Houghton Mifflin Harcourt Company
Q3 2016 Earnings Call Transcript

Published: 3 Nov 2016

[Operator:]

Good morning and welcome to Houghton Mifflin Harcourt's Third Quarter 2016 Earnings Call. I would like to inform you that this call is being recorded for broadcast and that all participants are in listen-only mode. I would now like to introduce Rima Hyder, Vice President, Investor Relations for Houghton Mifflin Harcourt. Ms. Hyder, you may begin.

[Rima Hyder:]

Thank you, operator, 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 www.hmhco.com. A replay of today's call will be available via phone until November 10, and the webcast will be available on our website for one year. We filed our financial statements and our quarterly report on Form 10-Q with the U.S. Securities and Exchange Commission earlier this morning, along with our third quarter 2016 earnings release. After our prepared remarks, we will open the call to questions from investors. To be fair to everyone, please limit yourself to one question, plus one follow-up. You may get back into the queue if you have additional questions. Before we discuss our results, I encourage all listeners to review the legal notice on slide 2, 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, reconciliation 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. This morning, Gordon Crovitz, Houghton Mifflin Harcourt's Interim Chief Executive Officer and Joe Abbott, HMHC's Chief Financial Officer, will provide a company update as well as an overview of the company's third quarter 2016 results. I will now turn the call over to the Interim Chief Executive Officer of Houghton Mifflin Harcourt, Gordon Crovitz.

[Louis Gordon Crovitz:]

Thank you, Rima. Good morning and thank you for joining our call today. I am pleased to be here with you this morning as Houghton Mifflin Harcourt's Interim CEO. Before we discuss the third quarter results, I'd like to take a few minutes to provide some perspective on the company and our path forward to the improved performance we are confident we can deliver. The board's decision in late September to make a change in the CEO reflected the directors' disappointment in the financial performance of the company. As Interim CEO, I can confirm the board's continued confidence in the company's strategy for serving our mission-driven markets as well as the commitment and ability of management to create greater value for shareholders and improve our financial performance. We know we have hard work ahead, but benefit from significant progress in many areas during the five-year tenure of the previous CEO, including the Company's initial public offering, and migrating a significant part of the business to digital. The board decided it was time to recruit a new CEO who will be charged with leading the team to restore growth in the core business, appropriately invest in our adjacent markets, oversee a disciplined approach to spending and to provide shareholders with greater visibility into the company's performance. The board of directors has engaged an outside recruiting firm to find the best candidate to become our new CEO. Since I have been associated with the company, I have observed that we have great brands, content, sales operations and a strong executive team. These leaders with the company are now operating in a more collaborative way to take full advantage of the enormous assets of the company, and monetize them to achieve growth. As an operational matter, we are committed to bottoms-up budgeting, not a top-down approach to help ensure alignment throughout the organization in order to meet the company's performance expectations. The team understands that it must execute better in order to regain market share in our core business as well as make the most of our opportunities in adjacent markets. Joe has only been CFO since March, but is already bringing to the company a more sophisticated financial approach to investments and understanding of risk. Joe will discuss our quarterly results shortly in greater detail, but let me say this. We are disappointed with the company's performance year-to-date, especially in the domestic education market and we recognize the impact this is expected to have on our full-year results. As you know, our largest market, the domestic education market, is highly cyclical, with the new adoption calendar driving significant volatility in the size of the market year-over-year. Our results are affected by both the size of the market and our market share, which also varies each year. Despite capturing strong market share in some adoptions, year-to-date, we have underperformed against our expectations for total market share in our addressable domestic education market, predominantly from the California English Language Arts adoption. While we continue to address the root causes of this performance in order to regain our market share, we have identified preliminary conclusions with respect to that performance. First, to recap what we have told you the past few quarters, the delays in the California English Language Arts adoption and the lower-than-expected growth of the EdTech business reduced our expectations for the full year. These factors had a heightened impact on our third quarter performance and we expect to see the adverse impact of these drivers in the full-year numbers. Beyond our earlier comments, today we will provide information about our market share loss in the domestic education market. We believe we will end this year with an overall market share in the range of 38% to 39%, versus a 42% market share in 2015 on a pro forma basis. Joe will provide more perspective on this market share estimate in a few minutes. We believe the main reason for the domestic market share loss stems from product and marketing choices made in the years leading up to this year's reading and English language arts adoptions, most notably in California. For that important adoption, we chose not to invest in an entirely new program from the ground up, which would have been the way we typically build and launch new programs ahead of large adoptions. Instead, we offered a California standards-based reading program that used as a foundation our existing industry-leading reading program, coupled with new technology and enhancements. It is now clear that our share in this large adoption was impacted by a perception that our California Reading program was not new, by the fact that we were not effective in marketing the program's enhancements and by increased competition. This decision also had a cascading share impact on other reading and English language arts adoptions in 2016, as well as reading program purchases in open territories. Our approach in California was predicated on our demonstrated success in the California Math adoption where we captured, and continue to capture, strong market share with our GO Math! program. In hindsight, however, the decision hindered our ability to deliver our expected market share. So, how will we address these issues? In response to challenges in California, we have increased our investments targeting opportunities in that state and we have worked to address operating factors that contributed to our lagging sales. More generally, we are committed, going forward, to allocating sufficient capital to our core educational products in support of large adoption opportunities and other initiatives to improve our competitive positioning. We are confident this will allow us to regain market share in the core business. Among the proof points showing the strong effect of allocating the right amount of capital, as mentioned, we have continued to capture high market share in the California Math adoption with our GO Math! Program, and additionally Collections, our English literature curriculum, performed very well in Florida and California this year. Our current level of content development spending in our core education business in 2016 is in line with our traditional product roadmap strategy. This level of investment reflects our commitment to ensuring that we have fresh, new products for the large adoptions coming up over the next few years. We are excited by the highly attractive opportunities ahead and are confident we are investing at a level that will enable us to take full advantage of these opportunities. Joe will provide some highlights about the new products we have recently released and plan to release, timed to the expected buying decisions of different states and districts across many areas of our products and services. Given the strength of our brands, domain expertise and experienced sales team, the company expects to be the clear market leader in the areas in which we compete. We are also committed to continuing to invest in our adjacent markets such as intervention, services, international, assessment, professional development and consumer, which both strengthen the company's competitive position in the core business, and importantly, allow us to participate in attractive, less cyclical and faster growing segments of the market. In light of recent performance, we also intend aggressively to pursue opportunities for efficiencies and operational improvements. While a smaller segment of our Company, we are excited about our Trade business. We continue to produce award-winning titles as we also find innovative ways to combine the strengths of our education and consumer operations in order to boost the performance of the core business as well as Trade. Another item that I wanted to update is the planned Investor Day which we announced on our most recent quarterly earnings call. Due to the recent management change, we have decided to postpone our Investor Day from December to next year. When we have a permanent CEO in place we will provide you with a more robust update on the company's long-term strategy. In the meantime, we are increasing the information we share with you about how we operate the business to help you better understand the drivers of our performance. Joe will provide a few examples later in the call that we hope will add to this increased understanding about our business over time. We know we must improve the recent financial performance of the company, but we also keep in mind the many reasons for enthusiasm about the opportunities ahead. One reason I am enthusiastic is that so many of the opportunities are within our control. We can allocate our capital more effectively. We can work better as a team. We can execute better. We can take full advantage of the great assets including the recent EdTech acquisition that adds so much to how we can help our customers deliver the best education experience. We're also committed to providing you the information you need to understand the steps we are now taking to return the company to a path of long-term growth and sustainable cash flows that we are confident we will attain. We appreciate your patience as we navigate this path forward for the company. I will now turn the discussion over to Joe for more details.

[Joseph P. Abbott:]

Thank you, Gordon, and good morning, everyone. I'll be providing a quick recap of our third quarter 2016 financials and then I'll get into our guidance and other business updates before we open it up to questions. We ended the third quarter with net sales of $533 million, a 7% decrease in net sales from the same period in 2015, while billings, which we calculate as net sales taking into account the change in deferred revenue, were $620 million in the third quarter, or 9% lower year-over-year. The decrease in net sales and billings was largely attributed to the decline in domestic education sales due to a smaller new adoption market in 2016 versus 2015, and as Gordon just discussed, lower market share. Additionally, we had lower professional services delivered and lower net sales from the assessment business, primarily in clinical assessments due to the natural decline of sales over time following the initial release of a new product version in 2014. Partially offsetting the decrease was an increase in net sales of the international business, due primarily to greater sales in Latin America as well as higher Trade Publishing net sales, driven by strong net sales of current-year and prior-year frontlist culinary and general interest titles. Net income in the third quarter of 2016 was $90 million, a 31% decline compared to net income of $131 million in the same quarter of 2015. The decrease in net income was largely due to lower net sales as well as a lower income tax benefit in the current period. This was partially offset by lower operating costs, including lower sales commissions and lower interest expense. Adjusted EBITDA for the quarter was $168 million, 12% lower than prior year. This was primarily due to lower net sales. Turning to additional metrics that we use to evaluate our performance, the change in deferred revenue for the quarter was $87 million versus $106 million last year. The smaller change in deferred revenue was due to changes in our product mix as well as continued recognition of deferred revenue from the larger new adoption opportunities in 2014 and 2015, and content development costs for the third quarter were $29 million, $4 million lower versus the same period last year, primarily due to timing of these expenditures. We continue to expect full-year 2016 content development costs in a range of $120 million to $140 million. As of September 30, 2016, we had cash and cash equivalents and short-term investments of $217 million compared to $432 million at year-end 2015, and $98 million at the end of the second quarter. Our cash from operating activities was $9 million for the nine months ended September 30th, compared with $164 million from the same period in 2015. The resulting free cash flow, which we define as cash from operations minus capital expenditures, was a usage of $176 million compared with positive free cash flow of $35 million for the same period in 2015. The decrease in free cash flow is primarily due to lower net sales, the impact of changes in working capital and increased capital expenditures. I'd now like to turn to our net sales billings outlook for the remainder of 2016. In late September, we disclosed that our preliminary view for billings expectations was to be at or near the low end of the revised billings guidance range of $1.525 billion to $1.595 billion. In the remaining days between that disclosure and the end of the third quarter, a number of critical billings opportunities underpinning our revised guidance range failed to materialize. We now expect to end the year with net sales of $1.32 billion to $1.38 billion. Our billings for full-year 2016 are now expected to be in the range of $1.37 billion to $1.43 billion. This revised range is reflective of weaker than expected results through the first nine months of this year, and our estimate of fourth quarter performance, which is expected to decline compared to last year due to lower market share and our decision to exclude previously recurring wholesale distribution arrangements that we have deemed are not in the best interests of the company at this time. Our original billings and net sales guidance for 2016 issued in February and our revised guidance issued in August were predicated on a number of market and operating assumptions which have not materialized. First, it has become clear through the first nine months of this year, and particularly in the third quarter that we have lost domestic education market share relative to last year due to factors contributing to our performance in the California English Language Arts adoption. While we continue to perform well in new adoption opportunities outside of California ELA this year, as Gordon stated, our domestic education market share is expected to be in a range of 38% to 39% for 2016 versus 42% in 2015 on a pro forma basis, which is adjusted from our previously reported 2015 market share of 40% to include market share attributed to the EdTech business, as if HMH had owned the business for the full year in 2015. Our performance in the first year of the California ELA adoption is a major contributor to our market share decline, and we are taking steps to improve our competitiveness in that adoption for the remaining opportunity. We are also investing in new programs which we believe will help us regain our market share in the domestic education market. I will provide more color on these programs in a few moments. Second, in 2016, we planned for a more rapid realization of sales synergies from last year's EdTech acquisition. While we anticipate increased growth from this acquisition, we now anticipate that we will deliver single-digit growth for the EdTech business this year. Our sales force integration efforts are ongoing and we expect full realization of revenue synergies in future years. And third, as I stated a moment ago, we made a decision to discontinue certain additional wholesale distribution arrangements with resellers this year which will impact our fourth quarter expectations and its comparability to last year. To give you further context, the midpoint of the revised billings guidance range we announced today of $1.4 billion implies an approximate $190 million billings reduction relative to pro forma annual billings of $1.592 billion in 2015, which includes EdTech billings for the full year as if the acquisition occurred on January 1, 2015. The drivers of this $190 million decrease in billings are as follows

[Operator:]

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

[Andre Benjamin:]

Thanks, good morning. As my first question, you acknowledged that the cuts in guidance had not only to do with issues in California but read across to other states who were watching what happened in California with regards to the reading program. Could you maybe talk about some of the other major states that included? And then you did call out doing pretty well in Florida, so I'm just wondering what did you do differently there and then what happened in California so we can better understand.

[Joseph P. Abbott:]

Yeah. Good question, Andre. Hi, it's Joe, and good morning. Yeah. You're right. I mean, this had to do with a broader set of opportunities just in the state of California as it relates to the reading opportunity there. There were a number of new adoptions in the reading and English language arts across the country. Any individual situation wasn't particularly large but in the aggregate it tended to be more skewed in terms of a new adoption calendar this year towards reading. And Florida specifically, that was a specific reference to the literature part of your English language arts program and that's the 6-12 portion of the adoption calendar. And that's an area where we didn't perform well. We feel very good with a strong product in that segment of the market.

[Andre Benjamin:]

And then since you are looking to pick up the level of investment to, as I'll say, get trued up on the quality of the product, I guess, how do we think about the level of spending as we try to roll our models into 2017 and 2018 and the timing of when these new products would then be ready, like in terms for you to execute. Will they be done in the next 6 months, 12 months, 2 years, like just how do we think about the timing?

[Joseph P. Abbott:]

Yeah, so we've already made and have been continuing to invest against the opportunities that we laid out in the remarks there, and as you can see in the slide deck, around some of the big adoption opportunities that we're targeting going forward. So, for example, the science program, the next generation science program has been launched. We're planning to launch the new social studies program here shortly and continuing to invest against the Texas Reading adoption upcoming. And so what you should expect is continuing spend on those programs that have not yet been launched. The timing that we provided in the scripted remarks is the first year of billings. As you know, typically in advance of those adoptions you would submit the year in advance so those programs would be ready to go in advance or in time for the actual calls for each one of those big adoption opportunities.

[Andre Benjamin:]

Thank you.

[Operator:]

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

[Joseph P. Abbott:]

Morning, Jason.

[Jason Boisvert Bazinet:]

Good morning. Thank you for the incremental color. I had one question that maybe you could help us with if we just widened the aperture a bit. At least the data that I have I think shows that the last sort of trough was 2012 in terms of the size of the K-12 market at about $2.46 billion. And you mentioned in your prepared remarks we were sort of at or near the low point. So if you went back and looked at the historical data, what is sort of the min-max in terms of the length of the cycle, sort of trough-to-trough, if you will?

[Joseph P. Abbott:]

It's a great question. And I do want to make sure – and thank you for pointing it out that when we're talking about the cycles here, as we would think about them, we're not talking about what we typically refer to as any given state's adoption cycle, which is...

[Jason Boisvert Bazinet:]

Right.

[Joseph P. Abbott:]

...typically a six-year to eight-year period of time. What we're specifically talking here is – when the large adoption opportunities tend to occur. What we've seen over the last few years really is – you're right – there was a smallish opportunity in 2012, something similar actually in 2013. But then 2014 was a large opportunity where you had Texas and California both coming to market in size. That market opportunity was roughly $3 billion at that point in time and that's been – think of that as sort of a local peak. What we see now in and around the market sizes that we've given you, and our best view on what it's going to look like this year is that we're in and around again another a local trough, and we expect that peak, the next peak here in this local cycle to occur as you start to see some of these large state adoptions come into play, in particular as you see them stacking up in the 2018 and 2019 time periods.

[Jason Boisvert Bazinet:]

Okay, all right. Thank you so much.

[Joseph P. Abbott:]

Sure.

[Operator:]

Thank you. Our next question comes from the line of Trace Urdan from Credit Suisse. Your line is open. Trace Adair Urdan - Credit Suisse Securities (USA) LLC (Broker) Thank you.

[Joseph P. Abbott:]

Morning, Trace. Trace Adair Urdan - Credit Suisse Securities (USA) LLC (Broker) Hey. Good morning. So you guys have kind of done a mea culpa on the prep for California, but it sounds like science and social studies are pretty well baked. So I guess my question is, when you are talking about investing in the programs going forward, we're just talking about getting reading back on track or are there other areas where you feel like you may have sort of underinvested the way that you're now acknowledging you did for reading ahead of California?

[Louis Gordon Crovitz:]

Hey, Trace, it's Gordon here. I think as our comments indicated, the California issue was quite isolated to a decision made a few years ago and we wanted to be very clear about that. And you should not read into that any other area affected by a decision like that or support for large adoptions going forward and will be, as we've described, adequate to make sure that we do well on those adoptions. Trace Adair Urdan - Credit Suisse Securities (USA) LLC (Broker) Okay. So we really – yeah, go ahead.

[Joseph P. Abbott:]

Sorry, Trace, one other thing I'd add there is that we are looking at a normal course product roadmap that will have us investing against the very large opportunities upcoming. So we kind of laid out for you both the opportunities as we look forward to really large opportunities coming up as well as the programs that we're investing in. And that is very much normal course for the remainder of the product roadmap that we're currently under development on right now. Trace Adair Urdan - Credit Suisse Securities (USA) LLC (Broker) Okay. So I just want to make sure that I understand. The error I guess really was under-investing ahead of California Reading. But apart from that, you don't really feel like there are other places where similar mistakes were made that need to now be corrected or remediated. Is that fair?

[Joseph P. Abbott:]

That is fair.

[Louis Gordon Crovitz:]

That's correct. Trace Adair Urdan - Credit Suisse Securities (USA) LLC (Broker) Okay. And then could I also ask you just give us a little bit more color on this recurring wholesale distribution arrangement that you are discontinuing; what is that, and how material is it to sort of billings and revenue overall? What has it been in the – like what's comps versus the prior on that?

[Joseph P. Abbott:]

Yeah, sure. Well, look, it's not material in the overall context of our billings. It is, given the relatively small size of the fourth quarter, it would be material as it relates to the fourth quarter results. Trace Adair Urdan - Credit Suisse Securities (USA) LLC (Broker) Okay.

[Joseph P. Abbott:]

Enough to certainly call out for you. But the important thing about the reseller strategy that we have here, we continue to think that it's an important one as we move forward, it allows us to, for example, extend the reach of our products and enhance our selling opportunities out there. We're simply saying that we decided against doing one in the near term here really because we feel like we can come up with a better economic arrangement. We're focused on ensuring that we've got improvement in our overall profitability and free cash flow and we think that we can come up with a better arrangement going forward within that broader strategy around the resellers. Trace Adair Urdan - Credit Suisse Securities (USA) LLC (Broker) Okay. And I'd understood you did use resellers in some cases internationally, but are we talking of other domestic resellers of your products?

[Joseph P. Abbott:]

Yeah, that's right. That's right. Both internationally and domestically, we'll use resellers to a certain extent. That's largely a function of how do you sell into the backlist, some of our backlist properties that gives us an opportunity to extend our sales presence frankly for that portion of our business. And we continue to expect to do that. We think it's an effective strategy, but we're – again just to reiterate this is more of an economic decision around the individual deals that we're doing and we've opted not to do one here in the fourth quarter which has an impact.

[Operator:]

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

[Jeffrey Marc Silber:]

Thanks so much. My first question actually has two parts. First of all thank you so much for the candor and the transparency on this call. It's really appreciated. You had mentioned what you thought was a loss in market share this year. I'm just wondering if we take out the California English Language adoption, if you think you still lost share. And then also – I know it's still a little bit early, but do you expect the addressable market of domestic education to grow or shrink in 2017? Thanks.

[Joseph P. Abbott:]

Sorry, Jeff could you – the first part of the question was...

[Jeffrey Marc Silber:]

In terms of market share, if I take out the California English Language adoption, do you think you would have lost market share this year?

[Joseph P. Abbott:]

Yeah. So, one thing I will point out is that while there was – California was a big driver, and in particular, on a relative basis, and California – and last year one of the big opportunities was California Math, where we performed quite well this year. That was less of an opportunity this year, California Reading was the big opportunity and we didn't perform up to our expectations. That was a major driver for us here. But I would say that outside of California on an isolated basis, there was, we think, some reduction in market share. We don't think that it was anything beyond some of the comments that we made in particular around the reading program of note, anything that we would expect to see outside of the norm here in the various ins and outs of the competitive dynamic that we see in general. But we do think that if you were to back that out specifically you would see some amount of share loss 2015 versus 2016, yes.

[Jeffrey Marc Silber:]

And then the second part was on the total addressable market for next year; is that something you think will increase or decrease?

[Joseph P. Abbott:]

Right. So we're not going provide guidance at this point, Jeff, for 2017. I think that is something that we will provide you a perspective on as we get to the fourth quarter and share the market size going forward. We do think that the biggest opportunities as it relates to the cycle upcoming of course are in the 2018, 2019 opportunities. But we will provide you more color into what we think is that addressable market size for us when we get to our fourth quarter call.

[Jeffrey Marc Silber:]

Okay, great. Thanks so much.

[Joseph P. Abbott:]

Yeah.

[Operator:]

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

[William A. Warmington:]

Good morning, everyone.

[Joseph P. Abbott:]

Morning, Bill.

[William A. Warmington:]

So a question for you on the free cash flow. I was hoping – I thought it would be helpful to go through a bridge from the last year's nine months free cash flow to this year's nine months free cash flow, just to understand where the $200 million swing has gone, in terms of what's impacted what.

[Joseph P. Abbott:]

Yeah, sure. Happy to give you a little bit of color there and then you can take – Rima would be happy to go through maybe some of the more specifics with you as you're working through your model on that one, Bill. But one of the biggest drivers, as I said in my remarks, is going to be around the billings opportunity, particularly in the core. As we've talked about, there is a high percentage of fixed costs in that aspect of the business, and so as the billings opportunity year-on-year varies, and in this instance goes down, you'll see an impact on free cash flow simply from the billings flow-through. But then the other thing to keep in mind here is that we've had elevated spend this year relative to last, in particular on content but also in the non-content portion of our capital expenditures as we continue to invest in infrastructure and platforms as we've talked about. We have a facilities move that you should consider one-time; we have a series of facilities moves that has increased that amount. So there is an elevated level of spend this year versus last. And then I think the last piece that we talked about in the last call, it's important to keep in mind as you're doing some of the bridging period, especially in the nine months versus nine months is that the EdTech acquisition, recall we owned for the last seven months of last year, which was really the cash-flowing months of that business, not dissimilar from our legacy business that I think you're pretty familiar with at this point. And so if you were to kind of do the pro forma on a free cash flow basis for us last year you would have been starting from probably a lower place than that 160-or-some odd million dollars of free cash flow that we actually produced last year.

[William A. Warmington:]

Got it. Okay, and then on California, you've talked extensively about the loss there as a result of the underinvestment. I'm trying to think through the implications in terms of how that flows through for the extension of that program into 2017 and 2018. So that share essentially has been seeded and will not be recouped in the out-years despite the delay in the timing – I just want to make sure that I'm understanding that correctly. And then if you had any specific share numbers around California I think that would be helpful.

[Joseph P. Abbott:]

Yeah. Well, look, we're going to be somewhat guarded in terms of specific share numbers, specific actions that we've taken really in any ongoing adoption, especially as early as it is in California where we think, we've said it in the past, really about two-thirds of the opportunity left to go in the last couple of years. But what I can tell you is that we've made certain enhancements to the offering. We think we've improved the marketing around both the program itself and some of the enhancements we had already made as well as some of the new enhancements. And we think we can do a better job of bringing those to the floor and helping tell that story a bit better. All of which we think will make us more competitive as we move through the remainder of the opportunity.

[William A. Warmington:]

Got it. Thank you very much.

[Operator:]

Thank you. Our next question comes from the line of Toni Kaplan from Morgan Stanley. Your line is live.

[Joseph P. Abbott:]

Hi, Toni.

[Jeffrey D. Goldstein:]

Hi. It's actually Jeff Goldstein on for Toni. Good morning.

[Joseph P. Abbott:]

Okay. Hey, Jeff.

[Jeffrey D. Goldstein:]

Hey. I was hoping you could provide an update on what percentage of your billings are now digital, and then bigger picture, are you seeing any negative pricing trends you're encountering that offset the cost benefits as a result of this shift to digital?

[Joseph P. Abbott:]

Yeah, good question. So we're still through the nine months here. I can tell you that we'll give you more of an update as we get into the fourth quarter on kind of the percentage of billings but we're still seeing – in our core programs, we're still seeing digital percentages in the upper 40s percent there yeah, moving forward. I'm sorry, Jeff, your second question?

[Jeffrey D. Goldstein:]

Just if you're seeing any negative pricing trends as a result of this shift to digital that's kind of offsetting any benefits on costs that you're getting?

[Joseph P. Abbott:]

No, no. In fact, and I think one of the things that we've continued to say here is that, we're continuing to see good price realization across the business and it's really around the added value that our customers are seeing as enhancements that come as a result of use of digital over time.

[Louis Gordon Crovitz:]

I think one way of looking at that – this is Gordon – is the digital itself has got value but it's the combination of the print and digital that has yet more value. So I think it's really the other way. It's not so much put pressure on price but it gives us some strategic pricing opportunities that we didn't have before.

[Jeffrey D. Goldstein:]

Okay. Got it, and then, can you just talk a little bit more about EdTech's performance in the quarter and any more color around why you expect this to now grow single digits versus your previous double -digit expectations. Thanks.

[Joseph P. Abbott:]

Yeah. Well, look, I think as we've pointed out before, while we've integrated the businesses we think we still now have a fair amount of continued integration to go in terms of the sales organization. I think one of the aspects that we're seeing here is that you've had a number of new folks in new roles. We're continuing to work through that, adopt best practices as we continue to integrate those two businesses together. And we think what we've seen in terms of those best practices that actually have been implemented and then working quite well, this is something we believe is extensible for the remainder of the business. And we're very optimistic about that business and its opportunity to grow over time. We just think that the synergies that we will realize are going to occur later than we had originally anticipated.

[Operator:]

Thank you. Our question comes from the line of Trace Urdan from Credit Suisse. Your line is open. Trace Adair Urdan - Credit Suisse Securities (USA) LLC (Broker) Hi, thanks. Just one follow-up, so you guys kind of acknowledged an area where you maybe hadn't invested appropriately ahead of California. I'm wondering if the board or you all on the call have any perspective about areas where you may have invested or spent too much that you're reconsidering?

[Joseph P. Abbott:]

Yeah. Trace, no, it is a good question. I think one of the things that we are highly focused on as we continue to evaluate and work through our capital allocation strategy is where we can make those investments that will generate the most return for our shareholders. And that's – for us, first and foremost going forward, we've been making investments across our portfolio now for a few years, and I guess you understand, against the strategy that we still think is an important one in terms of driving growth in the future and future returns. What we're very focused on, and I hope that that came across in the comments, as we move forward is, that it's important for us to ensure that we're investing against the big core opportunities that we see out there today because that has ramifications for our ability to generate free cash flows on returns. But we're also making sure that we're continuing to invest in those adjacencies that both strengthen our core opportunity as well as give us that opportunity to grow and build a stable base of cash flows as we move forward here.

[Louis Gordon Crovitz:]

So, Trace, this is Gordon, just to elaborate a little bit on Joe's point, when we talk about adjacencies, really think about most of those intervention, services, assessment, professional development as so close to the core of the business that it really strengthens us in the core of the business. So there are some other adjacencies that are obviously, farther afield like Trade, which is a smaller part of our company. But when you think about those adjacencies, those strengthen the core, they are good businesses on their own, they remove us from the cyclicality that we are all quite aware of in the core business; and in areas like consumer it is a big advantage to us to have the ability to monetize the intellectual property into different markets using technology in different ways. And we're optimistic that we will find value from all of these adjacencies and each one will have a somewhat different level of investment, but it's all part of the larger picture of how do we boost shareholder value and improve our financial performance.

[Operator:]

Thank you. Our last question for the day is going to come from Nick Dempsey from Barclays. Your line is open.

[Nick M. Dempsey:]

Yeah, good morning. Just first of all, I understand you've been disappointed by your performance in California English Language Arts. Pearson has not participated in probably the largest part of that adoption. So does that mean that McGraw-Hill has been dominating that adoption or are there a string of new players or smaller players who have done somewhat better there? And then my second question just on slide 11 there, are there any of those big adoptions in the top three states that you know now you won't be participating in the next couple of years?

[Joseph P. Abbott:]

Yeah. So to your California question, I mean, you're right. There are a number of competitors that have offerings for California as it relates to the specific share out there in any given year. There have been some shared numbers put out there by certain players in the market. Remember also that that's a one-year view on that market. But certainly there are a large number of folks that are actually out there and competing and that's a competitive adoption moving forward. What I can tell you about California is that we've taken steps just to reiterate, we've taken steps that we think will make us more competitive as we see the remainder of – the two-thirds of that opportunity as we move forward. And thanks for the question on the next year where we are or we're not planning to participate. One of the things that we've done here is share with you the really large opportunities that we are focused on that we plan to participate in. Without getting into specifics on some of the other adoptions that we're participating in, most of what you see represented there we'll participate in. We don't get into specific participation rates. For example, it's more important I think for us is to examine each opportunity on the merits of the investment case. What we're focused on is returns and generating return to our shareholders. So what will help you with and what I'll make sure is very clear is that we're investing in these opportunities, especially with new product that is against the very large opportunities where we think we have an opportunity to win and generate high return.

[Nick M. Dempsey:]

Okay. Thank you.

[Operator:]

Thank you. Ladies and gentlemen, that now concludes our question-and-answer session for today. I'd like to turn the call back over to Joe Abbott for closing remarks.

[Joseph P. Abbott:]

Thank you to everyone again for joining us on the call this morning. If you need additional information, please reach out to Rima Hyder in our Investor Relations department. Operator, this ends today's call. Thank you.

[Operator:]

Ladies and gentlemen, thank you again for your participation in today's conference. This now concludes the program. And you may all disconnect at this time. Everyone have a great day.