking ahead to 2020, we believe our addressable AAP market will again exceed $3 billion driven by significant billings opportunities for new adoptions in English Language Arts for grades 9-12 in Texas; English Language Arts for K-12 in Florida; and Science K-8 year 2 in California. We also expect growth in the open territory states, as many of those states are ready to replace programs aligned with the Common Core they purchased in the 2013-2014 timeframe. With these key adoptions (00

[Joseph P. Abbott:]

Thank you, Jack, and good morning, everyone. To echo what Jack said earlier, our second quarter and year-to-date results were a strong testament to our strategy of enhancing and extending the core and our renewed focus on execution. These results, coupled with our outlook for the rest of the year give us confidence in the guidance we set for 2019 on our February earnings call. Now, for the financial highlights of the second quarter and first half of the year. Our consolidated net sales were down 4% to $376 million in the second quarter of 2018, and net sales were down 3% to $595 million in the first half of 2018. Consolidated billings, which we define as net sales plus the net change in deferred revenue were down 2% for the second quarter of 2018 to $389 million, and billings were down 1% for the first half of 2018 to $571 million. I'll discuss the segment level drivers of our billings in a moment. Net loss for the second quarter was $23 million, an improvement of 50% versus last year, and the net loss for the first half of the year was $125 million, an improvement of 26%. Adjusted EBITDA declined 15% to $62 million in the second quarter and adjusted EBITDA was $47 million on a year-to-date basis, a decrease of 5%. Our gross margin improved due to a product sales mix carrying lower costs, and we continue to benefit from the year-over-year savings from our 2017 Restructuring Plan. Cost improvements in the first half were offset by higher employee benefit and medical expenses, as well as planned merit increases. Additionally in the second quarter, temporary increases in selling and administrative expenses were incurred to support the transformational initiatives of our HMH 2020 strategy. However, we remain on track to deliver $70 million to $80 million of run rate cost savings from our 2017 Restructuring Plan as we exit 2018. Our free cash flow in the second quarter was a usage of $116 million compared to a usage of $83 million in the same period last year. Our free cash flow in the first half was a usage of $251 million compared to a usage of $224 million during the same period last year. The increased cash usage in the first half was due to the higher cash incentive compensation payments relating to our 2017 performance and an unfavorable change in net working capital as we build inventory ahead of the selling season. Recall that our free cash flow generation is weighted to the second half every year and we typically use cash in the first half of every year. Total capital expenditures were $87 million for the first half compared to $84 million for the first half last year. Our cash and cash equivalents were $31 million on June 30, 2018 compared to $79 million at the same time last year. We ended June with $50 million drawn on a revolving credit facility to support seasonal working capital requirements which was fully repaid in the month of July. Moving on to our year-to-date segment highlights. Education billings were down less than 1% to $498 million on a year-to-date basis driven by a decline in Core Solutions and offset by strong performance in Extensions. Core Solutions billings were down 13% to $201 million on a year-to-day basis due to lower sales and adoption in open territory states. Timing of new adoption shipments had an effect on our year-over-year first half Core billings performance. Every year sets up a little differently depending on which individual states are buying. Last year, we shipped a larger portion of our new adoption sales in the first half of the year. This year we're expecting to ship a larger portion of our new adoption sales in the second half of the year. In the open territory states, our sales of Core Science and Social Studies programs performed well. However, the overall opportunity has been lower for Reading and Math solutions as many of the districts in those states are not yet ready to replace programs aligned with the Common Core they purchased in the 2013 and 2014 timeframe. Additionally, California Grades 9-12 are categorized as open territory, despite purchasing generally in line with the lower grade level of adoptions. The current third year of the California Literature adoption is a substantially smaller opportunity than last year, contributing to declines in our Core Solutions billings and the open territory market. Extensions billings in the first half increased 10% to $296 million. Growth was driven by an increase in Heinemann and Professional Services offset somewhat by intervention. While we still have the very important third quarter ahead of us, our Education segment performance relative to the AAP market is encouraging. Through June, our addressable AAP market declined more than 10%, while industry sales of Core Basal materials declined through the first half. Growth in our Extensions solutions resulted in nearly flat billings in our Education segment. This dynamic demonstrates the benefits of our strategy. As we continue to build scale in the faster growing Extensions portion of the market, our business is better positioned to mitigate the troughs inherent in the Core adoption cycle. Finally, Trade segment billings were down 7% to $73 million in the first half of the year. The billings decrease was due to the timing of key backlist releases such as Handmaid's Tale and 1984 in the first half last year. Trade also experienced lower sales from the young readers and general interest categories in addition to a decline in overall e-book billings, partially offset by an increase in licensing income. Given our outlook for the year, coupled with our year-to-date results, we're reiterating our guidance for 2018 and we're successfully executing on our longer-term strategic vision. We remain focused on execution so that we're well-positioned to successfully intercept the upcoming adoptions in 2019 and 2020. And we have introduced exciting new Into Learning programs for these adoptions. We also remain focused on achieving the final pieces of our 2017 restructuring plan to realize full cost savings potential by year-end. With that, I'd like to turn the call back over to Jack. Jack?

[John J. Lynch:]

Thank you, Joe. Now before taking your questions, I'd like to sum up what we've covered with you this morning. The HMH 2020 strategy is coming to fruition as we're refocused on enhancing our Core Basal business. And we're extending that Core business by investing in our Extensions offerings. Our year-to-date results demonstrates the merits of this strategy. Education billings were essentially flat in the first half of 2018, even while our addressable AAP market declined more than 10%. Our Extensions delivered strong billings growth of 10% driven by Heinemann and Professional Services, offsetting declines in Core Solutions. As a leader in both Core and Extensions, we're developing integrated solutions that will deliver value to educators. Our execution has improved with submissions complete for all the major adoptions coming in 2019. As I mentioned previously, Texas gave HMH an 100% alignment rating for K-8 ELA and California review panels have recommended HMH Science for approval. On the strength of these new adoptions, our addressable AAP market opportunity will be approximately $3.2 billion in 2019. Finally, given the results we announced today coupled with our unchanged outlook for 2018, we're reaffirming our guidance for the full year. Now, we will turn the call back over to the operator to open up the line for questions. Operator?

[Unknown Speaker:]

Operator Thank you. And our first question comes from the line of Jeff Goldstein from Morgan Stanley. Sir, your line is now open.

[Jeffrey D. Goldstein:]

Hi. Good morning. Thanks for taking my question. So with reiterating your billings guidance for the year, it seems like you're implying a roughly flat to slightly positive second half. So, I'm curious with you [Technical Difficulty] (00

[Joseph P. Abbott:]

Yeah. Hey, Jeff. It's Joe. Thanks for the question. We are expecting that we'll see continued growth in the Extensions portion of the market. We don't give specific guidance in the pieces of that business, but your conclusion is correct. And we're reaffirming guidance and that suggests that we'll see growth there on the Extension side of business.

[Jeffrey D. Goldstein:]

Okay. Thanks. And then as you prepare for the Texas Reading adoption and some of these other big adoptions of next year, how should we think about your strategy for selling into those markets, in anyways it differs from maybe a strategy with California Reading over the last few years? Thanks.

[John J. Lynch:]

Yeah. I think Jeff, and maybe the first thing is they're brand new programs and I think encapsulate our Learning company strategy. So we're integrating not only the Core curriculum content, but in addition assessment as well as professional services. So they are brand new programs, very high quality, rigorous content and solutions. And that's important because it is a distinction between California ELA which was in an updated edition of our product. And so when you think about California versus Texas, really it's apples and pears comparison.

[Jeffrey D. Goldstein:]

Great. Thanks.

[Operator:]

And our next question comes from the line of Jason Bazinet from Citi. Your line is now open.

[Jason Boisvert Bazinet:]

Yeah. I just had a question on the free cash flow. I think your guidance is negative to flat for the year. And when I went back and I just looked at the back half free cash generation, it happens every year going all the way back to 2012. It's a couple hundred million dollars. But then on the call, you sort of said you repaid that $50 million revolver in the month of July [Technical Difficulty] (00

[John J. Lynch:]

Yeah. Hi, Jason. As we've said in our – as we reaffirmed our guidance (00

[Jason Boisvert Bazinet:]

Okay. Thank you.

[Operator:]

And our next question comes from the line of Peter Appert from Piper Jaffray. Sir, your line is now open.

[Peter P. Appert:]

Thanks. Good morning. So the 10% growth in Extensions is pretty impressive and it's well above I think, Jack, what you've talked about previously in terms of your longer term growth expectations for that business. So sort of two questions. One is just anymore granularity in terms of the drivers of the Extension growth. Is it specifically timing related? Or second question, does it [Technical Difficulty] (00

[John J. Lynch:]

Yes. Thanks, Peter. I think this is largely as we indicated, both Heinemann and our Professional Services. If you look at Heinemann, we've just had a great growing business for over 10 years, and this is a particularly good growing business. This year, we had a Fountas & Pinnell Classroom of at least last fall. So, we had partial year growth associated with that product, while full-year growth is associated with that product this year. And then for Professional Services, this is a focus, again our learning company strategies, we're focused on outcomes. In order to achieve outcomes, you have to implement these programs with fidelity. And so, we are not just selling Professional Services kind of add-on. We're selling Professional Services because we truly believe that it's important to achieve the student outcomes that educators want for their students. So, that's you're beginning to see greater emphasis on Professional Services. You'll continue to see that as part of our strategy.

[Peter P. Appert:]

So still low mid-single-digit longer-term growth in that business?

[John J. Lynch:]

Yeah. I mean, I think that as far as Extensions, that category goes, that is going to be low to mid-single digits. And so we're not guiding for anything greater than that. But I think what you're seeing is outperformance of the category.

[Peter P. Appert:]

And then, Jack, on the intervention business, what's happening there, why the weakness in that segment?

[John J. Lynch:]

Yeah. Peter, as we discussed back in February with our transformational goals, we're leveraging our capabilities to create best-in-class intervention solutions to meet market demand. So, intervention is incredibly important part of our overall strategy. We're seeing great conversion rates on READ 180 Universal. And we introduced a new subscription model. You may recall that our intervention line was a perpetual license prior (00

[Peter P. Appert:]

Is the issue – sorry to dwell on this. Is the issue the – as you convert to subscription base, that has a temporary negative impact on revenue or is it just these older products are going away, so the total market opportunity is less?

[John J. Lynch:]

Yeah. Right now, it's not subscription related. And it's really the legacy solutions really at the end of their life cycle.

[Peter P. Appert:]

Got it. Understood. Thank you.

[Operator:]

And our next question comes from the line of Jeff Silber from BMO Capital Markets. Your line is now open.

[Henry Sou Chien:]

Hey. Good morning. It's Henry Chien calling for Jeff. Just a question, guys, on the addressable market and how that's shaping up for 2019. To the extent that you have visibility on it, [Technical Difficulty] (00

[John J. Lynch:]

Henry, we've said that the addressable market will increase by $700 million, largely as a result of the adoptions that we talked about few moments ago. We had no change in that outlook. We feel very good about that increase. If you think about Core curriculum, teachers spend about 50% of their time in Core instruction. So this is really a staple for educators, and we would expect that the funds associated with categorical funding will be there next year.

[Henry Sou Chien:]

Okay. Got it. Okay. And in terms of the sales process, is that later in this calendar year, you'll start to kind of see some feedback from your sales force and getting on (00

[John J. Lynch:]

Yes. We will. For both California and Texas, we'll have official approval from the state education agencies there, and once we do, we will begin the sales process in those states. In Florida, we have districts who are already reviewing our program, and so that sales process is commencing right now this summer.

[Henry Sou Chien:]

Got it. Okay. Fine. Thanks for the update.

[Operator:]

Our next question comes from the line of Bill Warmington from Wells Fargo.

[Unknown Speaker:]

Good morning, everyone. This is Jake (00

[John J. Lynch:]

Good morning, Jake.

[Unknown Speaker:]

We were wondering roughly what percent of the Extensions belong to this quarter, our multiyear subscription based versus more of a one-year or a one-time payment?

[John J. Lynch:]

Yeah. A de minimis portion of them would be multiyear. It's basically – the majority is single year.

[Unknown Speaker:]

Got it. And if available, what was the alignment rating for the previous Texas (00

[John J. Lynch:]

I don't know that. It's a trick question. We can find out for you, but the one thing I will say about the Texas adoption that we're very proud of is that you go through this process where you submit your solution and they evaluate it, and they may give you a little less than 100% or a lot less than 100% depending on who you are. We had for just about virtually every grade 100% first time true which I think is indicative of the quality and the rigor that went into the development of this solution. So, we're very proud of what we've accomplished thus far, look forward to receiving the official word on the final adoption now later in the fall.

[John J. Lynch:]

Sounds good. Thank you very much.

[Operator:]

And our next question comes from the line of George Tong from Goldman Sachs. Your line is now open.

[George Tong:]

Hi. Thanks. Good morning. Can you elaborate on the time line for the submission and review process for Reading in Texas and Florida and Science in California?

[John J. Lynch:]

Sure, George. As we indicated earlier, the programs were submitted in the April timeframe for both – for Reading, Science and Math into the districts in Florida. So, essentially second quarter those three programs were submitted. In the last month or so, Texas and I'd say last 30 days both Texas and California essentially approved the submissions. Now, there's additional steps that we need to go through, but those are the major steps that we will be going through. And then we'll have kind of official review and board approval later this fall in the early fourth quarter, late third quarter depending on which state you're in. And then we are done on the adoption process and recommence the sales process.

[George Tong:]

Great. And then as a follow-up, you've indicated you're on track to achieve a planned cost savings for 2018. Can you discuss what cost savings initiatives you may have in place beyond this year?

[Joseph P. Abbott:]

Sure, George. What we've been focused on is maintaining the fixed cost base that will be emerging in 2018 with and we plan to do that by offsetting the inflationary cost pressures in our cost base through continued operational excellence initiatives in the form of process reengineering and overall efficiencies that we think we can gain through better process and systems investment. So that's really what we've been focused on. The intent here is not large program, but rather maintenance of that fixed cost base.

[George Tong:]

Okay. Thank you.

[Operator:]

Our next question comes from the line of Drew Crum from Stifel. Your line is now open.

[Drew Crum:]

Okay. Thanks. Good morning, everyone. Wondered if you could talk about or remind us what the competitive landscape looks like for Texas Reading relative to the California Reading adoption a couple of years ago? And then separately for Joe, could you give us some indication as to how you're thinking about pre-pub spend for this year and where it goes in the out years? Should we expect [Technical Difficulty] (00

[John J. Lynch:]

Drew, I'll take the question on California versus Texas. The major companies in core curriculum are in Texas just as they were in California. As I said earlier, we feel really good about our submission for ELA in Texas, in large part because it is a new program developed for Texas and in particular for balanced literacy that includes not only high-quality content, but assessment in professional services. So, I think it's a very different offering than the one in California but it's the same players there in both California and Texas.

[Joseph P. Abbott:]

Okay. And then, Drew, I think your question was prepublication expense, content development spend. And we've guided for 2018 in the range of $125 million to $150 million. We've reaffirmed that and we expect that it will be in that range. As we move forward then into 2019, while we have gotten through these very, very large adoptions with the first iteration of the new program, we will continue to have modifications that we need to make to some of those programs in the form of new national programs that we'll be launching shortly after – we're actually working on some of that now but that spend will continue into next year. And then the other thing to keep in mind is that we've also got in 2020 the large Florida Reading adoption which will be coming up and contributes to that market, the Texas 9-12 portion of their ELA adoption. And so for next year, while we will see some degree of reduction, we think in our content development spend, I wouldn't think your term was precipitous.

[Drew Crum:]

Okay. Thanks, guys.

[Operator:]

And our final question will be from Matt Kaplan from CIFC. Sir, your line is now open.

[Matthew Wayne Kaplan:]

Hi, guys. On the Florida adoption, I know you guys are still currently [Technical Difficulty] (00

[John J. Lynch:]

Matt, no one has been approved on a major district evaluation. We've actually had a couple of sales already. This is a great program, but not from a major school district. They've been smaller schools that want to get a head start. But they're beginning the evaluation right now and we would expect that that will continue through the remainder of the year.

[Matthew Wayne Kaplan:]

That's great. And then on these timing differences which you mentioned more (00

[John J. Lynch:]

I'm sorry could you repeat the question.

[Matthew Wayne Kaplan:]

Sure. So, one of the things I'm trying to understand is slightly lower billings for the first half of the year, but (00

[John J. Lynch:]

Well, typically what we'll see is that you have in the back half of the year and this is historically you're going to have 60% or more of your billings that occur in the second half of the year. Not in every case. So, while we're not providing specific information about the month of July, what we can tell you is our guidance range implies that you'll see that same dynamic develop through the back half of the year.

[Matthew Wayne Kaplan:]

Okay. Thanks.

[Operator:]

And that concludes our Q&A session. I would now like to turn the call back to Jack Lynch for closing remarks.

[John J. Lynch:]

Thank you Brian, and thank you, everyone, for listening to our call today. We look forward to speaking with you on our third quarter call in early November. Have a great day.

[Operator:]

Ladies and gentlemen, thank you for your participation in today's conference call. This concludes today's program and you may all disconnect. Everyone, have a great day.