Houghton Mifflin Harcourt Company
Q3 2015 Earnings Call Transcript
Published:
- Operator:
- Good morning and welcome to the Houghton Mifflin Harcourt Third Quarter 2015 Earnings Call. I’d 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, Abigail, 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 Web site at www.hmhco.com. A replay of today's call will be available via phone until November 12 and the webcast will be available on our Web site 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 earnings release. After our prepared remarks, we will open the call to questions from investors. To be fair to everyone, please limit your questions to one plus a 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, reconciliations to the most direct 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, Linda Zecher, Houghton Mifflin Harcourt's President and Chief Executive Officer, will provide an overview of the Company's third quarter 2015 results, followed by the presentation of financial results by Eric Shuman, HMH's Executive Vice President and Chief Financial Officer. I will now turn the call over to Chief Executive Officer of Houghton Mifflin Harcourt, Linda Zecher.
- Linda Kay Zecher:
- Thank you, Rima, and thank you everyone for joining us today. This morning we reported our third quarter results with net sales increasing by 4% year-over-year and billings down 1%. We continue to maintain a leading market share of around 40% in a smaller 2015 domestic education market. Additionally, given our confidence in the long-term prospects of the business, we’ve expanded our share repurchase program to an aggregate $1 billion and plan to increase our leverage over time. Eric and I will cover these points in more detail in a few moments. Let me begin by talking to the main factors that impacted our third quarter results. Areas where we exceeded expectations and are doing very well include intervention. Thanks to the Educational Technology and Services or EdTech business that we acquired in the second quarter of this year, our consumer business which continues to have good growth, our professional development business, which is up 40% year-over-year, and finally our digital leadership. These are the key areas that we believe will help fuel our growth in the future. We also continued our strong performance in the core domestic education market capturing 45% of the new adoption market year-to-date, and bringing total market share through the first three quarters to approximately 40%. While these were bright spots in the third quarter as you may have already seen in our earnings release this morning, we’re revising our guidance for the full-year based on several driving factors. First, we saw softness in the open territory market based on two main market timing issues. For instance, many large open territory districts opted to wait for the release of the next generation science program that maps to the new science standards. While this impacted billings in 2015, we believe that positions our new science program very well. Also in large open territory states like Pennsylvania, purchases were deferred due to a delay in budget approval. Second, the transition to digital resulted in lower sales has been our supplemental book in residual business. As we’ve discussed in the past, the move to digital as exemplified by the 2014 Texas goal map adoption that was 70% digital is happening quickly. Although this is good for our business long-term, there is a short-term negative impact on our supplemental book and residual business. It's important to note that supplemental and residual sales typically happened late in the third quarter after back to school commences, which makes our billings harder to predict until late into the third quarter. And last, while our performance in California this year has been strong, with HMH capturing more than 50% share in the California math adoption, many of our customers chose to purchase one of our math program that resulted in strong market share, but lower billings due to a lowering net price per program. Offsetting these negative factors is a strong performance from the EdTech business. We are pleased with the year-to-date results and feel positive about how well the acquisition has now positioned us for 2016. It is going very well and exceeding our expectations. We believe the aforementioned market issues can have a positive long-term impact. First, we believe that there is pent-up demand in open territory heading into 2016 and while our supplemental book and residual business was lower due to the transition in digital, it creates an opportunity for us to move into versioning and maintaining pricing options within our subscription-based digital programs. Turning to our domestic education business, our overall addressable 2015 market remains in line with expectations at $2.7 billion, and we continue to service the leading provider with year-to-date market share of approximately 40%. Within this, our market share of the larger than anticipated new adoption market is 45% in line with our expectations. Our addressable open territory market grew 1% year-over-year through the third quarter, which is five percentage points below our initial expectation. As you may recall, through the first half of this year, open territories lag the prior year by 5%, but we believe the trend will reverse in the third quarter. We did see a rebound in the third quarter, but not to the extent that we had anticipated. In our domestic education market this year, we had some very impressive wins this quarter in New York, Michigan and Wisconsin, resulting in HMX capturing a two percentage higher market share year-over-year in open territories overall. We were also pleased that while the number of orders in open territory this quarter versus 2014 was lower, the dollars per order were higher. We believe this is a direct result of the positive changes we’ve made in our sales coverage model creating more cross-sell and up-sell opportunities. The recent addition of the EdTech business extended our portfolio of educational programs in our professional services offering. As we stated on our second quarter earnings call, we were concerned that EdTech results could be negatively impacted by the integration process. To the contrary, year-to-date performance of the EdTech business has been solid delivering $134 million in billings since we acquired it in the second quarter. We are already leveraging the cross-selling opportunities and believe that the positive momentum we’re gaining and the collaboration integration of the sales team is setting us up very nicely for the California reading adoption, where we will compete in all five categories. You’ve heard me talk about a learning transformation powered by technology. There are strong signs that the transition in digital is accelerating. Digital content accounted for approximately 44% of the total billings; it’s been our large education programs for the first three quarters of 2015 and 33% of the total billings. While these year-to-date percentages were slightly lower compared to 2014, it's important to remember that digital billings will continue to ebb and flow based on purchasing trends. As I’ve stated previously, we feel we’ve reached a pivotal point in the digital transformation and we'll continue to lead. To do this we continue to differentiate ourselves in the competition by investing in our digital channels, including new partnership, new programs, and game changing digital content. The switch to digital also creates an opportunity for us to further optimize our pricing model. As I mentioned, we believe we have a strong opportunity to sell in subscription based services that will drive recurring maintenance revenue. But before I go into further detail on our digital leadership, let's take a closer look at our operational performance for this quarter. We continue to perform particularly well in large populous state. For example we’ve taken a greater than 50% share in the California math adoption and approximately 30% share in the Texas, 6% to 12% social studies world geography adoption, which is particularly rewarding considering we competed in an older existing program. We chose not to make an incremental investment in a new program ahead of our new Digital Social studies release. In other states not having a new program, negatively impacted our ability to compete. However, this was a cost versus benefit decision made by us. And more importantly, the HMH world geography program was the only program in its category that met 100% of the Texas standards. Also in Texas, we voluntarily chose to pull our national government program due to required revisions by Texas that could not be supported by our research backed content. Staying with our core program, there continues to be strong demand for GO Math in Texas and Tennessee and our reading and language arts program took a leading market share in States such as West Virginia, Florida, Georgia and South Carolina, to name a few. Beyond our K-12 core content business, HMH’s professional services offering has been in area of growth in 2015. We are very pleased with our progress on this front with a newly integrated education services organization, which combines the legacy HMH and EdTech professional services team, we believe we are well positioned to create valuable new services offerings at a scale to grow this business. We look forward to highlighting our education services growth in future quarters. Throughout the business, we are already seeing the benefits of our newly combined footprint. In particular, HMH’s nationwide sales force has facilitated introductions in regions where the EdTech team did not previously have a presence. As a result, we have secured several multi-million dollar contracts for EdTech programs and continue to find opportunities with existing customers. Additionally, HMH and EdTech products will be competing in all California reading categories, which further strengthens our position heading into the 2016 reading adoption. As we look to extend classroom learning into the home, the momentum in our consumer business continues to build and growth from the year is outpacing our expectations. Through the third quarter, our year-over-year growth is 12% bringing the three-year compounded annual growth rate for this business to almost 85%. All aspects of our consumer business are trending up. Web traffic has increased by 9%, orders were up or increased in size by 17%. We are seeing benefits from our efforts to optimize our advertising model around Cliff's Notes. As the Web site continues to attract more users, we are converting them into paid subscribers. We continue to look at ways to grow the consumer business and expect to seek about the business on a more granular level in 2016. A major element of this consumer the growth strategy entered the market a few weeks ago, with the official launch of Curious World. Our Chief of Consumer Brand and Strategy, CJ Keller, has aptly described this interactive content service as the Netflix for learning. And we think it is a perfect analogy. For monthly or annual subscription, Curious World provides children and parents with a one-stop shop for an ever expanding collection in games, videos and e-books, mapped to key learning areas. The platform features well loved HMH characters, engaging games and videos from partners such as PBS Digital and National Geographic and our own exclusive content. An interactive parent dashboard sets Curious World apart by facilitating family engagement in providing real world tips for offline learning. By engaging both children and parents with customized content, we believe Curious World will redefine playful learning and significantly augment our presence in the consumer space. We view this platform as a true game changer in the early childhood space, and the buzz from national and local press, as well as tech and parenting publications echoes these sentiments. Also within our consumer business, we recent acquired select e-book and technology assets of MeeGenius, an e-book subscription service for children up to eight years old that further strengthens our offerings beyond the classroom. Importantly, we see opportunities to leverage MeeGenius assets within Curious World over time. In addition, we recently formed a partnership with Osmo, the creators of a platform that is revolutionizing the way children learn on the iPad to bring our market leading math program and learning content to the new Osmo numbers game. Also during the quarter, we deepened our partnership with Trinity by adding a new digital curricular to their e-learning platform, which enables on and off line access to programs for K-12 educators and students around the world. Following the successful folio pilot program with Trinity, we have launched several of our award-winning science programs in international markets. Turning to our trade segment, despite facing difficult year-over-year comparisons, our revenues were down slightly for the quarter, but we anticipate full year-over-year growth. We continue to build our offerings and pipeline of new titles that we believe will help drive future growth in key lifestyle and general interest genres. For example, we recently released the critically acclaimed novel, Girl Waits With Gun, from New York Times best-selling author Amy Stewart. Rosemary, the Hidden Kennedy Daughter, by Kate Clifford Larson was also a New York Times best-selling title and has much attention in the media and beyond. And my personal favorite is FastForward by Melanne Verveer and Kim Azzarelli. Ambassador Verveer is the first ambassador of women’s issues in the State Department, and the author and book were just featured at the Fortune Most Powerful Women Summit in Washington DC. We also have much to look forward to in the coming months. Following his wildly popular title What if, we are looking forward to this month's release Randall Munroe's new title, The Thing Explainer. Additionally, this quarter we are celebrating the 30th anniversary of the beloved Polar Express with a newly designed and re-mastered edition of this classic. Next April we will release HDTV reality star Jonathan and Drew Scott, The Property Brothers’ debut book, Dream Home based on their popular home-improvement television program. Finally, building upon the success of HMH’s developer portal last quarter, we announced the HMH marketplace, an online destination for educators to discover, share, and sell resources that enhance the teaching and learning experience. Launching in early 2016 in beta, the marketplace will combine applications by EdTech developers and start up with original content made by teachers for teachers and a resource for supplementary education application that integrate with and support core curriculum. Through this new platform, we intend to streamline and search for quality content and innovative solutions to add value to the teaching and learning experience. In this marketplace, we will employ a revenue share model and over time we will be able to offer additional tools and services in order to drive revenue from this portal. In summary, we believe the health of our underlying business, our ongoing market leadership, and our long-term growth prospects remain strong. In addition, we believe there are efforts to diversify our revenue streams with new customers, early childhood and services offering will make us more resilient over the long-term. As an indication of our belief in the future of this Company, we have increased the size of our share repurchase program. We remain committed to our overwriting goal of creating value for our shareholders. To do this, we are constantly evaluating the most prudent ways to deploy our capital. We believe it is important for us to have the financial flexibility necessary to execute on our long-term vision for the Company, which entails investments and organic initiatives, as well as strategic M&A activity. In addition, returning value to our shareholders remain an important element in our capital allocation strategy. To that effect, we have been actively executing against our repurchase program. As of the third quarter, we have repurchased approximately 240 million of shares from our initial repurchase program of 500 million, which we put in place less than one year ago. Further to that effect, as I mentioned earlier, on November 3, our Board of Directors authorized an increase in the size of our existing program by an additional 500 million for an aggregate total of 1 billion. The aggregate 1 billion share repurchase program may be executed through the end of 2018. We believe, this is a significant buyback program for a company of our size and with our history, and that it reflects our ongoing confidence in our long-term growth. So thanks again and now I’ll let Eric walk you through the quarterly numbers.
- Eric L. Shuman:
- Thank you, and good morning, everyone. We have continued to execute on our business objectives in 2015. Our year-over-year comparables were impacted by the fact that 2014 was an exceptionally strong adoption year, as well as evolving industry dynamics that Linda already walked you through. Billings for the third quarter totaled $682 million down approximately 1% compared with $692 million in the third quarter of 2014. Overall net sales for the third quarter were $576 million, which is $25 million or 4% higher in the third quarter last year due to the strong results from the EdTech business. Excluding EdTech, which only impacts our 2015 results, our net sales this quarter would have been $493 million which represents an approximate 11% decline from the third quarter of 2014. Let me walk you through the factors contributing to our performance this quarter. Within our education segment, net sales grew $28 million or 5% year-over-year to $532 million due to the addition of EdTech, which contributed $82 million in the third quarter of 2015. This help to offset a $55 million decline in our existing domestic education business compared to the third quarter last year when we benefited from the strong Texas, Florida, and California adoptions. This quarter, we had key wins in the West Virginia and Tennessee adoptions along with continued wins in California math. And as Linda already stated, we captured an approximately 30% market share in the Texas social studies adoption. A 40% increase in professional development net sales also added to our results. Our trade publishing segment recorded $43 million in net sales, down $3 million or 7% year-over-year through third quarter on a tough comparable. Similar to the last quarter, our front list culinary titles including the Whole30, and The Real Paleo Diet Cookbook continue to perform well. In the third quarter, operating income of $103 million was $14 million or 12% lower year-over-year primarily due to higher cost of sales and selling and administrative expenses, partially offset by higher net sales. This quarter we had a $24 million increase in selling and administrative expenses, of which $29 million was attributed to the addition of the EdTech business. Excluding EdTech, legacy HMH selling and administrative expenses decreased year-over-year primarily due to lower sales commissions. Additionally, our cost of sales excluding the amortization were $15 million higher this quarter, primarily due to higher net sales, product mix, higher royalty costs, and technology costs support HMH’s digital products. Net income climbed over 22% year-over-year to $131 million in the third quarter compared to $107 million in the same period of 2014. Based on the $4 million increase was driven by the recognition of a $40 million tax benefit which was primarily related to the release of a liability that had been accrued for uncertain tax positions. Slightly offsetting this was a $6 million increase in interest expense related to the increase to our outstanding term loan, along with the previously mentioned factors impacting our operating income. Our adjusted EBITDA in the third quarter was $192 million, down $8 million or 4% year-over-year. This was mainly due to many of the same factors contributing to the increase to our cost of sales and selling and administrative expenses. Adjusted cash EBITDA was $298 million, which was $43 million or 13% lower than last year primarily due to lower deferred revenue from lower billings. As always, a detailed reconciliation of our GAAP results to adjusted EBITDA and adjusted cash EBITDA is included in the appendix to this presentation as well as in our earnings release. As of September 30, we have cash and cash equivalents and short-term investments of $524 million compared with $743 million as of December 31, 2014 as this year we funded the EdTech acquisition with a portion of our cash and have also actively return value to shareholders in the form of share repurchases. During the third quarter, we repurchased 2 million shares for approximately $48 million on the open market and through privately negotiated transactions, bringing the year-to-date total to approximately 240 million of shares repurchased. In the first three quarters of the year, we generated $163 million in cash from operating activities compared to $301 million in the first nine months of 2014. The primary driver of this win was the change in our deferred revenue along with higher interest. This change in deferred revenue reflects the smaller size of domestic education market this year, as well as the lower percentage of digital billings compared to 2014. Last year, digital billings were extraordinarily high due to the Texas math adoption, which was a significant contributor to our deferred revenue. Finally, Linda has already stated the reasons for our updated outlook for 2015. Our guidance is laid out in the earnings slide presentation is as follows. For the full-year 2015, we now expect our billings to be in the range of $1.530 billion to $1.580 billion and net sales to be in the range of $1.415 billion to $1.450 billion. In addition, we expect our content development spend for the full-year to be in the range of $110 million to $120 million. Our forecast for our addressable domestic market of $2.7 billion remains unchanged with new adoptions now forecasted to be approximately $690 million and open territory at approximately $1.3 billion. As part of our capital allocation framework, the aggregate $1 billion share repurchase program that Linda talked about, may be executed over a period extending through the end of 2018. Additionally, subject to market and other conditions, we plan to seek to increase our debt by an additional $250 million in new some or all of the net proceeds from the financing to fund a portion of our share repurchases under the share repurchase program. Looking ahead, we are working closely with customers, administrators, and school districts across the country to understand their needs for the coming year. By leveraging our extensive relationships, we are working to further enhance our visibility, anticipate demand and plan accordingly. [Audio break] confidence in our ability to continue generating free cash flow and growing our business is reflected in the increase of our share buyback program. With that, we will now open the line for Q&A. Operator?
- Operator:
- Thank you. [Operator Instructions] Our first question comes from the line of Peter Appert with Piper Jaffray. Your line is open.
- Peter Appert:
- Thanks good morning. So, Linda, I apologize for being so dense on this. But to the extent that the total market is constant relative to your expectations as you’re guiding down in terms of billings, that might imply some deterioration in share, but your commentary was pretty upbeat from a share perspective. So remind me what I am missing here?
- Linda Kay Zecher:
- Well, it’s a couple of things, Peter. I mean, number one; we had at the end of Q2 the open territory market was down about five points. And we saw at the beginning of Q3 into around late August, it was quite a swing back to where it is now up 1%, that's still lower than what we had anticipated. We had expected that to be up about 4%. But on top of that, the [audio break] are the areas in the open territory that they were not buying as much of the share for a couple of reasons. Number one, our Journeys program; we have a new Journeys program coming out in 2017. We have the new science program coming out in 2017, which will address the new science standards and we saw a lot of schools wanting to hold off to the science standards. And then the third thing was that we just did really well with GO Math last year and we expect it to do well this year, but the open territory market just wasn’t as robust in the areas where we are the strongest.
- Peter Appert:
- Got it. So which would all seem to imply that you would still be pretty optimistic in terms of the prospect for an acceleration in the rate of revenue growth in ’16 and I guess particularly ’17?
- Linda Kay Zecher:
- Yes, absolutely. In fact we haven't given guidance on the years yet. We will do that until the end of Q4, but we’re very optimistic in what we were seeing in the marketplace, in particular with science, we’re very enthusiastic about our science -- new science program that’s coming out that meets the national science standards. And we think that that’s going to be a real driver and we did see a lot of people waiting for that. The other thing that was kind of interesting is that we’re coming out in 2017 with our new digital social studies program. It was interesting the number of people that wanted to wait for that, because we’re in a presidential election year, so you might wait one more year. So the information is accurate, which really kind of also lead well into our new versioning approach that we’re going to in pricing.
- Peter Appert:
- Got it. And then if I could just sneak in one more thing, the -- in terms of the early selling efforts for California reading next year, can you provide any color on that?
- Linda Kay Zecher:
- I can’t really provide any color other than we’re very enthusiastic about our positioning in California. We are particularly excited now that we’ve our intervention solutions group and the fact that we can compete in all five categories. And then in the past as you know, we have had a fairly strong market share in reading in California and we did leave our sales team pretty much in place, so I think we're well positioned there. It's going to be an adoption over ’16 and ’17. If they do what Texas did, they will do more in ’16 and ’17, but we don't have any good insight into that right now.
- Operator:
- Thank you. Our next question comes from the line of Jeff Silber with BMO. Your line is open.
- Jeffrey Silber:
- Thanks so much. I know you're not giving official guidance yet for next year, but in terms of your expectations for the domestic market size, will it be flat, up, down, again, any color in terms of direction would be helpful?
- Linda Kay Zecher:
- Yes, I think next year we’d probably say the domestic market as we see it now is going to be flat to down -- down little bit. Somewhere between 2.6 to 2.7 and we said the market this year was 2.7. So we will be somewhere in that range. That’s our expectation right now.
- Jeffrey Silber:
- All right. That’s actually very helpful. I appreciate that. Can you also remind us in terms of your education business percentage of revenues or percentage of billings by specific subject areas at least the high level?
- Linda Kay Zecher:
- We actually don’t give guidance down to the product level. We don’t break out anything at this time other than our trade. But as you know we’re predominantly strong in math, science, and reading.
- Jeffrey Silber:
- Okay. And in looking at your fourth quarter implied billings and net sales guidance based on what you’re expecting for the full-year, it’s a pretty wide range. Can you talk to us about what the issues are, why it’s such a wide range?
- Linda Kay Zecher:
- Well, there is a coupe of things. I mean, it’s a wide range because we have a lot that happens in December. December is a pretty large month. But what we feel good about is if you look at how we’ve done historically in the Q4, and how we’re guiding, we’re well within our historical numbers. And so we’ve a lot of confidence in the number, but again since December it’s such a big month for us, we want to make sure that we leave some room for -- if something occurs that we’re not anticipating at this time.
- Jeffrey Silber:
- Okay, great. Thanks so much.
- Operator:
- Thank you. Our next question comes from the line of Bill Warmington with Wells Fargo. Your line is open.
- Bill Warmington:
- Good morning, everyone.
- Linda Kay Zecher:
- Good morning.
- Bill Warmington:
- So a question for you on the EdTech business came in at $82 million in revenue. How was that versus your expectations and how are you thinking about that for Q4 as well?
- Linda Kay Zecher:
- Well, at the end of Q2, I had stated that we were not as enthusiastic about the numbers in Q3 and the remainder of the year, because we thought there would be some impact on the shuffling of the sales teams, etcetera. And as I said earlier, we’re -- we were very pleased with the performance of the team and we believe that they’re going to be on target for what we believe is they’re going to do, if not exceed that. And we’ve not broken them out and we will not be doing that moving forward, because it’s very much tied into our overall education number. But again, I -- all I can say is that we feel very good about how they’re performing and we think that the opportunity for us to leverage the HMH sales force more broadly is going to be a real opportunity. In fact, we’ve already seen a couple of large deals that have occurred in areas where they had not had a presence that they’ve been able to work with our sales teams and that’s been really a highlight. I also believe that in California where we’re competing in all five areas and there is a lot of funding going into the intervention market. That opportunity for the two teams that are well established in California to be able to work together is going to be a very positive thing moving forward.
- Bill Warmington:
- And for my follow-up question I wanted to see if I could ask about free cash flow. Your thoughts on where you think free cash flow is likely to end up for 2015 and then to ask for some sort of a general range on 2016?
- Eric L. Shuman:
- Yes, as you know we don’t give guidance on free cash flow, but let me just say that the increase in our share repurchase program demonstrates our confidence in our long-term ability to generate free cash flow and was behind our reasoning to increase the share repurchase program.
- Bill Warmington:
- Thank you very much.
- Operator:
- Thank you. Our next question comes from the line of Andre Benjamin with Goldman Sachs. Your line is open.
- Linda Kay Zecher:
- Good morning, Andre.
- Andre Benjamin:
- Good morning. Two quick ones, the first one on the non-basal markets, if I just run the math on 44% share of a $3 billion market last year and then 40% to 41% or so of a smaller market this year, that would imply billings down more than what you’re guiding to. It seems like the biggest piece there is probably Scholastic EdTech, but some of it’s probably also the growth in the non-basal markets. So I just wonder if you can give a little more detail on how you’re thinking about growth in those markets relative to, I guess, some of the stuff that you laid out at the Analyst Day in terms of the opportunities there.
- Linda Kay Zecher:
- Well, I mean, as we -- as I said on the call, our consumer business is performing very well. And so through the third quarter our growth is over 12%, we felt pretty good about that with a three year compounded annual growth rate of about 85%. So all aspects of the consumer business are really trending up. The intervention or our ISG area that we from the acquisitions is also performing well. Professional development was up about 40% year-over-year in Q3, so we felt good about that. And then our overall international net sales were up about 7% year-over-year for Q3. So we feel pretty good about all of those areas. As far as the question on market share, again it really had to do with the product mix of what they were buying in Q2; Q3 versus it was stronger in product areas outside of math, science and reading where we’re strongest.
- Andre Benjamin:
- All right. That makes a lot of sense. And then, I guess, on the trade publishing side, you talked a lot about a lot of exciting new titles over the last couple of years, and that seems to be an area of focus. However, revenue is still kind of flat to slightly down, and margins have been coming down for the last couple of years implying the spend on the content, it’s going up. So I’m just wondering how you’re thinking about the balance of investment in great content versus the monetization of it and how we should be thinking about margins in that business going forward?
- Linda Kay Zecher:
- I think one of the things that I would say is, we will be talking a lot more about trade over the course of the next six months to nine months. But we’re very enthusiastic about some of our back list areas in trade and how we can leverage that more broadly in both our basal programs and also in our consumer business. And we’ve had several announcements of things that we’re doing with our consumer -- with our basal -- I’m sorry, with our trade product and consumer such as the work that we’re doing with Gossie & Gertie, what we’re going to be doing with some of our other assets, and we think there is a tremendous amount of crossover there. So you’re going to be hearing a lot more about that over the course of the next six to nine months as we talk more about consumer. We also are -- we believe that trade has a lot of upside especially with our strong back list. And we’ve some great front list programs that are coming out to, so and as you look at what we just did with Curious World and the announcement of Curious World, that’s going to tie in to trade a lot. And I don’t know if any of you realized this, but if you have young children, Curious World was actually the number one app in the children’s category in the iTunes store, and it’s going to very, very strong. And so that’s going to be another avenue for us to really leverage our trade. So we’re looking at trade in a much broader way moving forward than we have in the past.
- Andre Benjamin:
- Thank you.
- Operator:
- Thank you. Our next question comes from the line of Jason Bazinet with Citi. Your line is open.
- Jason Bazinet:
- Thanks. Maybe I can try and connect some of these dots that you laid out there. You mentioned that digital I think so far has represented a third of your sales, which was down versus last year but also said you thought it was poised for an inflection point. And then you suggested the addressable market would be probably down next year 2.6% to 2.7%. And I guess, my question is longer term if I take those two data points and think back to your Investor Day, do you think that the migration to digital is going to put more downward pressure on revenues such that the long-term guidance you sort of laid out or aspirations for 2019 are no longer achievable?
- Linda Kay Zecher:
- Actually quite the contrary, let me explain why digital is down this year. The reason its down is the comparison to last year with Texas where the Texas had a huge math adoption and 70% of that adoption was digital. So when you run that number in a large adoption against this year in the smaller market, smaller adoption area, especially in the areas that we were strong that’s what makes that comparison look odd, and that’s why you have to have context around it.
- Jason Bazinet:
- Yes.
- Linda Kay Zecher:
- As far as what we think digital is going to be a real driver for us. We actually think that’s one of the reasons that in open territory there is a wait for the new science standards and also a wait for our new 2017 social studies program, because those are going to be really strong digital program. But we’re getting a lot of uptake on our digital and we do think that our versioning strategy and our new pricing models that we’re going to be introducing are going to give us a lot of opportunity there. The other thing about digital which I’m particularly excited about is how we can leverage it in some of our adjacent markets and we can take it into markets that we’ve not in private and parochial in a bigger way, in adult education in a bigger way. So that gives us more opportunities there. So I think digital is on the uptake, and I think that was just a timing issue based on year-over-year comparisons with Texas.
- Jason Bazinet:
- But you don’t think that the -- yes.
- Linda Kay Zecher:
- Go ahead.
- Jason Bazinet:
- If you don’t think the uptake in digital is going to put downward -- meaningful downward pressure on the size of the addressable market, because what I’m struggling with is I get that the $3 billion market in 2014 was maybe an overshoot. I’m just a little surprised that we are sort of 2.7-ish this year with the arrow pointing down next year when the economy seems like it’s doing not great, but not horribly.
- Linda Kay Zecher:
- Well, I think it has to do with just what the adoptions are. I mean, in 2014 you had very large adoptions in Florida, Texas, and California math. And so this year there wasn’t as big of an adoption market, although it’s slightly larger than we had anticipated. And then next year in 2016, you don’t have as many adoptions and then they come back in 2017. Again, this is all public information which we track. What we do believe for next year is California reading is a two year adoption. So we’re not assuming that they will do a larger buy in ’16 and ’17. We’ve kind of looked at that as a 50-50 split over the two years. And if you go back historically and look at what Texas did, their adoption was for ’14 and ’15 and they did the majority of that math adoption in ’14. So that impacted this year’s market versus last year, made last year larger than we anticipated and the same thing could possibly happen next year, if California buys more in ’16. Now having said that, there is a tremendous amount of pent-up demand in California and the money is there, they have the opportunities to spend it on educational and structural materials. Whether they do that or not, its -- that can be up to the districts and we’ve been surveying them, but don’t have a good read on it as of yet. But then again you can’t budget to that. You have to budget to a split over the two years.
- Jason Bazinet:
- Makes sense. Okay. Thank you.
- Operator:
- Thank you. Our next question comes from the line of Ian Zaffino with Oppenheimer. Your line is open.
- Ian Zaffino:
- Hi. Great. Thank you. Glad to see the increase in the buyback here. Can I just ask a question as far as the impetus for that? Is there just the share price kind of where it is here is that what’s driving this? Is it the lack of M&A opportunities? Just walk us through your thinking on the increase. Thanks.
- Linda Kay Zecher:
- Well, I think its overall confidence in our long-term prospects as a Company. I mean, we feel very good about where we’re and we want to make sure that we’re growing shareholder value, we recognize that there are opportunities in the debt markets that are favorable, but most importantly we recognize that we -- the long-term prospects of the Company. I mean, I think that if you ask me personally I think the Company has a lot more value than it’s represented today in the market. And I believe that we want to kind of put our money where our math is, and we believe that there is a lot of opportunities.
- Eric L. Shuman:
- And even if there were a M&A opportunity that which we wish to execute on, we have the capacity to do that also.
- Ian Zaffino:
- Okay. And then a follow-up would be what type of leverage ratios are you now going to feel comfortable with? It looks like it’s going to be a little bit -- I guess, when you say in the $250 million that’s a little bit under a turn on an adjusted EBITDA basis. How much more can you take it up? What do you feel comfortable taking it too? And then also help us understand the cash balance and what you feel comfortable with as far as an operations standpoint.
- Eric L. Shuman:
- Well, I think we’ve been pretty consistent in that we need $300 million to $350 million from peak to trough depending upon the year, and then we do want some buffer cash. So I’d say the minimum we would want to have on our balance sheet at any point in time would probably be about 400 -- ending the year with about $400 million of cash. So that’s what I think we feel comfortable with. And in terms of leverage, we do have the capacity to go higher, should we desire too, but I think at the present time, taking it up by the $250 million was what we felt comfortable with, given the -- given our market and given what we think we’re going to be generating going forward.
- Linda Kay Zecher:
- Let me say also that when we did the buyback that we’ve done to date and the acquisition, a lot of that came right off of our -- out of our cash and so we feel confident, we were able to do that and so execute on this additional buyback program.
- Ian Zaffino:
- Okay. But I guess as far as the leverage ratio question though is because you’re also going to be generating free cash flow to pay down that debt. So you basically -- and then you have the business growth, you would effectively be deleveraging once you take up that $250 million. Is there kind of a plan to kind of keep it at a fixed leverage ratio, are you just going to work down that debt load?
- Linda Kay Zecher:
- I don’t think we’ve made a final decision yet on how we’re going to proceed from a leverage standpoint. We are looking at that. We just literally, the Board just agreed to do this additional buyback couple of days ago. And so we will be looking at that moving forward.
- Operator:
- [Operator Instructions] Our next question comes from the line of Denny Galindo with Morgan Stanley. Your line is open.
- Linda Kay Zecher:
- Good morning, Denny.
- Denny Galindo:
- Good morning. I’ve a question on kind of the predictability of the market. Your market size was somewhat stable during the year. Your guidance came down and it seems like the mix of subjects was the really hard part to predict. And then even after Q2 you felt confident at kind of maintaining your guidance. So just thinking about it for the future, when will -- when in the year do you really have a clear understanding of the mix? And it’s something about the market, maybe it’s digital transition making it just harder to predict year-to-year than it used to be exactly what that mix of subjects makeup is.
- Linda Kay Zecher:
- Well, a couple of things. I mean, we normally don’t give guidance until the end of Q3 for the simple reason that we have Q2 and Q3 are our biggest quarters. And that’s right in the timeframe of back to school. We pretty much know by the end of Q2, how we’ve done and we’ve done in the adoption and some of the open territory market, a lot of that comes in in August and early September. And then in early September that’s really when we see our residual business and our some of the other product residual stuff coming in. So it’s really hard to give a prediction at the end of Q2, and so that’s why we’ve always traditionally done it at the end of Q3. Having said that, this year because of the acquisition, we felt that we were in a position that if we didn’t give guidance at the end of Q2 based on what we saw at the time, we were going to get a lot of questions from all of you as to what was the updated guidance based on the acquisition. So we did the best we could at the time. Two things impacted our guidance at the end of Q2. We felt really good about what we were seeing in open territory. We were seeing a pretty strong swing from negative 5 at the end of first half of the year to plus one and we were seeing that trend, and so we thought very good about that. It just didn’t go as far as we thought. And then the second was the supplemental market. A lot of -- its one of the things that impacts that is the move to digital. And we just didn’t see as strong a supplemental as we thought we were, so that was the second thing. And then of course the mix in product.
- Denny Galindo:
- Okay. That’s helpful color. And then taking a step back the mix of products where you were competing versus where you weren’t competing was kind of important this year. You didn’t compete in all of social studies in Texas, so I guess that part wasn’t necessarily included in your share. And then today you announced a lower plate spend, so is there -- are you deciding with the lower plate spend to walk away from certain segments of the market in maybe ’16 and ’17 and any more color on which areas you think you might pull back on in those areas?
- Linda Kay Zecher:
- No. No, quite the contrary. We are not decreasing our investments at all. In fact, we have increased our investments in some of our plate spend around consumer where we think there are lot of opportunities. And then also we’re continuing our strong plate spend in the basal markets. Really the only thing that really cause our plate spend to come down this year is some just efficiencies. We -- with the acquisition we had some efficiencies and some things that from a platform perspective where we think we can leverage platforms across that also created efficiencies. So that’s the major reason for the change in plate spend for this year. And we didn’t really have good visibility into that until after we actually got them on board and we’re able to start valuating how we could leverage content across teams.
- Denny Galindo:
- Okay. And lastly on that just along these same lines the mix of subjects, the outlook for the mix of subject in say ’16 and ’17, is it a better mix of subjects next year? It sounds like ’16 definitely is with more science come -- I’m sorry ’17 with more science coming on, but would you say the mix would improve both years?
- Linda Kay Zecher:
- Significantly. In ’16 and ’17, the mix is better.
- Denny Galindo:
- Okay. That's it for me. Thanks.
- Operator:
- Thank you. Our last question comes from the line of Drew Crum with Stifel. Your line is open.
- Linda Kay Zecher:
- Hi, Drew.
- Drew Crum:
- Hi. Good morning, everyone. So I wonder if you guys could quantify your market share excluding the EdTech asset if you can do that. And then separately just kind of high level, Linda as you look to 2016 and beyond, at what rate should the open territory states grow? Going into the year you thought mid-single digits was the right run rate, and now you are looking at low single-digit. Is that the right trajectory going forward, or can the open territories accelerate? Thanks.
- Eric L. Shuman:
- Yes, we anticipate open territory growing into the future at low single-digits. And in terms of breaking our market share between EdTech and the HMH legacy business, we consider this to be one business now. And we will be providing market share data from the entire business.
- Linda Kay Zecher:
- At the end of the year.
- Drew Crum:
- Okay. Thanks guys.
- Operator:
- Thank you. This does conclude today’s Q&A session. I’d like to turn the call back to Linda Zecher for closing remarks.
- Linda Kay Zecher:
- Okay. So first of all, before I close out the call, I’m sure many of you’ve heard about HMH in the press recently, so let me state first that HMH holds itself to the highest ethical standards, and we take allegations and misconduct very seriously. The press reports regarding our association with Barbara Byrd Bennett referred to a 2009 contract, which predates the current management team, and it is our policy not to comment on matters involving law enforcement, but to cooperate fully when asked. So with that, I’d like -- I appreciate everyone taking time to join us on the call today and look forward to seeing many of you at the Wells Fargo T&T Conference next week. If you need additional information, please contact Rima and our Investor Relations Department. So with that, again thank you and operator this ends the call today.
- Operator:
- Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program. You may all disconnect. Everyone have a great day.
Other Houghton Mifflin Harcourt Company earnings call transcripts:
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