Houghton Mifflin Harcourt (HMHC) Q1 2019 Earnings Call Transcript

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Houghton Mifflin Harcourt (HMHC)
Q1 2019 Earnings Call
May. 09, 2019, 8:30 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good day, ladies and gentleman, and welcome to the Houghton Mifflin Harcourt first-quarter earnings conference call. [Operating instructions] As a reminder this conference may be recorded. I would now like to turn the conference over to Brian Shipman, senior vice president, investor relations. You may begin.

Brian Shipman -- Senior Vice President, Investor Relations

Thank you, Sonya, 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 May 19, 2019, and the webcast will be available on our website for one year. Our 10-Q was also filed earlier this morning, along with our first-quarter 2019 earnings press release.

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

[Operator instructions] 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 first-quarter 2019 results. Now I'll turn the call over to Jack.

Jack Lynch -- President and Chief Executive Officer

Thank you, Brian, and good morning, everyone. Today I'll share with you the results for our first quarter, and I'll then pass it over to Joe, who will provide you with the financial highlights. We are pleased to report that we have good momentum as we entered this year. We are executing on our HMH 2020 strategy and seeing the results as we successfully advance our transformation from K-12 publisher to learning company.

Our billings for the first quarter were in line with our expectations and down year over year by 6%. Remember that in large, new adoption years like this one, residual billings are generally lower in the first quarter, ahead of an upturn in new adoption orders later in the year. We continue to expect double-digit growth in billings in 2019, and as you know, our sales are typically weighted significantly toward the second and third quarters of the year. In Texas, we are extremely pleased with our sales performance for our next-generation ELA K-8 program.

In a short period of time, this product has performed strongly with HMH taking a leading share with over two-thirds of the decisions made in Texas. This is a great example of the momentum we are building. Importantly, our Texas English Language Arts program, the first comprehensive new program our new management team has released to the market under our HMH 2020 strategy. The program is part of our next generation Into Learning series, and we're thrilled about the feedback we're hearing out in the field so far, and our sales results are reflecting this enthusiasm.

The process in California is also moving along well, but it is still very early. We received state-level approval for our next-generation science program back in November, and we feel very good about the program and look forward to sharing the results later in the year when school districts in California begin making decisions. As we successfully execute on year two of the HMH 2020 strategy, the ELA program's success year to date in the marketplace is a clear proof point that our strategy is working. Our investments in next-generation curricula and effective personalized solutions for students and teachers are paying off and creating value for our customers and in turn, our shareholders.

In Q1, we also continue to execute on the other key tenets of our HMH 2020 strategy. In March, you probably saw that we announced an exclusive partnership with Amira Learning. Amira is the creator of the first AI-based intelligent reading assistant that listens to, assesses and tutors learners. Our partnership is just another example of our commitment to bringing next-generation solutions to the classroom that enable better learning and more effective teaching.

We also continue to expand integrated solutions offerings in two additional states, and we have added subscription offerings for several products within the extensions portion of our business. These are just a few achievements that represent how we're driving our strategy forward, steps that are positioning core solutions and extensions for long-term growth and paving the way for our learning company transformation. Taken together, these actions represent our continued focus on generating attractive free cash flow. Our focus on free cash flow growth will position us well capitalized on the elevated adoption opportunities we see in 2020 and beyond.

In parallel, it will also enable us to sustain and grow our company through the adoption cycle as we shift our billings mix toward extensions and focus on operational excellence to improve profitability and free cash flow for the long term. You'll hear more about this from Joe today. Given our performance year to date and in light of the strong recent performance in Texas, today we are reaffirming our guidance for the full-year 2019. Now on to the highlights of our results for the first quarter.

As we expected, our overall Education billings were down $13 million driven by a decline in core solutions and slightly offset by growth in extensions. Core solutions billings were down $15 million for the quarter due to anticipated lower residual billings in advance of growth in our new adoption market as previously mentioned. We saw a $2 million increase in our extensions billings in the first quarter of 2019 driven by growth in Heinemann and offset by supplemental professional services. HMH Books & Media, formally known as Trade, continued to see strong growth in billings, up 8% in the first quarter compared to Q1 2018.

We continue to see the benefits of our HMH Books & Media strategy, which focuses on building and leveraging strong brands and employing a multimedia approach. We're also pleased with the licensing income associated with the delivery of season two of the animated series Carmen Sandiego to Netflix. I've spoken already about the key adoptions we have in flight. Now I'd like to update you on how HMH is positioned for the evolving education marketplace and for the upcoming 2020 adoption opportunities.

HMH had many products entering the market this year that will fuel growing momentum in the future. You already know that we have brand-new Into Learning programs, which are doing well in the large new adoption this year. And the national versions of these programs will be positioned to intercept the increased open territory demand that we anticipate. HMH also now has a new advanced placement exclusive partnership with Wiley.

Having AP products increases attractness of our entire grade six to 12 portfolio by offering full articulation of secondary titles. We've also added a suite of digital supplemental solutions through our acquisition of Waggle and our recent partnerships with Amira and Writable. HMH was already the leading provider in both core solutions and extensions, and these transactions make us that much stronger and better positioned for the future. As you know, we anticipate a healthy market environment with 2020 new adoptions spending expected to be between $700 million to $800 million and $750 million and $850 million in 2021.

As we continue to implement our strategy and build great new products that lay the foundation for long-term growth, we believe HMH is well positioned to capitalize on this increased industry spending. We have a strong portfolio of next-generation programs and offerings that clearly differentiates us, ensuring we will gain share from our competitors and continue to meet the fast-evolving needs of today's students and teachers. Among others, the largest adoption opportunities we see in 2020 is the Texas literature for grades 9-12, which we submitted to the Board of Education in April. We're also expecting the California Science year two market opportunity to increase over 2019, and as I mentioned earlier, we already have the needed approval in hand.

With that, I'll turn the call over to Joe, who will provide a deeper dive into our first-quarter results. Joe?

Joe Abbott -- Chief Financial Officer

Thank you, Jack, and good morning, everyone. Thanks for joining us on the call. To echo what Jack said earlier, we have good momentum and are continuing to see the benefits of our HMH 2020 strategy. Here are the financial highlights of the first quarter of 2019.

Our consolidated net sales were $195 million in the first quarter, down 3% year over year. Billings, which we define as net sales adjusted for the net change in deferred revenue, were down 6% in the first quarter to $155 million, which is in line with our expectations as residuals have tapered off ahead of the upturn in new adoption orders. Our first-quarter billings were also impacted by the timing of a recurring international distributor order that occurred in the first quarter of last year but we expect to occur in the second quarter of 2019. I'll discuss additional segment-level drivers of our billings in a moment.

Net loss from continuing operations for the first quarter was $117 million, an unfavorable change of 11% compared to the first quarter of 2018. Adjusted EBITDA for the first quarter declined $3 million to a loss of $27 million due to the decline in net sales. Our cash flow year to date was a usage of $212 million, compared to a usage of $135 million during the same period last year. The increase in usage of cash in the first quarter was due to higher net working capital associated with inventory purchases ahead of the new adoption orders we anticipate in later quarters of the year as well the timing of collections.

Total capital expenditures were $36 million for the quarter, compared to $36 million in the same period last year. Moving on to our year-to-date segment highlights. Education billings were down 10% to $115 million in the first quarter driven by declines in core solutions slightly offset by growth in extensions. Core solutions billings were down $15 million for the quarter.

Our customers typically purchase less residual material in the period just prior to new core curriculum purchases, and we're seeing that practice continue this year with the large new adoption opportunity in Texas. We also anticipate increased demand in the [Audio gap] Our extensions offerings started the year well with billings growth of 2% to $93 million for the first quarter. Growth was driven by strong performance in Heinemann partially offset -- formerly known as Trade, increased 8% to $40 million for the quarter. Growth was largely driven by licensing income from our delivery of the second season of the animated series Carmen Sandiego to Netflix.

We're pleased with our strong sale performance in Texas. Our first-quarter results were in line with our expectations, and our outlook remains consistent with our view in February. As a result, we are reiterating our full-year guidance. Looking ahead to the second quarter, we anticipate strong year-over-year billings growth in core solutions and for the company overall given the sales performance in Texas.

As a reminder, total billings for the company was $371 million in the second quarter of 2018, which reflects the divestiture of our Riverside testing business. So now I'd like to take a moment to talk about the elements of our strategy that will help us grow HMH's free cash flow. As we transform our company, we are improving the free cash flow generation fundamentals of HMH for the long term in building a stronger, leaner company focused on capturing a larger share of the roughly $11 billion U.S. instructional materials market.

As you heard from Jack, we're making good progress on our strategy, executing on our three pillars of enhancing and extending our core, delivering integrated solutions and focusing on operational excellence. Each of these pillars improves our ability to generate free cash flow growth from market cycle to market cycle. For example, we see ample opportunity to increase our operational efficiency, and we have set the internal objective of offsetting annual inflationary cost growth in our business via our operational excellence initiatives, which range from process and systems reengineering to full automation. Stabilization of fixed costs will help us generate more free cash flow from billings growth.

Shifting our portfolio mix is another important part of our plan to increase free cash flow, specifically via growth in the extensions to our core. We see opportunity to improve the free cash flow contribution from existing offerings in our extensions portfolio, which grew 7% last year. Here we're further leveraging the infrastructure already in place to support our core as well as refining our professional services sales and delivery models to improve resource utilization. Additionally, we have been investing in new extensions offerings via partnership and acquisition, which have introduced a small but growing base of Software as a Service offerings to our business.

As these new offerings grow and mature within our portfolio, we expect the impact of recurring revenue and reduced friction in customer acquisition to increase the overall free cash flow contribution from extensions. Our extensions investment is also [Audio gap] solutions to address additional and specific instructional and development needs of teachers and students. As the market leader in core and extensions, HMH is uniquely positioned to provide the full suite of these solutions to our customers in an integrated seamless offering. We believe delivering integrated solutions will help us capture increased overall market share as well as share of individual categories such as the core.

Given the degree of operating leverage in our core model, increased billings from share capture flow through to free cash flow at increasing rates. As demonstrated in years where we have performed well in large new adoption market opportunities. And finally, as we complete development of the next generation of our core offerings, we will also seek to better leverage investments we have made in content spend by adopting a software-like development model. We expect this shift from episodic program development to continuous delivery of improvements informed by usage and efficacy data will improve the utility of our offerings for our customers, reduce the annual variability in our capital expenditures and decrease the level of new content investment required to meet our customers' needs.

We remain committed to growing our average annual free cash flow in each successive cycle, and we believe our strategy will deliver that growth while driving our business to generate sustainably positive free cash flow even in the troughs of our core market cycle. So with that, I'd like to turn the call back over to Jack. Jack.

Jack Lynch -- President and Chief Executive Officer

Thank you, Joe. Before we take your questions, I'd like to reiterate a few key points that we covered this morning. Our HMH 2020 strategy is working and driving tangible results including the good momentum we're seeing in 2019. Our new ELA program has performed very well in Texas, and we're excited about its potential as we extend that program to the rest of the market.

Given our sales performance so far in 2019, we're reaffirming our guidance for the full year. We see elevated adoption and billings opportunities continuing for the next several years. The investments we made for the last few years have us well positioned to intercept these opportunities beyond 2019. We also expect continue growth in extensions given our strategy to allocate capital to this faster-growing, higher-margin category.

And finally, we remain focused on the significant opportunities ahead to drive billings growth, generate strong free cash flow and create value for shareholders. With that, we would now be pleased to take any questions you may have. Operator.

Questions & Answers:

Operator

[Operator instructions] Our first question comes from Drew Crum of Stifel.

Drew Crum -- Stifel Financial Corp. -- Analyst

Maybe just a point of clarification to start on Texas, you mentioned leading share in your addressable market being more than two-thirds capture rate. Just remind us what your expectation is for Texas in terms of the size of what your addressable market is there. And then separately, Joe, just on your point concerning changes to how you invest in content going forward. Can you put some numbers to that? I mean obviously, you've got your guidance for this year.

We know what the company spent in the past. What should that look like going forward?

Joe Abbott -- Chief Financial Officer

Hey, Drew. Just a quick clarification on the first part of your question which is related to the size of the market. So what we've said is that we have a leading win rate at this point of a set of decisions that have been made in Texas, and we estimate that the decisions that have been made cover about two-thirds of the addressable market opportunity, OK. So I just wanted to make sure that that was clear.

There's still adoption opportunity in front of us. Now while we haven't sized the Texas addressable market for this year, it is a substantial driver of the more than doubling of the new adoption opportunity that you see in our outlook for 2019, so it's a very large portion of that where we're performing very well. The second part of your question related to the change in content spend and the profile there. So that is something that we'll be developing further plans for as we are getting through the final investments and builds that are necessary for our next-generation set of programs.

There's still work that's undergoing there. But the intention here really is to, over time, you should see less variability in the annual capital expenditures related to content development spend, and then through a cycle, what you should see is a reduction in the overall level of content development spend. You typically see very large episodic investments that precede the peak market opportunity years. And so we would expect to see that variability reduce as we evolve our model.

Operator

And our next question comes from Bill Warmington of Wells Fargo.

Bill Warmington -- Wells Fargo Securities -- Analyst

So a question also on the Texas market share. We did some sampling, and we were finding a win rate that was running around 55%, 56%. And I wanted to get a sense where you felt that was high or low or what you're seeing since you obviously see a lot more the market than we do.

Jack Lynch -- President and Chief Executive Officer

Bill, this is Jack. Yes, I'm not going to comment on your sampling, but I will reiterate that we feel very good about the success we're enjoying in the Texas adoption with, as Joe said, two-thirds of the decisions already made. So we feel very good about our performance.

Bill Warmington -- Wells Fargo Securities -- Analyst

And then my follow-up question, you mentioned that about two-thirds -- that the decisions that cover two-thirds of the market opportunity have been made. I wanted to see if there was a distinction here. The -- are you talking about two-thirds of the districts have made decisions related to K through 8? Or are you saying 100% of the districts related to K through eight have made their decisions and that the remaining one-third represents the nine to 12 grades that are going to come next year?

Joe Abbott -- Chief Financial Officer

It's closer to the former, which is that while it's not specifically districts, we think about it more in terms of total addressable enrollment. What we have stated is that decisions that capture over two-thirds of the addressable enrollment have been made.

Operator

And our next question comes from Jeff Silber of BMO.

Henry Chien -- BMO Capital Markets -- Analyst

It's Henry Chien calling for Jeff. I wanted to ask you if you guys could provide some color on some of the other large states just in terms of either the timing of their adoptions and if you have any visibility how sales are going there. I guess I'm thinking Florida and California.

Jack Lynch -- President and Chief Executive Officer

Yes. I think for those two states -- first, I'll take California. This is a science adoption. It is unlike Texas, which is a one-year adoption.

This is a three-year adoption, so we're in year one of that process. And it's still very early to comment on performance where school districts are -- what they typically do in California is pilot the programs before they make the decision. And so we're seeing good progress there in terms of pilots.In Florida, as you may recall, that adoption from math was canceled. However, we had a very large customer footprint there for our GO Math! program.

So we are extending the GO Math! program in Florida for math so those school districts have a math program they can use for the next school year, and that process is going very well.

Operator

[Operator instructions] Our next question comes from George Tong of Goldman Sachs.

George Tong -- Bank of America Merrill Lynch -- Analyst

You've indicated that, historically speaking, customers purchase less residual materials just before an upcoming adoption cycle and that particularly you're seeing that impact in Texas. Are you also seeing in other states a pullback? How would you characterize buying decisions in California also where were you have upcoming adoptions in the open territories?

Jack Lynch -- President and Chief Executive Officer

Yes, it is, it's a phenomena that applies to states who are doing major new adoptions and for reasons that make a lot of sense and that is you're not going to be buying a lot of residual materials from older programs while you're looking to purchase a new program.

George Tong -- Bank of America Merrill Lynch -- Analyst

Got you. And to follow up on that, how would you characterize the performance in other states outside of Texas? Is the pullback similar to the pace of the Texas pause? Or is Texas particularly pronounced in its pause of buying opportunity?

Jack Lynch -- President and Chief Executive Officer

It's particularly pronounced because if you look at the core category, 80% of it is reading and math, and the largest percent of that 80% is reading. So that's why it's particularly pronounced in Texas.

Operator

And ladies and gentlemen, this does conclude our question-and-answer session. I would now like to turn the call back over to Jack Lynch for any closing remarks.

Jack Lynch -- President and Chief Executive Officer

OK. Thank you, everyone, for joining us on today's call. We look forward to updating you at -- on our next earnings call in August. Have a great day.

Operator

[Operator signoff]

Duration: 26 minutes

Call participants:

Brian Shipman -- Senior Vice President, Investor Relations

Jack Lynch -- President and Chief Executive Officer

Joe Abbott -- Chief Financial Officer

Drew Crum -- Stifel Financial Corp. -- Analyst

Bill Warmington -- Wells Fargo Securities -- Analyst

Henry Chien -- BMO Capital Markets -- Analyst

George Tong -- Bank of America Merrill Lynch -- Analyst

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