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Houghton Mifflin Harcourt Co  (NASDAQ:HMHC)
Q4 2018 Earnings Conference Call
Feb. 28, 2019, 8:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day ladies and gentlemen, and welcome to the Houghton Mifflin Harcourt's Schedules Conference Fourth Quarter and Full Year 2018 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct the question-and-answer session, and instructions will be given at that time. (Operator Instructions) As a reminder, today's conference may be recorded.

I would now like to turn the call over to Mr. Brian Shipman, Senior Vice President of Investor Relations. Sir, you may begin.

Brian Shipman -- Senior Vice President, Investor Relations

Thank you Chelsea and good morning, everyone. Before we begin, I would like to point out that the slides referred to on today's call can be found on the Investor Relations section of our website at hmhco.com. A replay of today's call will be available until March 10th, 2019, and the webcast will be available on our website for one year. Our 10-K was also filed earlier this morning along with our fourth quarter and full year 2018 earnings release.

Before we discuss our results, I encourage you to review the cautionary statement on Slide 2, which explains the risks of forward-looking statements and the use of non-GAAP financial measures in the slide presentation and on today's call. Please also refer to our most recent Form 10-K filed this morning for a discussion of factors that could cause actual results to differ materially from these forward-looking statements. In addition, please refer to the appendix of the slide presentation for reconciliations of these non-GAAP measures to the most directly comparable GAAP measures.

After our prepared remarks, we will open the call to questions. During the Q&A, please limit yourself to one question, plus one follow-up. You may get back into the queue if you have additional questions.

This morning, Jack Lynch, Houghton Mifflin Harcourt's President and Chief Executive Officer, and Joe Abbott, HMH's Chief Financial Officer will provide a Company update as well as an overview of the Company's fourth quarter and full year 2018 results.

Now, I'll turn the call over to Jack.

John "Jack" J. Lynch -- President, Chief Executive Officer, and Director, HMH

Thank you, Brian and good morning, everyone. This morning I plan to discuss our Q4 and full year results, and then highlight a few of our achievements in 2018, including the progress we made on the HMH 2020 strategy. Then I'll turn the call over to Joe, who'll offer more insight to our fourth quarter and full year results and provide you with our outlook for 2019.

First, the highlights from 2018. For the second year in a row we delivered on our guidance for the full year, with billings growth of 1% in Q4, and modest growth to $1.315 billion for the full year. We also successfully completed our planned restructuring, reduced our cost base, and expanded our adjusted EBITDA margin by 50 basis points to 14.5% in 2018. We achieved these solid results not only while operating in a lean year for our industry, but also while successfully executing on our 2020 strategy, advancing the transformation of our Company from K-12 publisher to a learning company. In executing that strategy, we drove strong growth in extensions billings, improved free cash flow, and we've taken several steps to optimize our portfolio by sharpening our focus on the businesses that are essential to our strategy, and will drive our long-term growth.

As a part of our portfolio optimization we announced in Q3, our strategic decision to divest Riverside clinical and standardized testing portfolio to Alpine Investors for $140 million. Last month we took additional portfolio actions, including the acquisition of Waggle, a web-based adaptive learning platform, and entering in an exclusive advance placement partnership with Wiley. Both represent our continued drive toward enhancing and extending our Core Solutions business, while also furthering our efforts to develop seamless integrated solutions that enable more powerful and personalized teaching and learning for our customers.

Looking ahead, in 2019, we expect double-digit growth in billings and strong free cash flow generation, driven by an upturn in the adoption cycle, and continued growth in extensions.

Now I'll take you through the financial highlights from 2018, while Joe will go deeper into our Q4 and full year results in a few minutes. In our Education segment, we outperformed our addressable AAP market for the full year. The addressable AAP market declined 3% to around $2.4 billion in 2018, while our Education segment declined only 2%. Growth in extensions was 7%, which was driven by strong performance in both Heinemann and Professional Services. The strength in extensions was offset by a decline in our Core Solutions business of 10%. The decline in Core Solutions was driven by a new adoption calendar as well as softer demand for older programs in open territory states, which are winding down ahead of the roll out of new programs in 2019.

Now turning to Trade. Our Trade segment outperformed the long-term market growth rate again in 2018, with billings up 11% for the full year. The increase in Trade Billings was attributable to a new agreement renewing the classic George Orwell backlist titles 1984 and Animal Farm. We also relaunched the iconic Carmen Sandiego brand in conjunction with a new Netflix original series and a middle grade book series. The strong performance reaffirms our confidence that our trade strategy is working with our focus on building and leveraging strong brands and employing a multimedia platform approach.

Now I'd like to take a moment to talk about the progress we made in 2018 on the HMH 2020 strategy. You'll recall we shared the strategy with you last year, outlining the roadmap for our transformation to a learning company. We are executing on the three strategic pillars that we believe will enable us to generate attractive free cash flow grow throughout our business cycle and over the long-term. Some achievements in 2018 that show the momentum we are making within each pillar you'll see on the slide. On the first pillar, to enhance and extend the core, we released new Next Generation programs in three major subject areas. We also achieved key adoption milestones with approvals in both California and Texas for Science and English Language Arts respectively. We optimize our portfolio for long-term growth, divesting Riverside and expanding our Supplemental and Intervention Solutions portfolio, with key acquisitions and partnerships.

On the second pillar, to develop integrated solutions, we received positive early feedback from integrated solution pilots in select markets. We also experienced growth in services, driven by tighter integration of services with our core offerings. And we launched our blended services offering, allowing us to deliver high-value coaching and professional development, both face-to-face and online.

Finally to achieve operational excellence, we continue to become a linear more efficient organization, completing our restructuring program in 2018, streamlining our product portfolio by divesting and retiring products and applying Lean Six Sigma across our operations. Given the progress we've made in executing against the HMH 2020 strategy, acquiring key assets and capabilities and partnering for others, we are shifting our capital deployment priorities to place a greater emphasis on deleveraging our balance sheet.

Now before turning the call over to Joe, who will go through the specifics of our operating results and our outlook, I would like to address two other important topics. First, the recently announced changes with respect to the Florida adoption calendar, and second I'd like to discuss some changes we are making to the guidance we will provide. Regarding Florida, a few weeks ago Governor DeSantis issued an executive order to replace its state's current educational standards. As a result, just two weeks ago, the Florida Board of Education decided to delay its mass adoption, which was in progress, and it's English Language Arts adoption originally scheduled for implementation next year. These decisions were highly unusual with an adoption process already well under way and were unexpected by our customers. Following these events, we began reaching out to existing customers in Florida to help them manage through this disruption, and as a result, we anticipate the renewals of our existing programs this year will help HMH mitigate some of the near-term billings impact from the delayed adoptions.

As you know, HMH has a large installed customer base, using our GO Math! program in Florida, and we remain committed to partnering with our customers to provide flexibility and the necessary support for them to continue educating the children of Florida. Despite the news in Florida, we continue to expect strong billings growth from our Core Solutions in 2019, driven by $900 million to $1 billion in new state adoption opportunities as well as growth in open territory states.

Turning to our outlook for 2019, and as we discussed on our Q3 earnings call, as our transformation progresses, we increasingly recognize limitations in utility of the AAP market measurement as an indicator of our Education segment performance. The AAP measures a subset of our addressable market, defined as performance of a narrow set of six AAP reporting companies versus the larger $11 billion K-12 instructional materials market where many more companies compete for share. In the coming years, we expect to see an increasing portion of our growth coming from areas that fall outside of the AAP measurement, but within the larger $11 billion US instructional materials market, as well as international opportunities that we consider addressable. Therefore we will no longer plan to guide to an estimate of the AAP market size nor do we plan to guide to a market share measurement. We will however provide guidance for Core Solutions Extensions And Trade Billings growth, and we will indicate our expectations for the coming new adoption opportunities. Measurements that we believe will more accurately reflect the expanded addressable opportunities we see as a learning company.

With that, I'll turn the call over to Joe, who'll provide a deeper dive into our outlook for the year ahead and our 2018 results.

Joseph P. Abbott -- Chief Financial Officer

Thank you Jack, and good morning, everyone. Thanks for joining us on the call. To echo what Jack said earlier, our results for the full year 2018 and fourth quarter were a strong testament to the progress we're making on our HMH 2020 strategy. It's important to note that my discussion of our results this morning will be on a continuing operations basis. Thus, the results and variances I discuss will assume we did not own Riverside in either 2017 or 2018.

In 2018 we delivered on our financial guidance for the second consecutive year. $1.315 billion of billings was a slight increase over 2017. Net sales were $1.322 billion, which was up the upper end of our guidance range. Content development spend for 2018 was $123 million, and total CapEx was $177 million, both metrics were in the lower end of our guidance range for the year. We are pleased with these results for 2018, especially the performance of our Education segment, inline with the smaller AAP addressable market opportunity than we had anticipated at the beginning of the year. The addressable AAP market measurement for 2018 was $2.4 billion, down 3% compared to 2017. And yet due to growth in the parts of our Education offerings that are not captured by the AAP, our Education segment was down only 2%. As a result, we ended 2018 with 37% share of the addressable AAP market.

Before I talk in depth about our 2018 financials, I'd like to share an update on how we're performing against our long term billings growth framework and mix of billings. As a recap, we expect the long-term average growth of Core Solutions to be in the low-single digits, but we expect annual growth in any given year will perform generally in line with the addressable market. In 2018, Core Solutions Billings declined 10%, and contributed 40% of our consolidated billings mix, primarily driven by lower sales in open territory and adoption states. We expect extensions, which consists of Heinemann, Intervention, Supplemental and Professional Services, to grow in the low to mid-single-digits on average consistent with our long-term market growth. In 2018, extensions billings grew above that long-term outlook at 7% and contributed 45% of our consolidated billings mix, driven by strong performances, both in Heinemann and Professional Services. We expect Trade to deliver long-term average growth in the low-single digits, consistent with market growth rates. In 2018 Trade Billings grew 11%, outperforming the market for the second consecutive year. Trade contributed 15% of our consolidated billings mix in 2018.

Now turning to our 2018 cost structure. This is an area where we are executing and making great progress, consistent with our strategic focus on operational excellence. In 2018 we reduced our adjusted fixed costs to $617 million or 47% of billings, down from $628 million in 2017, driven by the full-year run rate affect of actions we took in 2017, and the remaining actions we took in 2018 under our 2017 restructuring plan, partially offset by higher incentive compensation and inflationary pressures in our labor costs. Our 2017 restructuring plan delivered $72 million of savings in fixed, variable and capitalized costs, relative to our 2016 normalized cost base, in line with our original estimates of $70 million to $80 million of savings. Adjusted variable costs as a percentage of billings, excluding noncash and nonrecurring items, were 39% in 2018, on par with 2017.

Moving on to our fourth quarter and full year 2018 results. Net sales for the quarter were $249 million, up 7% from $234 million in the fourth quarter of last year. Net sales for the full year 2018 were $1.322 billion, a slight decrease compared to net sales in 2017. Our billings, which we define as net sales plus the change in deferred revenue, grew 1% in the fourth quarter to $207 million. For the full year, billings were up slightly to $1.315 billion in 2018, driven by our Trade Publishing segment, which increased $20 million or 11%, primarily attributable to licensing income from our Orwell titles in Carmen Sandiego. Partially offsetting the growth in trade was a decrease of $19 million or 2% in our Education segment, driven by lower Core Solutions billings, which decreased by $59 million due to lower sales in both open territory and adoption states. Partially offsetting the decrease in Core Solutions billing was a $40 million increase in extensions billings, driven in part by strength in Heinemann and services offerings.

For the full year 2018, our net loss from continuing operations was $137 million, which changed unfavorably from the $120 million loss reported in 2017. Adjusted EBITDA for 2018 was $192 million, an improvement of $7 million despite the decline in net sales, primarily due to savings related to our 2017 restructuring plan. Free cash flow, which we define as cash from operations less capital expenditures, was a usage of $73 million compared to a usage of $82 million for the same period in 2017. This year-over-year improvement, despite comparable billings performance was driven by lower capital expenditures. Savings from our 2017 restructuring plan offset the increase in working capital as we built inventory ahead of the large opportunities for adoption in 2019. We finished 2018 with $303 million of cash, cash equivalents and short-term investments compared to $235 million at year-end 2017. As a reminder, we closed the Riverside transaction, adding $135 million in net proceeds to our cash balance during the fourth quarter.

Now turning to 2019. By way of context I'll first share what we anticipate in the market in terms of new state adoption spending before providing our financial guidance. As Jack mentioned earlier, we no longer plan to track AAP market size and shares key performance indicators going forward. This is because we expect an increasing portion of our billings to come from areas that fall outside of the AAP measurement, and within the larger $11 billion U.S. instructional materials market, as well as international opportunities that we consider addressable. This expectation as well as the out performance of our Education segment relative to the AAP market highlights the decreasing utility on the AAP as a reference point of our financial performance. Instead, in order to provide you with a more representative picture of our annual billings growth expectations, we will indicate our outlook for upcoming stated adoption opportunities. The timing and composition of new adoptions is the most significant factor impacting year-over-year changes in Core Solutions billings, giving rise to the cyclical pattern seen in our historical results. Over the next several years, we anticipate an elevated new adoption market opportunity, and we believe HMH is well positioned to intercept the increased spending in the industry. In 2019, we expect new adoption spending to more than double to be between $900 million and $1 billion, up from $400 million in 2018. We expect 2020 new adoption spending will be between $700 million to $800 million. And in 2021, we expect new adoption spending to be between $750 million and $850 million.

Florida's postponement of math and ELA adoptions has smoothed out our expectations for new adoption market size in the next few years with 2019 and 2020 opportunities in that state moving out to 2021 and 2022. In the key adoption states of California and Texas, we have the needed approvals to sell our Science, Reading and Literature programs, and that selling activity is under way. We will also begin selling the national versions of our Next Generation Reading, Literature and Math programs in open territory states. These subjects have historically represented about 80% of the addressable open territory market opportunity. In open territory states, we expect to see a resumption of growth in 2019 as many districts reach the beginning of a replacement cycle for the common core aligned program they purchased back in 2013 and 2014.

And with this market backdrop, I'll now turn to our expected financial performance for 2019. Given the expansion in new adoption opportunities this year, we were assuming a Core Solutions billing growth rate, between 30% and 45% in 2019. We are anticipating the bulk of this growth to occur during our second and third quarters of the year, aligned with our typical selling season. Additionally, as in past large new adoption years, residual billings opportunities are expected to be lower in the first quarter, ahead of the upturn in new adoption orders later in the year. Our assumption for extensions billings growth is consistent with our long-term billings growth framework in the low to mid-single-digit range. And, we're assuming that Trade Billings growth will be down slightly in 2019, given the strong growth from that segment in the last couple of years. These assumptions lead us to expect total company billings to be within a range of $1.49 billion to $1.59 billion for 2019. We anticipate strong positive free cash flow at all points of our billings guidance range, subject to the following additional guidance and assumptions. First, we anticipate adjusted variable costs as a percentage of billings to be comparable with 2018 at approximately 39% billings. We expect our adjusted fixed costs, which were $617 million in 2018, to increase by approximately $20 million due to higher incentive compensation, driven by expected improved performance relative to our targets for the coming year, as well as infrastructure investments supporting expected extensions growth. We expect content development spend in a range of $100 million to $120 million, and we expect total capital expenditures inclusive of content development spending to be in the range of $150 million to $170 million.

Over the last few years, annual changes in working capital have had a relatively minor impact on our free cash flow generation. In 2019, we're anticipating changes in working capital to be an approximately $20 million use of cash as we build inventory to support large adoption opportunities in 2020. And finally, as you'll recall from prior discussions, the interest rate on our debt (inaudible) LIBOR plus 300 basis points. Thus, we expect our interest expense to fluctuate with interest changes and interest rates. However, you should note that approximately half of our interest rate exposure is hedged, which acts to mute the impact of fluctuations to a degree.

In conclusion, given our outlook for the year, coupled with our year-to-date results, we are entering 2019 with positive signs of the effectiveness of our long-term strategy to enhance and extend the core, deliver integrated solutions and achieve operational excellence. We remain focused on execution, so that we are well positioned to successfully intercept the significant upcoming adoption opportunities as well as grow our extensions portfolio.

And with that, I'd like to turn the call back over to Jack to sum up what you've heard today before we take your questions. Jack?

John "Jack" J. Lynch -- President, Chief Executive Officer, and Director, HMH

Thank you, Joe. Now before we take your questions, I'd like to highlight a few key points that we covered this morning.

In 2018 we delivered results that were in line with our guidance for the second year in a row. The achievements we made toward our HMH 2020 strategy are proof points that the strategy is working, investing in our core as well as the extensions to that business, developing integrated solutions for our customers, and becoming a leaner more efficient organization. These strategic areas of focus are the foundation that will drive our long-term growth, particularly as we entered 2019 for a renewed position of strength. New adoption opportunities in 2019 and 2020 even without Florida math this year are significantly larger than what the market generated last year. And as you heard from Joe, we anticipate strong growth in our Core Solutions business as well as continued growth in our extensions portfolio.

And finally we expect that our new Next Generation Core programs combined with growth in our extensions portfolio and our increased ability to offer integrated solutions will continue to improve the free cash flow generation fundamentals of HMH well into the future.

With that, we would now be pleased to take any questions you may have. Operator?

Questions and Answers:

Operator

Thank you. (Operator Instructions) And our first question will come from the line of Jeff Goldstein with Morgan Stanley. Your line is open.

Jeff Goldstein -- Morgan Stanley -- Analyst

Hey guys, thanks for taking my questions.

John "Jack" J. Lynch -- President, Chief Executive Officer, and Director, HMH

Good morning, Jeff.

Jeff Goldstein -- Morgan Stanley -- Analyst

Based on the some of the added detail you provided an Slide 18 regarding your '19 outlook, I'm backing into a free cash flow as submitted and kind of the $75 million range based on your guidance. So one, is that how you're thinking about it as well? And two, what can drive your results higher or lower than this current free cash flow estimate?

Joseph P. Abbott -- Chief Financial Officer

Hey Jeff, great question. Thanks. Yeah, we provided you the assumptions that allow you to model that free cash flow. I think as you're kind of going through your model and building that up, the number that you would come up with would be pretty consistent with somewhere in the midpoint of that billings guidance range that we provided you. And so really to answer your question about what could drive performance higher on that free cash flow metrics certainly improved billings performance. As you know we've got the tremendous amount of operating leverage in this business. As we generate more billings, we would have the opportunity to generate more free cash flow.

Jeff Goldstein -- Morgan Stanley -- Analyst

Got it. And then on the Florida suspension, what kind of expense impact does this have? Meaning, where there investments done with Florida specifically in mind or because the program you were selling I think it was HMH into Math is a national program is the expense impact just immaterial? How should we be thinking about that?

John "Jack" J. Lynch -- President, Chief Executive Officer, and Director, HMH

Well, look, the majority of the investments that we make for the math program really are used to lay the foundation for the national program, the national addition of the program. There is some customization work that is done for Florida state standards. Generally though we've got a cost base really to address Florida in the form of sales force there, and there's an awful lot of opportunity there for us to continue to generate or return in all of our investment in Florida as we look to extend existing relationships with our customers with our very large installed base of customers using our GO Math! program.

Jeff Goldstein -- Morgan Stanley -- Analyst

All right. Thanks for the color.

Operator

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

Peter Appert -- Piper Jaffray -- Analyst

Thanks. Good morning. So Jack I'm interested in what needs to happen to get the extension business to grow faster than the low to mid-single-digit growth target? And given your enthusiasm for it, it just doesn't seem like that aggressive a target?

John "Jack" J. Lynch -- President, Chief Executive Officer, and Director, HMH

Yeah. Thank you, Peter. As you've seen, we've been kind of outperforming that category estimate for long-term guidance. Last year came in at 7%, so at the higher end -- well beyond the higher end and mid-single digit growth. And we continue to feel very good about that portfolio. That growth was largely driven by our services as well as Heinemann, and in the case of services, that really cuts to our second pillar of our strategy integrated solutions combining services with our products to help teachers improve student outcomes. So we feel really good about the growth path we're on for extensions. And as you know, as we noted in our comments, we forged a partnership with Wiley, we acquired Waggle, and we went ahead, and earlier this year forged a partnership with Writable. So made some really good investments in extensions and we expect to continue to see good growth in that portion of our business.

Peter Appert -- Piper Jaffray -- Analyst

Okay. And then in violation of the shipment rule, I'm going to ask two follow-up questions. One is just a clarification. Jack, did you say -- I think I heard you say debt reduction is the more important use of free cash flow. I just want a clarification on that if that's impact (ph) what you said, and does that imply sort of a changed attitude toward M&A and expansion of the extensions business? And then second, any color on early success in terms of the California Science or the Texas reading adoptions?

John "Jack" J. Lynch -- President, Chief Executive Officer, and Director, HMH

Yeah. So Peter just to clarify, the question was about capital allocation from -- a movement from extensions to deleveraging, is that the question?

Peter Appert -- Piper Jaffray -- Analyst

Yes.

John "Jack" J. Lynch -- President, Chief Executive Officer, and Director, HMH

Yeah. So as we've stated previously, we're very focused on growing the extensions business on allocating capital to extensions, because it is -- and as we evidenced this past year, it's a faster growing business, and it's also a higher margin business. And so we've made some pretty significant investments through partnerships, and most recently in M&A four extensions. We'll continue to make organic investments in that extensions business to continue to drive the growth rate of extensions. But what we said earlier is that, we want to assign a priority to deleveraging the balance sheet. And the reason we want to focus on that is, we want to have access to debt markets at any point in our business cycle. And arguably if you look at the last couple of years, we just -- we didn't have access to the market. So it's now a capital allocation priority to deleverage.

And then I think the second question, Peter, was on California Science. And as you know, it's not our practice to comment on our performance of adoptions under way. We feel very good about our Next Generation Science program in California, and look forward to talking about the results once the adoption is complete.

Peter Appert -- Piper Jaffray -- Analyst

Okay. Thank you.

Operator

Thank you. (Operator Instructions) And our next question comes from the line of George Tong with Goldman Sachs. Your line is open.

Blake Johnson -- Goldman Sachs -- Analyst

Good morning. This is Blake Johnson for George. Thanks for taking the question. You mentioned that you expect the Core segment to benefit from new state adoption opportunities in growth in open territory states. Can you quantify your expectations here relative to the potential impact of the Executive Order in Florida?

John "Jack" J. Lynch -- President, Chief Executive Officer, and Director, HMH

Do you want to take that one?

Joseph P. Abbott -- Chief Financial Officer

Yeah. Well we've got the -- Blake, we have factored in the movement in the delays associated with that in our guidance range on billings. I think it's important to note is that, even with the move there in Florida, you're still seeing the new adoption opportunity that's more than doubling in 2019 relative to where we were in 2018. And as we pointed out in some of our base assumptions behind our guidance range, we are anticipating Core Solutions billings to grow this year by about 30% to 45%.

Blake Johnson -- Goldman Sachs -- Analyst

Great. Thank you.

Operator

Thank you. And this concludes today's Q&A session. I would now like to turn the call back to Jack Lynch, Chief Executive Officer for closing remarks.

John "Jack" J. Lynch -- President, Chief Executive Officer, and Director, HMH

Thank you everyone for joining us on today's call. And we look forward to updating you on our next earnings call in May. Have a great day. Thank you.

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.

Duration: 34 minutes

Call participants:

Brian Shipman -- Senior Vice President, Investor Relations

John "Jack" J. Lynch -- President, Chief Executive Officer, and Director, HMH

Joseph P. Abbott -- Chief Financial Officer

Jeff Goldstein -- Morgan Stanley -- Analyst

Peter Appert -- Piper Jaffray -- Analyst

Blake Johnson -- Goldman Sachs -- Analyst

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