Houghton Mifflin Harcourt Company
Q1 2017 Earnings Call Transcript

Published: 4 May 2017

[Operator:]

Good morning and welcome to Houghton Mifflin Harcourt's First Quarter 2017 Earnings Call. I would like to inform you that this call is being recorded and that all participants are in a listen-only mode. Later, we will have a question-and-answer session and instructions will be given at that time. I would now like to introduce Brian Shipman, Senior Vice President of Investor Relations for Houghton Mifflin Harcourt. Mr. Shipman, you may begin.

[Brian S. Shipman:]

Thank you, Bridgette, and good morning, everyone. Before we begin, I would like to point out that the slides we will reference during the course of this presentation can be accessed via the Investor Relations section of the Houghton Mifflin Harcourt website at hmhco.com. A replay of today's call will be available until May 12, 2017 and the webcast will be available on our website for one year. Our 10-Q was also filed this morning along with our first quarter 2017 earnings release. Before we discuss our results, I encourage all listeners to review the legal notice on slide two which explains the risks of forward-looking statements and the use of non-GAAP financial measures. Additionally, please refer to our Forms 10-K and 10-Q for a discussion of risk factors that could cause actual results to differ materially from these forward-looking statements. Our slide presentation and discussions on this call will include certain non-GAAP financial measures. For such measures, reconciliations to the most directly comparable GAAP measures are in the appendix to the presentation. This non-GAAP information should be considered supplemental in nature and should not be considered in isolation or as a substitute for the related financial information prepared in accordance with GAAP. In addition, these non-GAAP financial measures may not be the same as similarly entitled measures reported by other companies. 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, 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 first quarter 2017 results. With that, I'll now turn the call over to the President and CEO of Houghton Mifflin Harcourt, Jack Lynch.

[John J. Lynch:]

Thank you, Brian. Good morning, everyone. This company has a long rich history and I'm excited to be here at a time where the company is poised to create exceptional value for our customers. We started off 2017 with a solid quarter. But before we dive into our results, I want to take this time to tell you why I joined HMH. First, I joined because of the company's scale. Not only are we the largest K-12 learning company, we have the largest sales force, we have the largest customer base, 3 million teachers and 50 million students who are impacted by the work we do each and every day. Think about that, 3 million teachers and 50 million students. That is an uncommonly powerful platform upon which we can create value for educators and the students they serve. And I'm inspired by how our people value and nourish the relationship between a teacher and her students, creating solutions that lead to those inspiring classroom moments of wonder, of growth, and of mastery. HMH's scale for creating a broad impact in education is the first reason I joined the company. So what's the second reason? I recognized that our solutions have life-changing impact for many students. Today, too many children sit in classrooms incapable of absorbing grade-level content simply because they're not ready to learn what is being taught in their classroom. For them, it is confidence-crushing and reinforces an all-too-familiar cycle of failure they see within their communities. We have the intervention solutions that can break that cycle, meeting students where they are on their own individual learning path and bringing along on that path regardless of the grade they happen to be in, ultimately restoring their confidence in themselves and restoring confidence in their future. HMH intervention solutions have the power to change lives. This brings me to the third reason for joining the company. We have powerful integrated solutions with evidence that those solutions improve student outcomes. I've been in the K-12 industry for a third of my career, and I know that educators don't buy core curriculum products. They don't buy intervention solutions. They don't buy professional development services. At the end of the day, what they buy is the opportunity to improve student outcomes. They place great value on integrated solutions that combine core curriculum with the intervention and professional development in a system, each component of that system designed to work together with the next to improve student achievement. I believe HMH is the only provider that can put together a truly integrated solution to meet this demand. Last reason. Our Trade Publishing business is a point of pride for HMH and is a particular point of pride for me. From beloved classics to current bestsellers, this business provides ongoing potential for revenue generation both as a stand-alone segment in our portfolio and as a partner to our core K-12 business. So I hope you can tell from the reasons I chose to come here that I believe in the long-term growth potential of the company and I believe in the enduring strengths and value of our business. We have all the necessary keys to success

[Joseph P. Abbott:]

Thanks, Jack, and good morning to everyone joining us on the call today. As Jack mentioned, we started off the year with a solid first quarter. As a reminder, historically the first quarter is a seasonally light quarter for HMH. Nevertheless, we're encouraged by the first three months of the year with Q1 2017 billings up 10% year-over-year and free cash flow meaningfully improved in the quarter compared to Q1 of last year. We also commenced our operational efficiency initiatives and have taken action on many of the early steps in that plan. Finally, we plan to hold an Investor Day on June 23 in New York City and we'll have more details on that soon. In our Education segment, we had a solid quarter with net sales of $185 million, up more than 6% compared to the first quarter of last year, mostly due to higher sales in California Reading. Additionally, we saw an increase in sales from our Heinemann business driven by our popular classroom libraries offering as well as a one-time fee associated with the expiration of a distribution agreement. While we did see a $6 million decrease in sales from our international business, this was primarily due to the prior year period benefiting from an international distributor order. We continue to move forward with our strategy to strengthen our business and invest in state-of-the-art core curriculum programs that we believe will make us even more competitive in upcoming adoptions. This includes our recently launched K-6 Social Studies program which we discussed last quarter, and our brand new Reading and Math programs which are currently under development. We expect that our new all-in-one technology platform, Ed, will be a powerful differentiating tool as we market these new core curriculum products. While we saw lower Professional Services revenue in the first quarter, we continue to see this business as well as intervention solutions as key growth opportunities that have strong synergies with our core education business. We're committed to investing and growing in businesses where we see the most potential to leverage the strength of our basal business. Turning to our Trade segment. Sales were up 16% year-over-year driven by top titles including the Whole30 Cookbook and Tools of Titans as well as stronger e-book sales. In addition to these contemporary bestsellers, HMH also has a strong backlist of classics, award-winning literature that continues to inspire readers and drive sales. For example, we have recently seen a trend towards increased sales of dystopian fiction giving backlist titles such as Orwell's 1984 and Atwood's The Handmaid's Tale a new resurgence in sales. Now, turning to our financial performance for the quarter on a consolidated basis. Net sales for the first quarter were $222 million, an 8% increase compared to the same quarter in 2016 mostly due to higher sales in California Reading, a $5 million one-time fee associated with the expiration of a distribution agreement, and increased sales in our Heinemann and Trade businesses, partially offset by a decrease in international sales. Billings, which we define as net sales plus the net change in deferred revenue, were $184 million in the first quarter of 2017, a 10% increase compared to the first quarter of 2016 primarily due to the same drivers affecting net sales. Further, there was a $5 million increase in our Heinemann professional publishing sales driven by our classroom libraries. Pre-publication or content development costs were $28 million in the first quarter of 2017, down 15% compared to last year, mostly due to timing. Total CapEx was $45 million during the first quarter. As you know, our next-generation programs, which are launching this year and next, will cover all core subject areas, and we still expect content development costs to be between $140 million and $160 million in 2017. Overall cost of sales was $149 million in Q1 2017, a decrease of $3 million compared with $152 million in Q1 of 2016. Cost of sales, excluding publishing rights and pre-publication amortization, increased by $2 million to $108 million in the first quarter of 2017 from $106 million for the same period in 2016 driven by higher sales volume. Selling and administrative costs in the first quarter were $156 million, down $12 million compared to the first quarter of last year. This decrease was a result of tighter cost controls which led to discretionary cost decreasing $14 million driven by a reduction in marketing and advertising costs, lower professional fees, and lower travel and entertainment expenses. The decrease was partially offset by higher office lease cost and higher depreciation as a result of our increased investment in business systems, technology platforms, and infrastructure. For the first quarter, our net loss was $121 million, $44 million less than the $165 million net loss we reported in the first quarter of 2016. This was largely due to the previously mentioned factors impacting net sales, cost of sales, and SG&A expenses. Operating loss for the quarter was $96 million compared to a loss of $122 million in the first quarter of 2016. The decrease was primarily due to the same previously mentioned factors. Adjusted EBITDA for the quarter was a loss of $24 million, a 42% improvement compared to the same period in 2016, mostly due to the same factors impacting net sales, cost of sales, and selling and administrative expenses. As of March 31, 2017, we had cash, cash equivalents and short-term investments of $164 million compared to $307 million at year end 2016. Cash from operations was a usage of $96 million during the quarter. Given the seasonality of our business, it is typical for us to use cash in the first half of the year. Free cash flow in the first quarter of 2017 was a usage of $141 million, meaningfully improved compared to a usage of $170 million for the same period in 2016. The change in free cash flow was primarily due to improved profitability and reduced capital expenditures. As we discussed during our full year 2016 earnings call, 2017 is an important investment year, as we continue to develop the next generation of HMH products ahead of large adoption opportunities in 2018 and beyond. With our strong portfolio of best-in-class products and a solid pipeline of new and exciting updates, we're confident that these products will enable HMH to be highly competitive in the large adoptions we see coming up in the next few years. Last quarter, we also talked about taking steps as a company to improve our operational efficiency and rightsize our cost structure, beginning with a thorough review of our operating model and organizational design to help ensure we're structured efficiently and effectively, to simplify our business, and better enable us to reinvest for long-term growth. On April 18, we issued an amended 8-K updating our March 16 filing in which we detailed the major actions we're taking and the expected financial impact of those actions. To recap that disclosure, we expect that the actions we have planned this year and next will result in approximately $70 million to $80 million in annualized cost savings by the end of 2018 and will result in total charges of $41 million to $45 million, of which $32 million to $36 million will be cash charges. Some of these actions we have identified include changes to our organizational design and other rightsizing initiatives that will result in reductions in workforce intended to streamline our processes and decision making and reduce organizational complexity, making us more nimble and agile to better focus on the needs of our customers and create long-term shareholder value. We have been in close communication with our employees about these changes. We expect that substantially all of our organizational design changes will be complete by the end of May 2017 with the other planned actions to be completed by the end of 2018. In total, we expect the majority of the $70 million to $80 million in savings to be actioned in 2017. We do expect to realize a portion of these savings from these actions in 2017, and we had factored in a level of savings in our qualitative commentary provided on the fourth quarter earnings call regarding our adjusted EBITDA margin and free cash flow expectations for the year. As we stated in the 8-K, we have not changed these expectations. As a reminder, on our last call we stated that variable compensation is expected to be higher this year, so the cost base from which these actions will occur is expected to be higher than our 2016 cost base. We will provide more detail on this topic at our Investor Day in June where we also look forward to sharing more information on upcoming opportunities in the pipeline as well as a deeper dive into the metrics we use to model our business. We will provide location and other logistical information via press release in the coming days. We look forward to speaking with you in June. And with that, we'll go ahead and open the line for questions. Operator?

[Operator:]

Thank you. Our first question comes from Jason Bazinet with Citi. Your line is open.

[Jason Boisvert Bazinet:]

Thanks. I just have a question for Mr. Lynch. I appreciate your comments at the beginning about why you joined Houghton. I was just wondering if you could talk a bit given your experience at Renaissance and bigchalk, what are the vulnerabilities that you see among incumbents in the K-12 space as they sort of grapple with these new online attackers, if you will? And then second, are there any sort of first blush observations that you have about Houghton relative to your experience at Pearson? Thanks.

[John J. Lynch:]

So I think in terms of the first question, vulnerabilities, I think you're referring to vulnerabilities of incumbents like HMH. And frankly, I think the biggest thing in K-12 in terms of vulnerability but also in terms of strength is distribution and distribution scale. And so I think, typically, what you see in K-12 are a lot of companies who do not enjoy the same kind of distribution scale that we have who are more formidable, frankly, when they're bringing new products to market. So I feel very good about the inherent strength of the business from a threat standpoint of new entrants. And, Jason, the second question. Could you repeat that?

[Jason Boisvert Bazinet:]

Just in terms of your first blush. I think you've been on the job for a few weeks. So is there anything that strikes you as sort of big opportunities or areas of distinction relative to your experience at Pearson?

[John J. Lynch:]

Yeah. My experience in K-12 at Renaissance and Pearson and bigchalk has really been in the software. So my entire career has been really at the intersection of software and content. And I think one of the more surprising things to me in coming to HMH was that we have pretty sophisticated understanding of cloud and of agile development methodologies and continuous development methodologies, and those are key strengths that will be foundational to the company's future.

[Jason Boisvert Bazinet:]

Very good. Thank you.

[Operator:]

Our next question comes from the line of Jeff Silber with BMO. Your line is open.

[Henry Sou Chien:]

Hey, it's Henry Chien calling for Jeff. Welcome. I just wanted a follow-up for Jack. Just curious. I know you have an Investor Day planned and I'm assuming you'll talk more about your strategy. But if there's any kind of hint or just kind of introduction of how you're thinking of approaching from a strategics perspective of, say, adapting Houghton Mifflin to the digital and just sort of trends in the market?

[John J. Lynch:]

Yeah. Henry, for whatever reason it was difficult to hear you. But I think the question was what are your kind of initial perspectives on strategies. Was that essentially the question?

[Henry Sou Chien:]

Yeah. Essentially, yeah. Thank you.

[John J. Lynch:]

Yeah. I hope everyone can appreciate that I've been actually officially in this role for three weeks, so I'm going to really focus on doing a deep dive into the operations of the company including a review of past strategic decisions. And, really, the forum that we've set up in June for the Investor Day in New York City is the first time that I'll be in a position to talk to you about our plans moving forward.

[Henry Sou Chien:]

Got it. Okay. Fair enough. And I guess just in terms of current trends. Any comment you can provide on the performance in billing versus the market, whether you see the market kind of improving this year and as well for the rest of the year, and how much of the growth in billings is Houghton versus the market? Any color you can provide on trends there?

[John J. Lynch:]

Yeah. Do you want to take that?

[Joseph P. Abbott:]

Yeah. Got it. Hi, Henry. Good morning. Thanks for the question. So it is the first quarter. I think as we always want to point out to folks that this is a seasonally small quarter for us as it relates to the full year. I think as you saw in our comments this morning as well as our performance for the first quarter, it's an encouraging start to the year but really too early to call overall market trends at this early stage of the selling season.

[Henry Sou Chien:]

Okay. Fair enough. Thank you.

[Operator:]

Our next question is from Toni Kaplan with Morgan Stanley. Your line is open.

[Jeffrey D. Goldstein:]

Hey, this is actually Jeff Goldstein on for Toni. Can you just provide a little bit more detail on your cost savings initiatives as it relates to the labor force? So just what areas in particular are being impacted and would you expect these cuts to have any impact in your ability to grow in the future and to the level that you hope?

[Joseph P. Abbott:]

Yeah. Good question, Jeff. Thank you very much. A couple of things about that. We have focused really broad-based across the entire company, and the real intent behind what we're doing here is to ensure that we're improving the operational efficiency of the company. So for us, as we talked about in the remarks here, this is mostly about speeding our ability to make decisions, making us more agile overall, and we think at the conclusion of these efforts we will be much more efficient. You asked about the potential impact to our growth potential. That has been, obviously, a very, very important part of our planning effort was to ensure that any actions that we take here do not put our ability to grow at risk. In fact, we actually think it will enhance our ability and grow efficiently over time. So that's been a part of the real effort here.

[Jeffrey D. Goldstein:]

Okay. Got it. And then can you just provide an update on what you're seeing in the California Reading adoption? I know you mentioned increased sales there in the quarter. But was that a result of any changes in strategy that helps you gain share or just increased industry sales in general in California?

[Joseph P. Abbott:]

Yeah. So in California, look, we're encouraged by the early performance this year as we've said but, really, it's too early to draw any conclusions based on what we've seen so far. We have and we talked, I think, at length last year about improvements that we were making overall to our offering that we believe will make us more competitive. But, again, as we look at the fact that we're very early in the selling season, probably too early to call what we think the impact of those decisions will be. And just to recap, it was enhancements in the program, certainly, changed how we marketed our program there and overall operating improvements we think both in terms of the team and the leadership there that we think will make us more competitive.

[Jeffrey D. Goldstein:]

Got it. Thanks.

[Operator:]

Our next question comes from the line of Andre Benjamin with Goldman Sachs. Your line is open.

[Andre Benjamin:]

Thanks. I guess I first wanted to confirm that I heard correctly on the prepared remarks that the most of the cost savings of $70 million to $80 million will be in 2018 versus an elevated cost base in 2017. And then, I guess, on the back of that, will those savings actually be intended to flow through the bottom line or are you planning to reinvest most of that into content development for 2018 and beyond?

[Joseph P. Abbott:]

Hi, Andre. Good question. Thanks. Yeah, you heard correctly. We intend to action most of that $70 million to $80 million in 2017. Those actioned savings, of course, should impact overall in 2018. There'll be some amount of cost savings that we action in 2018, therefore you won't see the full run rate benefit in 2018. But, again, the majority of the actions will be taking place in 2017. I think your question on reinvestment is a great one. So what we've done here, and where we've been very, very focused in terms of the cost actions that we're taking here, is in impacting the fixed cost base. There will be some amount of variable cost as we noted in the remarks and there is some intent to continue to reinvest in the business as we move forward. Whether that's content or technology, we'll continue to do that. But for us, what was very, very important was bringing our cost structure in line as we've talked about on prior calls to give ourselves the opportunity to generate free cash flow on future trough years. And so that's where we've been very focused.

[Andre Benjamin:]

And then I guess as we think through that, how should we think about margins? Actually, I know you'll probably not going to give firm guidance, but just trying to see would it be getting too far ahead of ourselves if we start building in some healthy improvement in 2018 and 2019. I'm just trying to think through the ultimate impact of all of this.

[Joseph P. Abbott:]

Sure. Look, again, we're not changing our qualitative commentary about margins, free cash flow for 2017. The actions we are taking are intended to improve our margin profile as we move forward. We're not providing guidance at this stage or forward-looking guidance. We do, however, intend to talk about that in our Investor Day to give you a better sense for how to think about how that $70 million to $80 million can flow through in concert, of course, with the higher billings opportunities that we're expecting coming up for the next couple of years.

[Andre Benjamin:]

Thank you.

[Operator:]

And our next question comes from the line of Bill Warmington with Wells Fargo. Your line is open.

[Unknown Speaker:]

Hey. Good morning, everyone. This is Jake on for Bill. How are you?

[Joseph P. Abbott:]

Good morning, Jake.

[Unknown Speaker:]

We're just looking for a quick update on the sales progress in LA County Reading.

[Joseph P. Abbott:]

Sales progress in LA. Well I think, Jake, as you know it's not our policy to comment on individual districts or individual performance within the states. I know there's been a fair amount written about LA within California specifically but we're not, in the normal course, planning to update on specific district performance.

[Unknown Speaker:]

Got it. Understood.

[Operator:]

I'm not showing any further questions, so I'll now turn the call back over to Mr. Abbott for closing remarks.

[Joseph P. Abbott:]

Great. Thank you to everyone for joining us on the call this morning. If you need additional information, please reach out to Brian Shipman at HMH. Bridgette, this ends our call today. Thank you.

[Operator:]

Ladies and gentlemen, this does conclude the program. You may now disconnect. Everyone, have a great day.