Houghton Mifflin Harcourt Company
Q2 2017 Earnings Call Transcript

Published: 5 Aug 2017

[Operator:]

Good day, ladies and gentlemen, and welcome to the Houghton Mifflin Harcourt's Second Quarter in 2017 Earnings Conference Call. I would like to inform you that this call is being recorded. [Operator Instructions] I would now like to introduce your host for today's conference, Mr. Brian Shipman, Senior Vice President of Investor Relations for Houghton Mifflin Harcourt. Sir, you may begin.

[Brian Shipman:]

Thank you, Kayleigh, and good morning, everyone. Before we begin, I would like to point out that the slides referred to on today's call 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 August 11. And a webcast will be available on our website for one year. Our 10-Q was also filed earlier this morning, along with our second quarter 2017 earnings 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 for questions from investors. During the Q&A, please limit yourself to one question plus one follow-up. [Operator Instructions] This morning, Jack Lynch, HMH's President and Chief Executive Officer; and Joe Abbott, HMH's Chief Financial Officer, will provide a company update, as well as an overview of the company's second quarter 2017 results. I will now turn the time over to Jack Lynch, President and CEO of Houghton Mifflin Harcourt.

[John Lynch:]

Thank you, Brian, and thanks, everyone for joining us on the call this morning. It was a pleasure to meet many of you at our Investor Day in June. Today we reported results for the company that were in line with our expectations. Before Joe goes through the second quarter and first half details in a few minutes, let me start with a summary of some of our key metrics for our year-to-date results through Q2. Our net sales for the first half of 2017 were up 3% compared to the first half of last year. Our billings for the first half were essentially flat compared to the same period in 2016. Our free cash flow usage rate during the first half was significantly improved compared with the first half of last year. At this halfway point of the year, given our results through Q2, heading into the second half of the year, where historically more than half of our billings are generated, we remain on track to deliver the guidance we issued on our Q4 earnings call in February. At our Investor Day in June, we shared with you some of the tenants of our vision for growth in HMH's Education segment. We are more focused than ever on strengthening our core Basal business, optimizing free cash flow generation through this [cycle] and allocating capital to faster-growing higher-margin extensions, which include intervention, supplemental and professional learning. We are seeing some encouraging results in the extensions, particularly intervention and Heinemann, which contributed strong performance in the first half of the year. Within intervention, our new READ 180 Universal solution, started the first half with strong growth, driven by our approach to integrated solution selling. We saw a continuation of the positive trends in our Heinemann business in the first half of the year, for example, we have experienced ongoing success with our classroom collections offering, which brings contemporary and classic fiction and nonfiction libraries directly to students and teachers. These collections are curated by exceptional team of scholars, Heinemann author Lucy Calkins [audio gap] along with numerous literacy leaders and children's literature experts. As we shared on our fourth quarter call earlier this year, we are expecting our AAP addressable market to be flat to slightly up in 2017 compared to 2016, a trough year in our business cycle. The second quarter and first half 2017 results in our K-12 Education segment were consistent with that outlook. While the new adoption market appears leaner in 2017, relative to a peak year we saw in 2014, we are continuing preparations for major adoption opportunities we anticipate in 2018 and 2019. Investing in our core curriculum solutions to help ensure that we enter those adoptions with highly competitive products, including next-generation programs in all four major subject areas. Adding to our consolidated performance for the first half of 2017, our Trade segment saw 13% growth for the first half of the year, boosted by front list releases, such as the New York Times best-selling memoir Papi by David Ortiz, and the latest edition to the Tolkien anthology Beren and Luthien, as well as strong e-books and backlist titles such as The Handmaid's Tale. In summary, we are pleased with our overall results for the first half of the year and are on track with the outlook we provided at the start of the year. We're committed to our strategy of strengthening the core Basal business, while also building out our extensions. We are confident that this approach will enable us to further strengthen our leadership position in the industry and further establish HMH as the only player in this space that is offering truly integrated solutions. We are passionate about our business and the role our solutions play in improving students' outcomes and we look forward to what the second half of the year will bring. With that, I'll now turn the call over to Joe Abbott, who'll walk you through the financials for the second quarter.

[Joe Abbott:]

Thank you, Jack, and good morning, everyone. It's a pleasure to join you today. As Jack mentioned, we're pleased to report that our Q2 and first half results are consistent with our expectations, and we feel we are entering the second half, in which we have historically generated more than half of our sales, and particularly Q3, which is historically the busiest quarter in our selling season on solid footing. We'll start with a quick recap of the first half results and then turn to the detail for Q2. Billings, which we define as net sales plus the net change in deferred revenue, were essentially flat for the first half of the year, compared to the same period in 2016. By segment, our Trade business billings were up $9 million or 12% in the first half. And our Education segment billings were down $10 million or 2% compared to the first half of 2016. As we discussed in Investors Day in June, we are now categorizing our net sales and billings for the Education segment into Basal and Extensions. Our Basal Billings, which include both domestic and international sales, were down $35 million compared to the first half of 2016. This was largely driven by a decline in domestic Basal math sales across adoption and open territory states. As last year's addressable market contained a number of sizable math opportunities, which have started to taper off as states and districts turn their attention to science and social studies purchases. International Billings, the other primary driver, were down in the first half, compared to last year, primarily due to a large Department of Defense order in the prior year not repeating in 2017. Offsetting the decline in Basal billings, was $25 million of year-over-year growth from extensions in the first half of 2017. The most significant drivers of this strong performance included Heinemann's Classroom Libraries offering, as well as Intervention product sales, led by READ 180 Universal. As we shared at our Investor Day, our extensions compete with faster growing market segments of our addressable market, and we believe they will be a key driver of growth and free cash flow for HMH long term. Importantly, adjusted EBITDA was up $15 million or 43% in the first half of 2017 compared to the prior period, despite the expected increase in sales commission in 2017. And our free cash flow usage in the first half improved by $66 million over the same period last year. We ended the second quarter of 2017 with a strong weighted forecast, which gives us confidence in our guidance for the remainder of 2017. Diving now into our financial performance for the second quarter on a consolidated basis. Net sales for the second quarter were $393 million, a 0.3% increase compared to the same quarter in 2016, mostly due to a $4 million increase in our Trade Publishing segment, partially offset by a $3 million decrease in our Education segment. The decline in our Education segment, which again includes our Basal business and our extension businesses, was driven by a $27 million decline in our Basal business to $187 million from $214 million in 2016. The primary drivers of the decrease in our Basal business were lower net sales of Basal math programs across adoption and open territory states and lower net sales from our international business, primarily due to the strength of the prior year department of Defense sales not repeating in 2017 period. Partially offsetting the decrease in our Basal business for the quarter, were higher net sales of our extension businesses, which primarily consists of Heinemann, Intervention, Supplemental and Assessment products, as well as professional services. Extensions for the quarter increased $25 million to $164 million, up from $139 million in 2016. The primary drivers of the increase in our extensions were higher intervention sales, primarily due to our new READ 180 Universal program, and an increase in our Heinemann business net sales, driven primarily by our Classroom Libraries offering. Within our Trade business, the increase in net sales for the second quarter was due to frontlist releases Papi and the latest addition to the Tolkien anthology Beren and Luthien, stronger e-books, such as Handmaid's Tale and backlist print title sales. Billings were $395 million in the second quarter of 2017, a 4% decrease compared to the second quarter of 2016, primarily due to the same drivers affecting net sales. Our overall cost of sales decreased 1%, or $3 million, to $216 million in the second quarter of 2017 from $219 million in the same period of 2016, primarily due to a $5 million reduction in amortization expenses related to publishing rights and prepublication assets. Our cost of sales excluding publishing rights and prepublication amortization, increased $2 million. Selling and administrative costs in the second quarter were $166 million, down $18 million compared to the second quarter of last year. This decrease was primarily due to a $10 million legal settlement in the prior period for permissions litigation. Additionally, as part of the initiatives related to our 2017 restructuring plan, we saw a reduction in external and internal labor related costs of $11 million and lower travel and entertainment expenses of $3 million, which were partially offset by $7 million of higher incentive compensation expense, primarily due to higher commissions expense resulting from higher sales quota attainment, compared to the same period in 2016. Restructuring charges in the second quarter were $33 million, related to our previously announced 2017 restructuring plan. These charges included severance and termination benefits of $14 million, office space consolidation of $7 million and implementation and impairment charges of $12 million. Overall, the total charges under the plan are expected to be between $41 million to $45 million, of which $32 million to $36 million will be cash charges. Since our last quarterly earnings call, we have substantially completed all of our organizational design changes, which has helped us to streamline the organization and make HMH leaner and more efficient. Our other initiatives are expected to be complete by the end of 2018. For the second quarter, our operating loss was $31 million, compared to a loss of $21 million in the second quarter of 2016. Our net loss was $47 million, $18 million higher than the $28 million net loss we reported in the second quarter of 2016. This was largely due to our charges related to the 2017 restructuring plan and the previously mentioned factors impacting net sales, cost of sales and SG&A expenses as well as an unfavorable change in our income tax expense of $9 million. Adjusted EBITDA for the second quarter of 2017 was $73 million, a decrease of $2 million from $75 million in the same quarter of 2016, primarily due to higher cost of sales excluding publishing rights and prepublication amortization, partially offset by higher net sales. Prepublication or content development costs were $29 million, compared with $32 million for the second quarter of 2016, primarily due to timing. We still expect content development costs to be between $140 million and $150 million in 2017, given the investments we're making in our next-generation curriculum products, which we'll launch this year and next year ahead of large adoption opportunities. Property, Plant and Equipment or PP&E spending was $9 million during the second quarter, compared to $31 million in the second quarter of 2016, bringing total CapEx to $39 million for the quarter. Our outlook for total CapEx remains unchanged as well, as we expect to spend between $190 million and $220 million this year. As of June 30, 2017, HMH had $79 million of cash and cash equivalents in short-term investments, compared to $307 million at the year end of 2016. Net cash used in operating activities for the six months, ending June 30, 2017, was $140 million compared to $169 million in the same period of 2016, largely driven by more profitable operations. As we've mentioned previously, our core business is subject to seasonality and it is typical for us to use cash in the first half of the year and we typically generate cash in the second half of the year. Free cash flow through June 30, 2017, was a usage of $224 million, a $66 million improvement compared to a usage of $290 million for the same period in 2016. We continue to make progress on our operating efficiency program, designed to properly align all resources across the organization to maximize value creation and improve our ability to generate free cash flow at all points along our multiyear business cycle. As a reminder, we expect that the initiatives we've identified for this year and next year will result in approximately $70 million to $80 million in annualized cost savings by the end of 2018. We expect to realize a portion of our cost savings this year and the 2017 guidance we shared at the beginning of the year takes this into account. In terms of our new program development, we're pleased to report that our next-generation science and social studies programs have been submitted to Florida and California, respectively, for those state adoptions in 2018. And we look forward to a large market opportunities on the horizon in these categories. We are continuing to develop our next-generation solutions for reading and math as well, in advance of major adoption opportunities coming up in the next few years. We are confident that HMH is on track to deliver against the 2017 guidance that we shared with you in February. Our assumptions underlying this guidance continue to include our AAP addressable market for 2017 being flat, slightly higher than 2016, and our maintaining a market share comparable to our share in 2016. Further, based on the foregoing, we continue to expect adjusted EBITDA margin and free cash flow to be in line with the qualitative commentary we also shared with you in February. We remain committed to our strategy of investing in our core K-12 Basal offerings to take advantage of large opportunities in 2018 and beyond as we approach the next cyclical peak in the market. With that, Jack and I will now take your questions. Keiley, you may now open the line.

[Operator:]

[Operator Instructions] Our first question comes from the line of Toni Kaplan with Morgan Stanley.

[Jeffrey Goldstein:]

This is actually Jeff Goldstein on for Tony. Can you just talk overall about what you saw in the adoption and the open territory markets in the quarter? And maybe if you outperformed in one versus the other? And then just if you're seeing any differences across geographies as well.

[Joe Abbott:]

Jeff, I'm sorry, I missed the second part of your question, I think the first part of your question was commentary...

[Jeffrey Goldstein:]

Yes. First part of the question was adoption versus open territory. Second part was any differences across geographies that you're seeing.

[Joe Abbott:]

Got it, got it. Well, so far, based on the data that we've seen, the growth in both state adoptions as well as open territories is consistent with what we were expecting for the full year, so effectively on track. It is early and there's only, at this point, less than half of the market that's traded that we expect for the full year but generally we're seeing the market develop as we anticipated for the year. That's really the case geographically as well, so no particular trend that I would point to through the first half, in terms of geography here that differs from what we might expect.

[Jeffrey Goldstein:]

Okay, and then just can you just update on what percentage of your billings are now digital? And maybe remind us how high you think this figure can get? Or just a sense of what inning you think we're in relative to this shift to digital?

[Joe Abbott:]

Sure. Happy to talk about it. Well look, I think we talked a bit about this on the Investor Day. It's a metric that we look at, it's a metric that of course, we track but it's not something that really drives our overall strategy, what drives strategy for us, and what's very important, is that we're delivering the solutions, be it print, be it digital, be it services, those things that are most important to our customers. I think what you're mostly focused on, the way we typically would report that statistic, is in terms of our major Basal programs. And through the first half, we have seen that, that statistic north of 40%, which is pretty consistent with where it was last year. I'll caution you that, that can vary, both through the year as well as year-to-year, depending on what the adoption situation is in any particular year and that's dependent on state, that's dependent on the subject areas that those states are adopting in that particular year. I think your next piece is where we think that goes over time. I think, over time, we're going to continue to see increasing usage of digital by our customers and we know and firmly believe that our customers see a great deal of value in the integrated solution that we're offering today, but at the same time, we still see a fair amount of usage of the print materials as well. So hard to say where that goes in the immediate term but over the longer term, we would expect that the digital component would start to tick up over time.

[Operator:]

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

[Jeff Silber:]

I know you had a plan to expand some of your coverage in the extensions area. Can you just remind us on a margin basis, if there's any difference our major difference between your Basal projects -- products and your extension products?

[Joe Abbott:]

Yes. So when we looked at the various categories, and I'll describe these in kind of broader categories of

[Jeff Silber:]

Is it possible maybe to give us an order of magnitude what you mean by higher margin?

[Joe Abbott:]

No. Not at this point, we're not breaking out the differences at this stage.

[Jeff Silber:]

And then just one other follow-up. In looking at the state adoption schedule you provided in your presentation and comparing it to one you had a few months back, I noticed there were some that came on in 2017 and some that came off, is it -- for the ones that came off and it may be small, but is it something that the company decided not to pursue? Were there delays from the states? Any color would be great.

[Joe Abbott:]

Yes. Sure, so it's not uncommon as we kind of get closer to the actual selling opportunity, we'll find that districts and even states themselves have decided to push off or accelerate, for example. So what you're seeing -- and those are all happening in sort of the small areas, like Mississippi was one, for example, where reading language arts kind of moved up a year, and there were a couple that kind of moved around in the latter part of the schedule there as well. All them were smaller opportunities and nothing from a funding perspective, much more around standards readiness and consistent with what we see, typically when states are making decisions or adoption decisions right now, it's typically not a funding decision, it's more around standards and readiness for the adoption.

[Operator:]

Our next question comes from the line of Jason Bazinet with Citi. Your line is open.

[Jason Bazinet:]

Just a question for Mr. Abbott. I guess as we've all gotten trained to focus on billings more than sales, we've all gotten used to sort of the quarterly undulations where the deferred revenue balance typically shrinks in the first and fourth quarter but we see a -- usually a positive in 2Q and 3Q. And just looking at the 2Q deferred revenue balance, it seems like over the last 4 years it's gotten smaller and smaller, meaning it's a $114 million in 2014, $76 million in '15, $21 million in '16 and now $2 million in the quarter you just reported. Is that just noise? Is it -- or is there some narrative underneath that, that you would like to talk...

[Joe Abbott:]

Well. Yes, there is probably the broader narrative here is just what's going on in the Basal market and I think as you know, there's been when you look at the new adoption portion of that market clearly 2014 is a peak, there was a high degree of Basal new adoptions. Basal typically carries higher rate of deferral as part of those sales than the extensions do, that's a general statement but generally the case. So as you see that Basal market come down, and particularly the new adoption portion in the Basal market come down over the last couple of years, that's really what you're seeing is that you're getting less new deferrals in every upcoming year, that has its quarterly effect as well. And then clearly as we see the recognition of some of those deferrals that nets against the lower deferrals we're adding to the balance sheet.

[Jason Bazinet:]

So I get that dynamic in terms of the peak year '14 sort of coming down. Am I wrong that I sort of thought there would be sort of an offset as the world became more digital that there would be a bit of an offset in terms of this deferred revenue balance? Is that the wrong way to think about it? Or is the deferred -- is the digital -- is the piece of a digital adoption moderated maybe?

[Joe Abbott:]

No. Actually it hasn't, and I think maybe going back to the first question that we talked about, it's been a pretty consistent proportion of the sales, which is the digital aspect of those bigger Basal programs over time. It literally is just the mix of the revenues within the Education segment that really is driving what you are seeing there.

[Operator:]

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

[Bill Warmington:]

The first question for you on the intervention market. If you could luck talk a little bit more about, specifically what's driving the strength there and the sustainability of that strength?

[John Lynch:]

Yes. I'll take that one. Thank you, Bill. Basically, what you're seeing driving the growth in the first half of intervention is the release of the new product READ 180 Universal in the second half of last year. In addition, what you're seeing is a -- what we talked about at Investor Day, a solution selling approach. So integrating services with the software. Basically, when we go to a school district, we kind of baseline the performance of the school district and then we talked about how we actually improve the student outcomes of that district and that's part of the solution selling technique, if you will. The last thing I would say is, this is the natural benefit of the merger of the ISG -- what we call ISG, the EdTech division formerly at Scholastic -- that we acquired a couple of years ago and leveraging the market reach that we have, with -- within HMH. So I think it's all those reasons kind of coming together.

[Bill Warmington:]

And then the second question for you is on the shift to digital, what's the tipping point you need to reach as a percentage of billing or some other metric that to actually start to result in cost saving some infrastructure and margin improvement?

[Joe Abbott:]

Bill, in terms of a tipping point, I think it's going to have to be substantially higher, it's going to be north of 50% before we really start really seeing step changes, in terms of the overall change in the cost structure as a result. So literally thinking about how can we start to change our support for distribution, transportation, fulfillment, those sorts of things. And that's going to take, I think a pretty substantial shift, in terms of just the mix that we're selling before you see some massive changes. But we continue over time to become more efficient in the way we do that, we're continuing to look at new models and ways that we can do that more effectively. So we expect over time to see more efficiency overall. And it's really the step change I think that you're asking about would require a higher percentage of sales of digital overall before that starts to make a major impact.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from the line of Peter Appert with Piper Jaffray. Your line is open.

[Peter Appert:]

Apologies if I missed this early on but can you talk a little bit about addressing the open territories in terms of funding environment and pace of sales growth?

[Joe Abbott:]

So in terms of the open territories right now, I think we have said at the outset of the year that we were expecting flat to slight improvements in that portion of the market. We are still expecting that, that would be the case as we look out there today, at some of the AAP data -- and again, that's not our addressable market that's out there, but some of the AAP data shows that the open territories are bit smaller than they were last year through this point in the year. But I will also say that open territory does tend to buy a bit later as a general trend, as a part of the year. So it's really too early for us to make a call overall. What we're seeing out there today is that there continues to be strong appetite strength in the open territories generally speaking. Those states that have dependence upon energy for their tax revenues, there's some pressure on those areas but property values continue to support education budgets in many of the states, the rest of the country in the open territories. And we're overall feeling pretty good about our -- the guidance we provided to you around the market size, provided the early part of this year.

[Peter Appert:]

And then on the new science and social studies programs, are they in the market yet? Are you selling them, for example, in the open territories? And if so, can you talk a little bit about early acceptance rates?

[Joe Abbott:]

So we are -- yes, so they are out in the marketplace today, and encouraged by some of the early feedback, but it is very-very early in terms of that new product. And a lot of what we're seeing in terms of customer buying out there in both the science and social studies categories, that there's a lot of kind of new evaluation that are -- that's starting to occur just now in those subject areas. So we're expecting to see more of a ramp as we kind of get into the back half of this year and then into the next year on those products. But generally speaking, good feedback on what we're seeing out there today. And then we've also -- as we mentioned in the remarks, Peter, we've submitted those products into the California and Florida for the adoptions that are coming up.

[Peter Appert:]

Okay, and then, Joe, relative to your comment earlier about relatively profitably of Basal versus extensions. Is the differential in terms of the better margins in extensions sufficient that it could actually move the needle in terms of overall company margin performance, say in 18', '19?

[Joe Abbott:]

Yes. Our expectation is that these are businesses that through the cycle -- and if we think about the cycle that we showed you on the Investor Day and think about the next one, we'd expect that at all points along with the cycle, as we continue to grow those extensions and if those extensions become a bigger percentage of the mix, that we're going to see a benefit and uplift in terms of our margin and our free cash flow profile. That's absolutely part of the thesis behind what we're doing there.

[Operator:]

And I'm showing no further questions at this time, I'd like to turn the call back to Mr. Abbott for closing remarks.

[Joe Abbott:]

Okay, thank you, Kayleigh, and thank you, everyone for joining us this morning for our second quarter of 2017 earnings call. We look forward to speaking to you again in early November for our third quarter earnings call. Have a great day.

[Operator:]

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