Houghton Mifflin Harcourt Company
Q4 2017 Earnings Call Transcript
Published:
- Operator:
- At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder this conference call is being recorded. I would now like to turn the conference over to your host Mr. Brian Shipman, Senior Vice President and Head of Investor Relations. Sir, you may begin.
- Brian Shipman:
- Thank you, Bridget, 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 March 8, 2018, and a webcast will be available on our website for one year. Our 10-K was also filed earlier this morning, along with our fourth quarter and full-year 2017 earnings release. Before we discuss our results, I encourage you to review the cautionary statement on Slide 2, which explains the risks, 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, 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 fourth quarter and full-year 2017 results. I will now turn the time over to Jack Lynch, President and CEO of Houghton Mifflin Harcourt. Jack?
- John Lynch:
- Thank you, Brian, and good morning everyone. I'd like to share a few of our achievements in 2017, before turning our attention to HMH's 2018 to 2020 strategy. Then I'll turn it over to Joe who will offer more insight to the fourth quarter and full-year results and our outlook for 2018. HMH delivered on its guidance for the full-year of 2017 with 1.4 billion of net sales, an increase of 3% compared to 2016. We also recorded a 1.4 billion of billings for the year, a decline of 1% despite a 6% decline in the addressable AAP market. HMH ended 2017 with fourth quarter billings growth of 9% compared to the same period in 2016. These achievements give us confidence that while the industry continues to evolve we are positioned for success in 2018 and beyond. At Investor day in June of last year, we gave an overview our new direction. Since that time, we've completed a comprehensive strategic review the results of which we will discuss in greater detail today. Our 2018 to 2020 is now in place and we have a new management team with proven experience in education software, general management, information technology, talent management and following our restructuring in 2017 we strengthen our talent bench more broadly making us a liner more efficient organization focused on execution. Looking ahead in 2018, we will continue to laid a foundation for transformation and prepare for the upturn in the adoption cycle. We'll also continue our development of innovative next generation solutions in reading and math for purchase in 2019, remembering that reading and math represent 80% of the addressable base of market. At the same time, we are moving to a lean, agile our continuous delivery model for software development, shifting IT infrastructure to the cloud and streamlining our back office. Now turning to the financial highlights from 2017. For Education segment performance was in line with the market. Our core solutions billings were down 6% year-over-year with a strong finish in Q4. Our new science and social studies programs are now in the marketplace, and with the completion of our new reading and math programs this year, we will have next generation solutions in each of our four major disciplines in time for the upturn in the business cycle in 2019. Also in the education segment billings for our extensions business grew 1% year-over-year, with growth driven by supplemental and Heinemann. The extensions continue to be a focus for investment and expansion where we believe we can leverage our core solutions, market position and distribution channel. We're very pleased with the above market performance of our trade segment, which delivered billings growth of 11% year-over-year. Strong performances from Whole30 series and Tim Ferriss' Tribe of Mentors and Tools of Titans, stronger eBook sales such as the Handmaid's Tale and 1984, and backlist print title sales such as The Polar Express and The Giver all contributed trade growth. Our trade business is a media platform innovator leveraging social media to build author franchises, TV and motion picture tie-ins to drive backlist sales as well as cross platform, audio and eBook titles to address the variety of ways people consume great content today. Now I'd like to provide you with more detail on our 2018 to 2020 strategy which defines our long term focus under three key pillars and provides a roadmap for transformation over the next three years. Let me begin with the industry context within which we conceived our strategy. As you know, the U.S. education market features a Basal adoption calendar that drives market size fluctuations year-to-year. But we believe that the future of HMH is about far more than an improving adoption calendar into 2019, while roughly half of the Basal market remains adoption centered, the extensions market is ever greening and is embracing the SaaS recurring revenue model, even the Basal market is showing nascent signs of transition to multiyear purchase agreements as a precursor to subscriptions. In addition, we believe there's a mix shift underway in our own portfolio, one in which extensions will make up an increasingly larger portion of our revenues over time. We believe that combined these factors will continue to lessen the impact of the adoption purchasing cyclicality in our business while increasing recurring revenue. The industry is also undergoing a decade long transition from print to digital, but progress has been slow due to immature technology infrastructure in schools and the cost and complexity of product development. What we've seen is that the initial phases of this transition were overhyped, many venture funded startups did not achieve critical mass, incumbents added costs without incremental revenue, and there were questionable returns on M&A. Importantly and this is the key point, we believe the transition to digital is much more than an immediate shift from print to digital. Software needs to address the teachers work flow, data and learning analytics need to measure and predicts during achievements, recommendation engines need to help teachers locate resources and strategies that are proven to be effective and improving through outcomes. We are now at a point in the shift to digital, where the industry has began to embrace the economic benefits of software with greater acceptance of subscriptions by schools and districts. We believe that's important for a number of reasons. The first being that SaaS solutions have higher fixed cost and much lower marginal cost, impacting the drop through to the bottom line of incremental subscription revenue growth. Second, subscription recurring revenue provides greater visibility into forward-looking performance and reduces operating risk. Third, continues delivery to the cloud gives teachers immediate feedback on the efficacy of the solutions they are using to improve during outcomes. Finally, continues delivery also provides an ongoing feedback group into our product development cycle, hence placing less emphasis on capital intensive, big bank projects and more emphasis on continuous iteration with customers to promote with sponsor design and development. So given this industry context, our strategy centers on transforming the Company from a K-12 publisher principally focus on creating great content to a learning company that holistically orchestrates great content insight from assessments and services to drive improved student outcomes. We are confident that this shift will position us for continued market leadership and long-term value creation. Our strategy has three pillars. Number one, enhanced and extend the core, strengthening our core solutions business through highly differentiated solutions that link assessment data to instruction so that teachers can target their instruction by skills or standards to meet the needs of each student regardless their academic ability. At the same time, we will invest in faster growing higher margin extensions of that business. Extension such as intervention solutions that address the students with the greatest needs and services that help teachers and school leaders build their capacity to improve student outcomes. Number two, deliver integrated solutions. We believe that the strength of our core solutions business and growth into extensions uniquely positions HMH to be the only player in the industry that can offer a fully integrated solution to our customers. We're leveraging the breadth of our portfolio and the larger sales force in the industry by integrated our offerings in basal, interventions, supplemental and services, so they work in constant with one another to improve outcomes while increasing revenue. And number three, focus on operational excellence. This will continue to be a core tenant of our strategy as we progress towards linear and more efficient operations and in still like philosophy of continues improvement throughout the organization. In combined, we believe these three pillars will enable us to generate attractive free cash flow through this cycle over the long-term. So let me go into each pillar in more detail and enhance and extend the core. A moment ago, I said highly differentiated core solutions. What does this mean? We are connecting assessment data to K-12 content to create far greater value in our core solution offerings for teachers, and the students they serve. This means an effect that we are building an efficacy engine at the heart of the common technology platform we call Ed. Today within our intervention products we used data and feedback loops to inform product design decisions concerning content and the instructional design which impact efficacy and student results. When we built READ 180 Universal for example, we ran meta-analysis on previous versions of the product to learn how we achieve the best student results based on both learning science and empirical data. We queried topics such as how long does it take students to master particular topics? How long the students take to meet proficiency scores before they exit the program? Which skills do students struggle with most and who in particular? In the future, we plan to leverage analytics like these across the HMH portfolio, our learning scientist and efficacy researchers will use this approach to improve all of our programs and solutions dynamically through continuous delivery in feedback loops, again creating efficacy engine within our Ed platform. What will that mean to educators and their students? Imagine a teacher receiving a recommendation from Ed. For student having difficulty mastering a math skill, our platform will mine click stream data representing 1,000s of student records to reveal similar learner profiles. It will determine what strategies were most effective in practicing and mastering that skill for what teachers can do to mark and intervene. We believe these analytics will help HMH understand more about the efficacy of learning designs, personalizing and customizing content in the factors for driving successful student results across all content areas at scale. In addition to improving instructional outcomes, the use of efficacy data will improve our core probably design and focus our investments to develop the products and features that provide the best return on investment and return on instructional time. While districts are purchasing core solutions on a multiyear adoption cycle, this new model provides us with a SaaS like feedback loop to improve products iteratively, isolating and investing in the most impactful aspects of that product. This improves our capital allocation, and customer engagement. Number two, we expect that continuous delivery in learning analytics would be a key differentiator for our core Basal solutions moving forward. We also plan to leverage this capability to create in-classroom intervention solutions, which represents an expansion opportunity for intervention product line to meet market demand. Number three, in addition we plan to build partner and/or acquire higher margin faster growing solutions that supplement our core solutions business, solving specific targeting challenges for schools and districts and leveraging our market position and customer relationships. Next our number two pillar, integrated solutions. Number four, our focus on delivering integrated solutions will initially be through go-to-market pilots that we're running in 2018. This will enable us to determine the most effective means through which we can leverage our market position to increase cross selling and up selling opportunities while creating integrated solutions that enable educators to improve student outcomes. Number five, also as a part of integrated solutions, we plan to launch blended service offerings, a blend of face to face and virtual professional learning experiences, designed to offer schools and teachers greater flexibility and increased touch points throughout the school year to drive success, while improving services margins. And the third pillar operational excellence, achieving operational excellence including number of initiatives focused on improving quality, operational effectiveness and efficiency and reducing unnecessary costs. Activities under our 2017 restructuring program, focused on organization and staffing model optimization and office space consolidation to improve our operational efficiency. With substantially all of the organizational design and staffing model activity is completed, the operational excellence initiatives we planned to focus on within our 2018 to 2020 strategy will consist of continuous improvement and reengineering efforts in our supply chain, order management, fulfillment, customer service and the product development lifecycle. We will use Lean Six Sigma, Robotic Process Automation and Agile Software Development principles and practices. In addition, under these initiatives, we plan to move our data centers to cloud service providers, such as AWS and Azure. Initiative number six in operational excellence is designed to migrate customers in content from our legacy platforms to one common platform Ed. Number seven is focus on gaining greater insight into our product level profitability. Number eight is designed to enhance the customer experience by implementing best-in-class user journeys to help ensure our customers have effective end-to-end experiences of HMH, weather with our staff in the field or on the phone, online at our website or when using anyone of our solutions. Number nine is focus on our reengineering and continuous improvement initiatives. Number ten finally we need to build capabilities skills and effective teams to ensure sustainable results, and deliver our business goals. In affect create a winning culture for employees. As we continue to achieve success, we are confident that this long-term strategy will enable us to generate attractive free cash flow through different market cycles allow us to invest in developing highly competitive best-in-class education solutions for customers and drive value for our shareholders. Importantly, we work in a double bottom line industry, which means that if we achieve the results we want to achieve, we will have more impact on educators and students they serve, that’s our double bottom line to marriage mutually reinforcing goals that result in high performance and high purpose results. Now, I'll turn it over to Joe who will provide a deeper dive into our 2017 financials and our guidance for the year ahead. Joe?
- Joe Abbott:
- Thank you, Jack, and good morning everyone. This morning I will provide an overview of our fourth quarter and full year 2017 financial results, followed by our outlook for 2018, afterwards we will take your questions. As Jack said, we delivered on our guidance with $1.392 billion of billings. Net sales were $1.408 million which was slightly above the top end of our range. Content development spent for 2017 was $139 million, slightly below the bottom end of our range as we benefited from efficiency savings and our content development processes. And total CapEx of $197 million was inside of our guidance range for the year. We achieved these results in a difficult market environment, while undertaking our 2017 restructuring plan and working diligently to deliver our next generation programs on time for the major stated option opportunities ahead of us. At Investor Day in June 2017, we told you we would update you at this time on how we're performing against our long-term billings growth framework and make some billings. As a recap, we expect the long-term average growth of our core solutions business to be in the low single-digits, but we expect annual growth will be in line with our addressable market. In 2017, our core solutions business billings declined 6% and contributed 45% of our consolidated billings mix, primarily driven by a decline in our addressable market. We expect our extensions businesses which consist of Heinemann, intervention, supplemental and assessment products as well as professional services to grow in the low to mid single-digits on average over the long term. In 2017, extensions business billings grew 1% and contributed 42% of our consolidated billings mix, driven by growth in the supplemental product line and at Heinemann, partially offset by implementation challenges we encountered in our intervention product line. We expect our trade business to deliver long term average growth in the low single-digits, and in 2017, trade billings grew 11%, a strong performance and increased this contribution to 13% of our consolidated billings mix in 2017. We also told you at Investor Day that we would update you at this time on our progress in rightsizing our cost structure. This year we successfully reduced our fixed cost from $673 million in 2016 to $657 million in 2017. We realized $46 million in fixed cost savings from actions taken as part of our 2017 restructuring program, that were substantially complete during the second quarter. We also realized savings on our variable and capitalized costs stemming from reorganizations of our engineering, IT and service delivery functions, which are additional to the $46 million of fixed cost savings. We expect to realize the full year run rate impact of all of our 2017 actions in 2018, and we'll undertake the remaining facilities consolidation actions under our restructuring program this year which will add to the realized cost savings total in 2018. Accordingly, we remain on track to deliver a total of $70 million to $80 million of run rate cost savings from our 2017 restructuring plan as we exit this year, partially offsetting fixed cost savings in 2017 were $10 million in merit based salary increases and $19 million of higher commissions and annual incentive compensation. As a reminder we quantified approximately $30 million of additional incentive based compensation as part of our normalized 2016 cost base which was not accrued in that year due to the Company's underperformance relative to targets. The $19 million of higher commissions and annual incentive compensation represents the portion of that run rate cost attributable to higher achievement of our performance targets in 2017. Adjusted fixed costs excluding non-cash and non-recurring items as a percentage of billings were 47% in 2017. Adjusted variable costs as a percentage of billings again excluding non-cash and non-recurring items were 38%, about 1% higher than in 2016. The higher adjusted variable costs relate to a change in billings mix in 2017 where we saw higher sales of book rooms in our Heinemann and supplemental businesses and an increase in royalties due to strong growth and trade. Moving on to our full-year 2017 results, net sales for 2017 were $1.408 billion a 3% increase compared to net sales of $1.373 billion in 2016 primarily due to net sales increases in our trade publishing and educate segments. Trade net sales increased 11% due to back lift in that sales growth and higher sub-rise income. Education net sales growth of 1% was driven by our extension businesses which grew 4% partially offset by our core solutions business net sales decline of 1%. Our billings which we defined as a net sales plus the change in differed revenue has decreased 1% to 1.392 billion in 2017 compared to 1.41 billion in 2016. This year we had a reduction in differed revenue as a result of lower billings as well as an increase in the proportion of products we sold that carried lower deferral rates. The billings decreased was driven by our education segment which decline by 36 million or 3% partially offset by an 18 million or 11% growth in today's publishing segment during 2017. Within our education segment, the decrease was primarily due to lower core solutions billings inclusive of international billings which decline by $40 million from $660 million in 2016 to 620 million in 2017. The primary drivers of the decrease in our core solutions business were lower reading in math billings and open territory states, lower math sales and adoption states and lower billings from our international business primarily due to a large department of defense order in 2016 not repeating in 2017. Partially offsetting the decrease in core solutions billings was a $4 million increase in our extension businesses primarily driven by higher Heinemann and supplemental billings. Growth in trade billings was back lift trials and higher sub rise income. Overall cost of sales decreased from $790 million in 2017 from $802 million in 2016 primarily due to a reduction in amortization expense related to publishing rights and prepublication assets. Cost of sales excluding publisher rights and prepublication amortization increased to 1% due to higher sales volume partially offset by improved profitability. Selling and administrative cost decreased 6% from $700 million in 2016 to $655 million in 2017 attributable to actions taken under the 2017 restructuring plan. The decrease in selling and administrative cost was partially offset by higher commission expense and anyone incentive compensation due to greater achievement of targeted sales levels year-over-year and a higher office leased cost due to the exploration of favorable office leases in 2016. Prepublication or content development costs increased 12% in 2017 from $124 million in 2016 to $139 million in 2017, as we increased our investment in next generation programs ahead of expected large market opportunities in 2019 to 2020. Operating loss for the full-year was $114 million a 197 million improvement from new 311 million operating loss recorded in 2016, primarily due to lower impairment charges and selling and administrative costs partially offset by our 2017 restructuring charge. For the full-year 2017 our net loss was $103 million which improved 64% from the $285 million loss reported in 2016. This improvement was driven by the same factors impacting operating loss slightly offset by an income tax benefit versus the prior-year. Adjusted EBITDA for 2017 was $219 million, an increase of 19% from $183 million in 2016, primarily due to higher net sales and lower selling and administrative costs. As of December 31, 2017, we had $235 million of cash and cash equivalents and short-term investments, compared $307 million at year-end 2016. Our cash from operating activity for 2017 was a $135 million compared to $144 million during 2016. The resulting free cash flow which we defined as cash from operations less capital expenditure was a usage of $62 million compared to a usage of $86 million for the same period in 2016. The primary drivers of our improved free cash flow were reduced PP&A capital expenditures and increased profit from operations, partially offset by lower billings. Now moving to the results for the fourth quarter of 2017. Net sales were $251 million an 8% increase compared to net sales of $242 million during the fourth quarter of 2016, driven primarily by net sales increases on our education and trading publishing segments. Billings for the fourth-quarter of 2017 were $229 million up 9% compared to billings from $210 million for the same period in 2016, also driven by billings increases in our education and trade segments. The primary driver of education segment growth was growth in core solutions due to increased residual demand and adoption state and growth in English language art from the open territories, partially offset by a decline in expansions. Finally, trade net sales and billing remained strong in the fourth quarter primarily driven by titles such as the Whole30 series, Tim Ferriss' Tribe of Mentors and Instant Pot Miracle. Overall cost of sales decreased 3% to $171 million in the fourth quarter of 2017 from $177 million in the same period of 2016, while cost of sales excluding publishing rights and prepublication amortization decreased 1% from 126 million in 2016 to $225 million in 2017. Selling and administrative costs decreased 4% to 154 million in the fourth quarter in 2017 from $161 million in the same period in 2016, primarily due to lower professional fees reduction in internal an outside labor related costs and lower discretionary cost attributable to actions taken under the 2017 restructuring plan. Operating loss for the fourth quarter of 2017 was $76 million a 70% improvement from the $251 million operating loss recorded in the same period of 2016. The improvement can be primarily attributed to our reduction in impairment charge for prepublication cost and intangible assets. For the fourth quarter of 2017 net loss was $26 million an 86% improvement compared to the net loss of $181 million in the second quarter of 2016. This improvement was primarily due to the same factors affecting operating loss offset by an unfavorable change in our tax position. Next I would like to share some context on our current view of AAP addressable markets. As we entered last year we had expected flat to slight market growth in 2017 resulting in a market size of approximately $2.7 billion. Instead the addressable market declined over 6% to approximately $2.5 billion. We believe a major driver of the market decline was lower than usual demand for reading and math purchases in open territory states in which Common Core was first adopted in 2013. We believe many open territory districts plan to continue to forego replacing products this year and instead wait until the next generation of reading, and math products are launched by HMH and other players in the industry. While we expect some modest growth in the adoption state segment of the market, overall we now anticipate a flat to slightly higher addressable market for 2018 of approximately $2.5 billion. We still expect a strong 2019 in the overall AAP market with Texas reading and Florida math driving strength in the adoption market, by shifting adoption schedules in other states combined with a smaller open territory opportunity caused us to adjust our outlook accordingly for 2019 and 2020. Our market share declined slightly to 38% in 2017. While we are disappointed with that result we believe that our strategy will allow us to regain share in the attractive market opportunities ahead. We're participating in the Florida science adoption this year which is now underway but as we disclosed in November we are not listed in the California social for this adoption. For 2018 recognizing the impact of California social studies we expect our market share to be equal to or greater than the 38% we achieved in 2017. Looking ahead to the next few years, this year we'll submit our next generation programs to Texas for its K through 8 English Language Arts adoption, Florida for its K through 12 math adoption and California for its K through 8 science adoption all with billings opportunities beginning in 2019. We'll also continue building the national program for next generation reading, literature and math this year, subjects which are foundation and have historically represented about 80% of the addressable open territory market. In 2020, Texas will begin buying literature, the Florida English Language Arts opportunity begins and California science continues in its second year. With this market backdrop we now turn to our expected financial performance for 2018. We expect billings in a range of $1.365 billion to $1.445 billion, net sales in a range of $1.350 billion to $1.430 billion. Content development spent in the range of $125 million to $150 million. Total capital expenditure inclusive of content development spent in the range of $185 million to $210 million. I'd also like to provide you with some additional insight through our guidance for 2018. As I mentioned previously we expect the addressable market in 2018 to be comparable to last year and we expect our market share to be equal to or greater than the 38% we achieved in 2017. We expect our adjusted fixed and variable costs to be comparable to 2017 as a percentage of billings at the midpoint of our billings guidance range. And finally we expect free cash flow for 2018 to be negative at the midpoint of the billings guidance range, but improved from 2017 levels. Then before we take your questions I wanted to touch briefly on the recently passed tax reform act. As you now we've large tax assets including net operating loss carry forwards and carry over interest reductions that allow us to reduce our federal taxable income in future periods. After careful review of the final bill enacted into law, we believe these assets will continue to allow us to offset future taxable income and we do not anticipate being a federal cash tax payer for the next several years. As we near completion of the planned actions under our 2017 restructuring plan, we are now shifting our focus to driving operational excellence through a continuous improvement and reengineering efforts on the areas as Jack outlined earlier. We fully expect the changes we made this past year and our continued focus on strategic investments in our core and extension businesses integrated solutions for our customers and improvements to our operational efficiency position us well for 2018 and beyond. We would now be pleased to take any questions you may have. Operator, you may now open the line.
- Operator:
- [Operation Instructions] Our first question comes from the line of Jason Bazinet with Citi.
- Jason Bazinet:
- I just had a question more about your 2018 outlook, if I look at that slide I'm trying to referring Slide 21. I just look at the actual 2013 to 2017 and I know there is some cyclicality in there, but if you look at those numbers and it feels like there is something structural that's going on that. I think if any given investor sort of pause about those comfort level with your outlook your '18, '19 and '20 projections so. Can you just talk about that a bit I mean is there something structural going on in this industry that sort of transcend and amplify some of the other issues that you've highlighted?
- John Lynch:
- Jason, no we don’t believe there was anything structural that's going on in the industry, we did extensive research in open territory in the third quarter. And one of the things that we found with the decline is that school districts are not ready to replace we have the coming core which was an extraordinary debt 2013 and school districts replace the reading in math programs at that point in time we're now at the beginning of the replacement cycle that's typically 5 to 7 years. The thing that's missing is from the market leader, a new reading a math program which we're working towards a solving this year with the adoption in Texas and for reading and a math for Florida and they'll be ready for sale in 2019. So we don’t see anything structural and in fact we think that market is robust and very attractive. We are the market leader in the intercepting the market that will grow from 2.5 billion to 3.2 billion to 3.1 billion over the next few years where as we said investing in extensions. And while we have one third approximately one third at the core solutions business, we have about 11% of the $6 billion extensions market and on top of that the underlying student enrollment continues to grow at about 1% per annum. So in short, we couldn’t be more optimistic about the attractive to the market and how well were positioned to grow in it.
- Jason Bazinet:
- Let me just take the open territory where there shouldn’t be that much cyclicality if I look at that '13 to '20 forecast, which is eight years even at a 2% inflation rate with the 1% student growth, you know it's 3% growth over eight years. It seems like you should see 20% to 25% growth over that time horizon, and yet, we're still at 1.4 billion. So what's the missing piece? What's the deflationary sort of offset?
- John Lynch:
- Yes, it's really a get back to the replacement cycle for the core reading and math in structural materials. We haven't had a situation like the common core where 46 states all of sudden had new state standards and that happened in 2013. So, we are in year five right now at that replacement cycle and that's what is different about this particular cycle.
- Operator:
- Our next question comes from the line of Peter Appert with Piper Jaffray. Your line is open.
- Peter Appert:
- So Jack, the program you outlined for integrated solutions cloud offering et cetera and it's pretty exciting. It also sounds potentially pretty expensive. I'm wondering, if some the structural changes you were talking about translate into fair development costs on an ongoing basis and what the economic implications that might be?
- John Lynch:
- We have been investing considerable amount in our technology and software development for some time. And as you know for upcoming reading and math programs, one of the big differentiators you'll see in this next generation programs is digital program it's not merely a digital version of the print product it will actually incorporate a pretty sophisticated integration and assessment as well as professional development micro lessons if you will online. So that’s kind of in our cost structure right now and we will continue to go ahead and invest in technology reusing and leveraging a lot of the investments we have already made and building on top of those investments. So a big part of our strategy in to migrate to one platform and invest to one platform we use innovations and we think from a cost perspective from an investor perspective, we are well served at a steady state level.
- Peter Appert:
- Maybe follow-up for Joe, you highlighted one of the chart fixed and variable cost comparable in 18% to 17% of billings that would suggest that you are not really seeing flow through from some of these savings initiatives. Why are we seeing some more operating leverage from this?
- Joe Abbott:
- Peter, yes, I think you are seeing the flow through, one of the aspects in our cost structure this year that was the mix of billings that, that we had we did have a higher variable cost percentage as a percentage of billing this year than we did last. But that is everything to do with the mix of billings in this particular year. We move into the future with more core adoption opportunities, those have a tendency to carry a lower variable cost element to them. And we expect to see that benefit as we move forward, but you are saying at least on the fixed cost side certainly the flow-through effect of the actions that we've taken so far.
- Peter Appert:
- So, the implication of Joe that we are not seeing it in '18, but perhaps we are seeing in '19?
- Joe Abbott:
- You will continue to see the continued improvements overall in our free cash flow and the yield on the billings that we generate not only because of the cost reduction that we've undertaken, but also just due to the operating leverage we have in the business for generating higher and higher levels of billings moving into these higher adoption opportunities in '19 and '20.
- Operator:
- Thank you. [Operator Instructions] And our next question comes from the line of Bill Warmington with Wells Fargo. Your line is open.
- Jake Williams:
- This is Jake on for Bill. We were just wondering, what's giving you the contents for maintaining your market share in 2018? Is it aided by your visibility of the 2018 adoption markets?
- John Lynch:
- Yes, I think the confidence really centers on the fact that we have a really good core solutions business getting better, as we move into the upturn cycle. We have a really solid extensions business and that will take up a larger percentage of our overall revenue mix. In open territory we have next generation science as well as next generation social studies, we're going to continue to have very strong growth from Heinemann as well as supplemental. We've course corrected number of the issues that Joe spoke about related to READ 180, those conversion issues. And so taken together these three factors really give us confidence that AAP market share will be flat to slightly up, in over 2017, and will be in 2018.
- Operator:
- Thank you. And our next question is from Jeff Silber with BMO. Your line is open.
- Jeff Silber:
- I appreciate the color on your strategy going forward and also the update that you've provided us in some of the targets on an annual basis. I am just curious, are there any other metrics that you'll need to provide or we should be monitoring to see your progress going forward? For example, you talk about shifting more of your billings towards the subscription model. I am just wondering if you can be providing us some milestones and how that's going?
- John Lynch:
- Yes, it's a great question. Not at this time, this is in the core solutions, this is still a relatively nascent trend and in extensions it's far more significant in the industry but still relatively new for HMH. So, we don't contemplate or providing any additional insight to that kind of mix shift from one time revenues to recurring revenues.
- Jeff Silber:
- Getting back to tax reform, I appreciate your guidance and the impact on your business, but I am just curious. At a higher level, I've been reading a lot of the trade rags some of the pressure that's on state budgets because of federal tax reform and maybe some potential cut backs from their perspective, I know it's still early but I am wondering if you're seeing or hearing any of that from your customers?
- John Lynch:
- Jeff, we're really not, yet hearing that from our customers and partially I think that is a function of where education fits in terms of priority, for our customers out there, even if it's in some of the higher state tax customers, located in those states. So thus far we haven't heard any real pressure that relates to the tax reform, at least as it relates to the -- on the demand side there.
- Jeff Silber:
- And then just one final question, just a little bit more granularity on your outlook specifically looking at free cash flow, you talk about expecting free cash flow to be negative, but improved at the midpoint of the billings guidance. If you come in at the low end your billing guidance, does that imply your negative free cash flow will be worst in 2018 than it would in 2017?
- John Lynch:
- Well, we have given you several of the building blocks as we kind of worked on the P&L and what we expect in terms of ranges of the capital expenditures et cetera. To the extent that we've found ourselves at the lower end of the billings guidance range, we would take steps to mitigate what we needed to do in order to continue to show improvement. And that's effective to what we have been aiming for as part of our restructuring efforts it's the key kind of our strategy here is to continually improve our free cash flow, so that we are showing growth in our average free cash flow through the cycle. And so that we have an opportunity to grow free cash flow, positive free cash flow really at any point in our business cycle.
- Operator:
- And we do have a follow-up from Peter Appert with Piper Jaffray.
- Peter Appert:
- I can't remember if you address this at the Investor Day, but if you talked about the relative profitability of the extensions business versus the Basal business and correlate to that, if the extensions business is growing faster. Is that the driver of that our margins sort of business overtime?
- John Lynch:
- It is Peter, I'll answer the later part first which is we've seen across the business in terms of the year-over-year growth as you've seen in our long-term guidance here that extension should grow in some of the low to mid-single digits area, long-term average higher than the long-term average of the core business. So that business continues to grow and contribute more to our overall mix that will have an impact on what our financial profile looks like. We do think that and as the extension businesses as they continue to gain scale, we will also continue to increase in terms of margin. We do see those as higher margin businesses and in general the core business we see that by looking at some of the other players in the market in those particular markets segments. We see that in businesses within our portfolio as well. So on a relative basis we do see and this is higher margin businesses and it's important for us and a key in our element of our strategy to continue to grow those businesses and get the free cash flow contribution from those businesses up overtime.
- Peter Appert:
- And Jack, how important is M&A to achieving the strategy? Are there missing pieces you need to acquire that everyone would be from a technology and product standpoint?
- John Lynch:
- Yes, I think as we've said Peter, when we look at extension building on what Joe just said, it we believe there are higher growth, higher margin opportunities there. And we will use the mix of organic and inorganic growth opportunities there. So M&A, our strategy in successful execution is not dependent on it, but I think we can accelerate our strategy through M&A.
- Operator:
- And our last question is from Jeff Goldstein with Morgan Stanley.
- Jeff Goldstein:
- Just looking again at that declining cash flow from operations in the quarter, it seems like the work in capital benefit was a little lower than last year. Is there anything particular to call there? How should we think about that for next year?
- John Lynch:
- Yes, sure, really two things in terms of the overall free cash flow end of the quarter. Certainly, one of the things you saw was increased content development spend, and then on the operating cash flow side, through the first nine months of the year, we talked a lot about improving collections as we move through the year. And so, as we got to the fourth quarter that leans frankly less to collect as we get to the fourth quarter. But if you take in whole across the year, great improvement in terms of our collections activity and due to a lot of hard work from our team here. But really what you are seeing is just the fourth quarter after three successful quarters of strong performance on the collection side.
- Jeff Goldstein:
- And then on California decision not to approve HMH in its social studies adoption process. Can you just talk a little bit more about what exactly occurred there? And any -- I don’t know any internal changes that are being made in response to that?
- John Lynch:
- Yes, I think answering last part of your question first, obviously lesson learned there. We brought in a general manager with extensive experience in our core solutions. We have investigated through an extensive postmortem what we could have done better. I think in this particular case at the end of the day what we could have done better is really understood leading, the entire process leading up to the adoption decision. The efforts that we needed to observe if you will with special interest groups through, we are very vociferously throughout the entire process. And as a result, we were not a successful clearly as we intended to be. I think the important thing going forward is not only to ensure that we have really good execution throughout the entire adoption process in California, but as it applies to other states we feel very good about our ability to execute there and in social studies in particular that product line is performing as we expected both in adoption states and open territory. So, we lessons learned and we believe we apply those lesson learned to go in forth.
- Operator:
- Thank you. I'm not showing any further questions. I'll now turn the call back over to Jack Lynch for closing remarks.
- John Lynch:
- Thank you everyone. We really appreciate your time today and look forward to speaking with you on our first quarter call in early May. Thank you. Have a great day.
- Operator:
- Ladies and gentlemen, this does conclude the program. You may now disconnect. Everyone have a wonderful day.
Other Houghton Mifflin Harcourt Company earnings call transcripts:
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- Q1 (2021) HMHC earnings call transcript
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- Q2 (2020) HMHC earnings call transcript
- Q1 (2020) HMHC earnings call transcript
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