Houghton Mifflin Harcourt Company
Q3 2018 Earnings Call Transcript

Published: 9 Nov 2018

[Operator:]

Good day ladies and gentlemen and welcome to the Houghton Mifflin Harcourt Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder this conference call may be recorded. I would now like to turn the conference over to Brian Shipman. You may begin.

[Brian Shipman:]

Thank you 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 November 17, 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 third quarter 2018 earnings press release. Before we discuss our results, I encourage you to review the cautionary statement on slide two, 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 third quarter and year-to-date 2018 results. Now, I'll turn the call over to Jack.

[John Lynch:]

Thank you, Brian and thank you, everyone for joining us on today's third quarter 2018 earnings call. Before I begin, I'd like to run through a few highlights from Q3 and our year-to-date results. First, our new programs are on track for approval in upcoming 2019 adoptions. Next, total company billings grew 1.5% in Q3 and were flat year-to-date. And finally, strong performance of our Extensions business, with billings growth of 8% in Q3 and 10% year-to-date, underscores the importance of extending our core market, a key pillar of the HMH 2020 strategy. As these highlights suggest, our third quarter and year-to-date performance remained solid. We're reaffirming our guidance for the full year 2018. As we said before, 2018 is a cyclical trough year in our industry with fewer large state adoptions taking place. Against this market backdrop, we performed well with strong growth in our Extensions and trade businesses. Next year, we expect that our new next-generation core programs, combined with continued growth in our Extensions portfolio and our increased ability to offer integrated solutions, will improve the free cash flow generation fundamentals of HMH. Just after Q3, we also closed on the previously announced divestiture of the Riverside standardized testing business for $140 million in cash. We are planning to invest the net proceeds of approximately $135 million from this divestiture into our Extensions business. Our Q3 and year-to-date performance shows that we are continuing to execute on our strategic vision, evolving from a publishing company focused on great content to a learning company focused on great outcomes. These efforts will position us for continued market leadership and long-term value creation for students, educators, and shareholders. As we have discussed with you previously, the three largest adoption states California, Texas, and Florida are buying new science, reading and math programs, respectively, in 2019. We continue to remain confident that our programs will be approved in these states. In California, the Instructional Quality Commission has recommended HMH Science Dimensions, our next-generation science program, for adoption. We expect the California board of education's final approval decision to be imminent. Similar to California, Texas' state review panel has recommended our English-language arts programs for approval, and we expect the Texas State Board of Education to make its final approval decision this month. In Florida, school districts are currently evaluating our math program and we have made it to the final selection processes in several key districts. Looking further ahead to 2020, we expect large adoptions will drive significant billings opportunities in ELA for grades 9-12 in Texas, ELA for K-12 in Florida; and continuation of the science adoption in California. With these key adoptions on the horizon for 2019 and 2020, we remain highly focused on execution, as they will move us from the trough to the peak of our business cycle. Additionally, we expect growth in open-territory states, as many of those states are ready to update the materials they purchased for the common core in 2013 and 2014. Now for our segment-specific results. Education segment billings declined 2% in Q3. For the first nine months, our Education billings declined about 1%, in line with the decline of the addressable portion of our market that AAP measures. Our total Education billings declined in line with the market, and Core Solutions billings declined $25 million in the third quarter and $55 million year-to-date. These declines were driven by softer demand for our legacy core reading, literature, and math programs ahead of our new programs entering the market next year, partially offsetting billings decline from our legacy programs, with the important win of an RFP in Puerto Rico. We are replacing our legacy core offerings with brand-new programs in these subject areas to compete both nationally and in the large adoption opportunities next year. We believe these offerings will help us grow share based on customer feedback to-date in Texas, Florida and California; as well as our success this year in science. Our next-generation science program, which launched in 2017, has helped our science portfolio gain market share in 2018 and gives us confidence that the new program launches will be successful. Turning to our Extensions business, we are very pleased with its performance. Billings were up 8% in the third quarter and 10% year-to-date. This growth was once again driven by Heinemann and services. The strength in services can be attributed to tighter integration with our core programs, which highlights our goal of offering integrated solutions to our customers. This growth was somewhat offset by supplemental and, to a lesser extent, intervention solutions, as we are in the process of building out these portfolios to match market demand. Extensions will remain a key focus area for us, as they are less subject to the core K-12 solutions business cycle. Billings in areas not measured by AAP such as the Puerto Rico win I mentioned previously and portions of our Extensions portfolio help to offset the decline in our legacy core programs. As a result of these declines year-to-date, our share of the addressable portion of the AAP market is down about two points. As we continue to evolve into a learning company and execute on our HMH 2020 strategy, we see limitations in the utility of the AAP market measurement as an indicator of Education segment performance. It measures a subset of our addressable market defined as the performance of a narrow set of six AAP reporting companies versus the larger $11 billion K-12 market where many more companies compete for share. In the coming years, we expect to see an increasing portion of our growth coming from areas that currently fall outside of the AAP measurement and within the larger $11 billion U.S. instructional materials market as well as international opportunities that we consider addressable. Now, for our trade segment. Trade delivered very strong growth of 33% in Q3 and growth of 9% year-to-date. Growth this quarter was largely attributable to new licensing deal pertaining to our classic backlist titles, Orwell's 1984 and Animal Farm. Looking ahead, a key driver of our trade strategy is the focus on leveraging the valuable titles in our backlist such as the examples I just shared. A few other examples include a multimedia strategy with planned high-end releases for important titles such as Mary Poppins, Carmen Sandiego, and Beautiful Boy. With that, I'll turn the call over to Joe, who will provide a deeper dive into our third quarter and year-to-date results. Joe?

[Joe Abbott:]

Thank you, Jack and good morning everyone. Thanks for joining us on the call. To echo what Jack said earlier; our third quarter and year-to-date results were a strong testament to the progress we are making on the three dimensions of our HMH 2020 strategy. Now, for the financial highlights in the third quarter and first nine months of the year. My discussion of our result this morning will be on a continuing operations basis. Thus, the results and variances I discuss will assume we did not own Riverside in either 2017 or 2018. Our consolidated net sales remained essentially unchanged at $516 million in the third quarter and decreased by 2% in the first nine months of the year to $1.07 billion. Billings, which we defined as net sales plus the net change in deferred revenue, were up 1.5% in the third quarter to $571 million, while year-to-date billings were flat at $1.108 billion. I'll discuss the segment level drivers in our billings in a moment. Net income from continuing operations for the third quarter was down 5% to [Indiscernible], while the net loss from continuing operations for the nine-month period improved 39% to $51 million. Adjusted EBITDA for the third quarter declined $1 million to $160 million, while on a year-to-date basis; adjusted EBITDA declined 3% to $190 million. The year-to-date decline in adjusted EBITDA can be attributed to a decline in net sales, partially offset by savings related to our 2017 restructuring plan. We remain on track to realize the full cost savings of $70 million to $80 million from our 2017 restructuring plan as we exit 2018. Our free cash flow year-to-date was a usage of $108 million compared to a usage of $101 million during the same period last year. Our increased cash usage was driven by higher working capital due primarily to increased inventory levels in anticipation of the upcoming 2019 adoptions and continued growth in Heinemann, as well as increased capital expenditures. Total capital expenditures were $134 million year-to-date compared to $121 million in the same period last year. As of September 30th, 2018, we had cash and cash equivalents of $134 million compared to $210 million at September 30th, 2017. We closed the Riverside transaction on October 1st, which adds $135 million of net proceeds to our cash balance on a pro forma basis. Moving on to our year-to-date segment highlights. Education billings were down 1% to $967 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 10% to $475 million on a year-to-date basis due to lower sales and adoption in open-territory states. Partially offsetting the decline in Core Solutions was a large win in Puerto Rico across several HMH programs. Looking ahead to next year, we believe the release of the new math and reading programs will position HMH to intercept the increase in demand we anticipate in the market. Turning to Extensions, performance remained strong with billings growth of 10% to $492 million for the first 9 months of 2018. Growth continues to be driven by Heinemann and services, somewhat offset by supplemental and intervention. As Jack mentioned, our share of the addressable market declined around two points on a year-to-date basis and we now expect share of our addressable market, as measured by the AAP, to fall below the 38% level for the full year. However, as Jack also mentioned, sales of our new next-generation science program have been strong in 2018. And we believe this bodes well for our new math and reading programs, which are set to be in the market next year. Our trade segment billings increased 9% to $141 million for the first nine months of 2018. Growth was largely attributed to a new licensing deal pertaining to our classic backlist titles 1984 and Animal Farm and higher general interest sales from frontlist titles such as the titles in our Instant Pot franchise. In conclusion and echoing what Jack said earlier on this call, given our outlook for the year coupled with our year-to-date results, we are reaffirming our guidance for 2018 and we are successfully executing on our longer-term strategic vision. We remain focused on execution so that we are 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. And with that, I'd like to turn the call back over to Jack. Jack?

[John Lynch:]

Thank you, Joe. Now, before we take your questions, I would like to summarize what we've covered with you this morning. Our Q3 and year-to-date financial results were solid, and combined with our Q4 outlook; we are reaffirming our 2018 guidance. The HMH 2020 strategy is coming to fruition and our year-to-date results demonstrate the merits of this strategy. We are extending our core business by investing in our Extensions offerings, which continued to achieve above target growth in Q3, offsetting the declines in Core Solutions. Our execution is on track and we anticipate that our new programs will be approved for the major adoptions in 2019. Review panels in both California and Texas have recommended our science and ELA programs, respectively, for approval. Finally, we expect that these new next-generation core programs, combined with continued growth in our Extensions portfolio and our increased ability to offer integrated solutions, will improve the free cash flow generation fundamentals of HMH. Now, we will turn the call back over to the operator to open up the line for questions. Operator?

[Operator:]

Thank you. [Operator Instructions] Our first question comes from the line of Bill Warmington of Wells Fargo. Your line is now open.

[Bill Warmington:]

Good morning everyone. So, a question for you on given the new math, reading and science programs heading into 2019, if you could talk a little bit about what kind of market share expectations you're thinking about for 2019 and how you're planning to get there?

[Joe Abbott:]

Yes, Bill. So we're not guiding at this point for a specific share for 2019. What we can tell you, though, is that based on the reception that we've received from customers and as they reviewed the programs thus far, based on the fact that we're doing very, very well with our new science program out in the broader market this year. This is a program that launched in 2017. We're seeing good success this year. We really feel like this is going to contribute to market share growth overall in the market in 2019 when all of those programs are out in the market.

[Bill Warmington:]

Got it. And then for California, Texas, and Florida, you mentioned the success at the review panels. What are the milestones that we're going to be able to see over the next few months that will indicate those programs are continuing to move forward? What can investors hope to see as evidence of success there?

[John Lynch:]

Yes Bill, the first thing is that any day now the California State Board of Education will approve our -- the science program. So, that's probably the first thing you'll see over the next few days. Also, this month, in Texas the State Board of Education will approve our ELA programs for K-8. And then you -- what you'll see is we've already begun preselling in California and in Texas. Once those programs are approved this month, you'll see purchases made in the first half of 2019, so -- and then also, for Florida math, the way Florida works is that the state actually approves after the districts have made their decisions. So, you'll begin to see decisions made actually in the fourth quarter this year and in the first quarter of next year. So, those are the major milestones.

[Bill Warmington:]

Thank you very much.

[Operator:]

Thank you. Our next question comes from the line of Peter Appert of Piper Jaffray. Your line is now open.

[Kevin Estok:]

Hey good morning guy. This is Kevin Estok in for Peter Appert.

[John Lynch:]

Hey Kevin.

[Kevin Estok:]

Hi good morning. My question is I was just wondering if you can discuss how the transition to digital content has impacted your business model, so far, I guess specifically revenue and margins?

[Joe Abbott:]

Yes, sure. Well, I think it's important to recognize that really the transition to digital for our business occurred many years ago. We've been operating in a world and in a business that has been offering to our customers both print and digital format for our content. So, if you think about the profile of our business now from a revenue and margin perspective, you're largely seeing the go-forward effects of the way we offer the content programs to our customers. Really for us, the aspect of digital that is most important for our customers is using digital for what it does best. And that's important for us to continue to empower teachers and educators, to make sure that we are using digital really for the aspects that make the content most engaging and most effective and help us deliver outcomes.

[Kevin Estok:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Jeff Goldstein of Morgan Stanley. Your line is now open.

[Jeff Goldstein:]

Hey guys. Thanks for taking my questions. You mentioned some softer demand for older programs this year, which drove some of the decline in your Core Solutions business, so I was curious. Was this a concerted strategic decision given the lower market outlook this year? Or kind of in retrospect, do you think investing in newer programs could have benefited 2018?

[John Lynch:]

Yes, Jeff, I think, if you look at the share decline, there's really three reasons. The first is -- first, I apologize for the noise you're hearing. But the first is discontinuation of unattractive distribution agreement that contributed to share in 2017 and is not contributing share in 2018. We mentioned previously that we're not participating in the California first state adoption. That contributed. And then finally, the point that you're making about the legacy programs; I think it stands to reason that at the -- we're at the end of the life of these legacy programs. So, they're not as competitive as they once were, and that's why we aren't excited as we are, but the new programs are entering the market in 2019. And so it wasn't so much a concerted effort as much as the adoption calendar laid up the way it did. And we developed our programs for Texas, California, and Florida, respectively, for reading, math -- reading, science, and math.

[Jeff Goldstein:]

Got it. That was helpful color. And then I want to ask about the M&A pipeline. It's been a couple of years now since the EdTech acquisition, so just curious on the appetite for another deal, if it meant issuing debt. And if so, what are the main areas you'd be looking at? Thanks.

[John Lynch:]

Yes, what we've said since we announced our HMH 2020 strategy is that we will allocate capital to our Extensions business. And the reason for that is that it's a fast-growing, higher margin business. And in particular, we see areas in the supplemental and intervention space and even more specifically within classroom intervention. So that will be a target area for inorganic and organic growth, but we do see within the Extensions area, because of it's -- because it's highly fragmented category, fast growing, higher margin, that there are significant opportunities for inorganic growth.

[Jeff Goldstein:]

Thanks.

[Operator:]

Thank you. Our next question comes from the line of Jason Bazinet of Citi. Your line is now open.

[Jason Bazinet:]

Yes. I just had a quick question on the $135 million that you're going to invest in the Extensions market. To the extent some of that is sort of organic investment, not M&A related, can you just spend a second and talk about how that would impact the P&L and cash flow statement? And sort of what is the gestation period between investment that you might make and then the subsequent benefits you might see on the top line on the back end?

[Joe Abbott:]

Yes, sure, Jason. So, you know what, to the extent that we were to reemploy proceeds organically, you would see that first in our content development spend, perhaps a bit in our non-content-related CapEx. And that's where you would see the initial investment show up. When we think about the longer term benefits of that investment, that really has everything, speed to market as it relates to inorganic opportunities and the development cycle associated with an organic type of an approach. So, difficult to answer that question with certainty, but you can think about it as all factors that we're considering when we are making the determination between, for example, build versus buy in that Extensions portfolio.

[Jason Bazinet:]

Sorry. If you did end up building, as opposed to buying, how long does it take to sort of develop a product before it hits the market and you might see topline benefits?

[John Lynch:]

Yes, Jason, it really depends on the product and its scope. I think in general our -- these programs are high quality instructional programs. They're research-based evidence, so there's -- it's a multiyear process typically to develop a product, but again it does depend on a couple of years.

[Jason Bazinet:]

Okay. Thank you.

[Operator:]

Thank you. Our next question comes from the line of Jeff Silber of BMO Capital Markets. Your line is now open.

[Jeffrey Silber:]

Thanks so much. Just want to go back to an earlier question. I know you're not providing specific guidance for next year, but do you think that you will gain market share next year? I know this market share metric is a little bit iffy, but just on -- based on that, do you think we'll see there's a tight turn in the right direction next year? Thanks.

[John Lynch:]

Yes, I -- Jeff, a couple of points. One, as you know, we guided to the AAP addressable market of this year about $2.5 billion. We're tracking to that, so we'll -- you'll likely see that play out the way we anticipated at the beginning of the year. We're guiding to $3.2 billion because of the major adoptions in 2019. And you may recall that 80% of the addressable market in Core Solutions is in reading and math. That is where we are particularly strong, and so I think it stands to reason that we will be looking for increased market share because that's our sweet spot, if you will, in the Core Solutions category.

[Jeffrey Silber:]

Okay, I appreciate you clarifying that. And we had some big elections in the past couple days. Was there anything in any specific states that developed to either positive or negative for your business? Thanks.

[John Lynch:]

Yes, by and large, no. No news. And so not at the federal level and not at the state level. It's no big news as a result of the elections.

[Jeffrey Silber:]

Okay, great. Thanks so much.

[Operator:]

Thank you. [Operator Instructions] Our next question is coming from the line of George Tong of Goldman Sachs. Your line is now open.

[George Tong:]

Thanks. Good morning. You've indicated that your science and ELA programs are being recommended for adoption in California and Texas. Once you make the approved adoption list, can you discuss what factors could cause potential variability in ultimate sales performance?

[John Lynch:]

Yes. I mean I think the way to think of the adoption list is a -- almost like a hunting list, if you will. So, the decisions are made at the district level and so it really comes down to how competitive you are in the eyes of the folks, those folks at the district who make those decisions. And so it's a state makes a decision to -- after an evaluation of program, that it meets their standards. And then district-by-district, they make their own individual decisions as to which of those programs that have been approved by the states they wish to purchase.

[George Tong:]

Got it, that's helpful. And then can you elaborate on some of the competitive dynamics you're seeing in market share performance in the open territory segment?

[John Lynch:]

Yes. I mean I think the -- it's a good question, George. What we've seen in open territory is about a 2% decline in open territory. We've actually seen an increase in share in open territory, first, for science. And we've seen us -- and for primary, K-6, we've seen slight growth in open territory and we've seen decline in secondary. And again, open territory is the way we view open territory at the trough of our adoption cycle is that right now they are kind of at the end of their refresh cycle for the programs they purchased in the 2013 and 2014 timeframe, which was the demand driven by the new implementation of the common core. So, we guided open territory will be flat. It was substantially down last year. It's down by 2% this year. We would expect that demand will start coming into open territory as a result of the new programs that we're releasing next year.

[George Tong:]

Got it. Very helpful. Thank you.

[Operator:]

Thank you. And our final question comes from the line of Drew Crum of Stifel. Your line is now open.

[Drew Crum:]

Okay. Thanks. Good morning everyone. So, I think you mentioned earlier expectations for free cash flow to improve in 2019. Not looking for specific guidance, but as you compare 2019 to what you were able to generate in 2014, which I believe was above $300 million, what are some of the puts and takes we should consider? And then separately, I just want to go back to Florida. If I heard correctly, you said that several districts are evaluating the program up for adoption. Could you give us a sense as to what percentage of the districts are looking at this program or percentage of students that are represented by these districts? I just want to get a sense as to what the opportunity is there and then what districts are not considering the program. Thanks.

[Joe Abbott:]

Yes, sure, Drew. Let me take the first piece in terms of thinking about free cash flow compared to 2014. Every year, as you know -- and we say this pretty frequently, but I think it bears repeating. Every year sets up differently. And so what's important in terms of the puts and takes between the 2014 and 2019 is what specific states and what specific products are being purchased in any given year. As you know, reading in Texas is one of the biggest adoptions out there, so that's very, very important for us compared to 2014. That was not a reading adoption in Texas. Another one is our relative competitive performance. And so as you also saw in 2014, we had a very, very strong market share year in that particular year. So, our performance in total will have an impact as well. We have been seeing that in the -- these very large state adoption opportunities we typically do see some benefits of -- so in our cost of sales and our variable costs. And so and to the extent that, that continues in 2019 that can have a benefit. And then further, just the relative fixed cost structure between 2014 and 2016 has an impact. Actually, one more addition is the relationship between the next year or two years adoption calendars beyond 2019 has an impact as well because that directly impacts our -- the need to continue to be investing on the content development side. So, a number of factors to consider here, Drew. And of course, as we get to our fourth quarter call, we'll be providing you more insight and colors that -- to think about 2019 specifically.

[Drew Crum:]

Okay. Thank you.

[John Lynch:]

Drew, on Florida, the question was what percentage of the Florida schools and students are covered by this Florida math adoption. It's actually the entire state, so the entire state and all the school districts and which represents, I want to say, close to 3 million students, are going to be addressable by this particular adoption in Florida.

[Operator:]

Thank you. That is all the questions we have for today. I'd like to hand the call back over to Jack Lynch for any closing remarks.

[John Lynch:]

Okay, well, thank you, everyone, for joining us today. And we look forward to speaking to you on our Q4 earnings call in February. Thank you.

[Operator:]

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