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Houghton Mifflin Harcourt (NASDAQ:HMHC)
Q2 2019 Earnings Call
Aug 08, 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 second-quarter earnings conference call. [Operator instructions] I would now like to introduce your host for today's conference call, Mr. Brian Shipman. You may begin.

Brian Shipman -- Senior Vice President, Head of Investor Relations

Thank you 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 August 17, 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 second-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. This morning, Jack Lynch, HMH's president and chief executive officer; and Joe Abbott, HMH's chief financial officer, will provide a company update as well as an overview of the company's second-quarter 2019 results.

After our prepared remarks, we will open the call to questions. [Operator instructions] Now I'll turn the call over to Jack.

Jack Lynch -- President and Chief Executive Officer

Thank you, Brian, and good morning, everyone. HMH achieved record 32% growth in the second quarter. I'm particularly thrilled with the leading share of our brand new programs delivered to the market this year. Here are a few highlights.

HMH took the leading position in the 2019 Texas K-8 ELA adoption, with a 56% market share. HMH also commanded the leading share in the overall new adoption opportunity outside of Texas, and we saw a solid performance nationally in open territory. Our Into Math program, the Florida version of which earned an all green score from third-party evaluator EdReports, just began selling in open territory states, and we see great potential as it enters the market. Importantly, across the board from HMH, we generated strong billings growth both for the quarter and year to date.

Total education segment billings were up 34% for the quarter and 22% year to date. Breaking that down, billings for core solutions were up 65% in second quarter and 46% year to date as a result of our leading share nationally, and extension billings were also up 5% in the second quarter and 4% year to date, driven by strong growth at Heinemann. Now HMH Books & Media billings grew 7% in the second quarter and 8% year to date. Given HMA's performance in the first half and sustained momentum in July, today we are raising our billings guidance for 2019.

We now anticipate total billings between $1.53 billion to $1.61 billion, with Core Solutions billings growth between 40% and 50% and Extensions billings growth in mid-single digits. For HMH Books & Media, our outlook remains unchanged. Now how are we generating these results. Very simply, relentless execution and steadfast adherence to our strategy.

A three-pronged strategy designed to capitalize on the market trends and customer needs, we identified nearly two years ago. First, enhance and extend the core. As I mentioned earlier, we have made some strategic investments in highly differentiated core solutions that are yielding strong performance nationally. Into Reading is performing exceptionally well, and not just in Texas.

Reading is also performing very well in all the other major adoption states and in the open territory states where estimated win rate has increased 10% over 2018. This is especially important because reading literacy is the largest category in K-12 education. And as in all of our Into Learning programs on the Ed platform, this program combines computer adaptive assessment with reading instruction to help teachers use data and insights to tailor their instruction to different groups of students across a range of academic abilities. We're excited to see the strong customer response and both key adoption and open territory states.

It signals that HMH's investments in next-generation solutions are paying off as we create better digital experiences for teachers and students and drive value for our shareholders. For Extensions, as you know, we've been expanding our portfolio via partnership and acquisition. Last year, Extensions grew 7%, and this quarter it grew 5%, giving us the confidence to raise our outlook for Extensions for the full year. And so now on to our second strategic pillar, delivering integrated solutions.

When we sell a core reading program to a school district, we want to sell a supplemental program and the intervention program and professional development to help a teacher meet all the needs of their students in their class, who perform across an achievement spectrum. We're only company with a market-leading position in both Core and Extensions. So the second pillar of our strategy is designed to leverage that portfolio strength for the benefit of the teacher and their students. To advance that strategy, we've added a number of innovative new extension solutions to our portfolio, which are gaining traction in the market for an enhanced, better together customer experience.

Notice, I used the word innovative. That's because we are not only the market leader in sales for K-12, we are also a leading innovator in the market. In fact, several of our programs have recently been recognized within the industry. READ 180 Universal and MATH 180 as well as our partner programs, Amira Learning and Writable have all been selected as winners of Tech & Learning's 2019 Best of Show Awards! And finally, our third pillar of our strategy, operational excellence.

We're continuing the simplification of organizational structures, systems and processes that will not only reduce costs but support our successful transformation to a learning company. Now on to the highlights of our results for the second quarter and year to date. Within our Education segment, Core Solutions billings were up $106 million or 65% in Q2 and $92 million or 46% on a year-to-date basis. This was driven by very strong market share capture in 2019's largest adoption opportunities.

In Texas ELA, as I said previously, we had a 56% win rate for our Into programs and had a strong performance nationally in open territory where our estimated win rate has increased 10% over 2018. And then -- we also experienced strength in Florida Math gap deals as we worked with customers to extend their use of our GO Math! program in the wake of a canceled math adoption earlier this year. We continue to be on track with our preparations for the 2020 adoptions, including Texas literature grades nine through 12 and the California Science year 2 market opportunity. The Texas Education Agency recently gave HMH Into Literature for grades 9-12, a 100% alignment rating for the upcoming adoption.

Turning to Extensions. Billings were up $8 million or 5% in Q2 and $10 million or 4% on year-to-date basis. This was driven by Heinemann and the sales growth they continue to generate year after year with meeting the market demand for teacher-centered curricular resources and professional development solutions developed by renowned author educators, such as Fountas & Pinnell, Lucy Calkins and Jen Serravallo. We're also excited by the early success we've had introducing several SaaS-based supplemental learning solutions and pricing strategies in the market in recent months.

Now onto HMH Books & Media, formerly our trade segment, which grew $3 million or 7% in Q2 and $6 million or 8% year to date. This growth was driven by the licensing income associated with the animated series, Carmen Sandiego on Netflix. In addition to New York Time's best seller titles, such as Maybe You Should Talk To Someone and The Giver. The performance here is a testament to our focus on leveraging our multimedia approach in HMH Books & Media and on creating strong brands that resonate with our customers.

We're also thrilled that Carmen Sandiego was nominated for 2019 Primetime Emmy award in the category of Outstanding Children's program, by the Academy of Television Arts and Sciences. The nomination is just another validation of our caliber of award-winning educational entertaining content that we're creating in HMH Books & Media. With that, I'll turn the call over to Joe. We'll provide a deeper dive into our second quarter and year-to-date results.

Joe?

Joe Abbott -- Chief Financial Officer

Thanks, Jack. Good morning, everyone. HMH had a record second quarter, as Jack said. Our strong performance, both in the second quarter and on a year-to-date basis, has been driven by the continued successful execution of the HMH 2020 strategy, which we set in place at the beginning of 2018.

Before we get into our consolidated second quarter and year-to-date results, I'd like to touch on a few important topics that should paint a clear picture for HMH's headed financially for the rest of 2019. First, I'll share with you how we think about the direction of our reported profitability metric, adjusted EBITDA. We were extremely pleased with the billings we generated during the first half of 2019. And so the way to think about billings is -- that's a cash revenue metric, which we define as net sales plus the change in deferred revenues.

As you can see, adjusted EBITDA was down $9 million during the first half of 2019. But what is missing from this picture is the cash component represented by the change in deferred revenue. As you can see on Slide 10, we experienced an $81 million positive swing in the change in deferred revenue from the first half of 2018 to first half of 2019. This substantial change in deferred revenue serves as a leading indicator of net sales growth as we recognized revenue from multiyear education segment programs in future periods.

That also serves as a leading indicator of adjusted EBITDA growth and margin expansion because our cost base is largely fixed and because the future costs associated with deferred revenue recognition are low. So while our adjusted EBITDA declined in the first half this year relative to the first half last year, we expect this measure to increase in subsequent years. And as I will cover again later in our discussion about full-year guidance. We continue to expect adjusted fixed costs and adjusted variable costs in line with the assumptions we provided back in February, which indicate our expectations for improved profitability this year versus last year.

The second topic I'd like to touch on is that we expect the increase in year-over-year billings, implied by our revised full-year guidance, will result in substantial growth in free cash flow in the second half of this year, above the level we anticipated when we provided full-year guidance in February. Our accounts receivable at the end of the second quarter, which was nearly $145 million higher than at the same point last year, is a leading indicator of cash we will collect in the second half this year. We have already begun to convert first-half receivables into cash. And as of August 1st, we had fully repaid the $60 million of revolving credit facility borrowings that we ended with in June.

Now moving to our financial highlights of the second quarter of 2019. Our consolidated net sales were $389 million in the second quarter, up 9% in $583 million for the first half, up 5%. Total company billings were up 32% in the second quarter to $489 million and up 20% to $644 million in the first half, reflecting growth in both Education and HMH Books & Media segments. Education billings were up 34% to $450 million in the second quarter, driven by Core Solutions billings growth of 65% and Extensions billing growth of 5%.

HMH Books & Media segment billings increased 7% to $39 million for the quarter. Year to date, education segment billings grew 22%, driven by Core Solutions billings of 46% and Extensions billings growth of 4%. HMH Books & Media segment billings increased 8% in the first half. Net loss on continuing operations for the second quarter was $41 million, an unfavorable change of $12 million compared to Q2 of 2018.

This timing related -- due to our incurrence of cost of sales and selling and administrative expenses associated with the heavy billings volume in the second quarter, ahead of the revenue we will recognize in later periods. Adjusted EBITDA for the second quarter declined $7 million to $47 million and declined $9 million to $21 million on a year-to-date basis due to the same timing factors impacting net income. Our free cash flow year to date was a usage of $340 million compared to a usage of $258 million during the same period of last year. This increased accounts receivable balance is a leading indicator for cash generation in second half of the year.

The primary driver of the unfavorable change in free cash flow was an increase in net working capital associated with large billings in the first six months of 2019, for which we have incurred costs, but not yet collected cash, coupled with a build-in inventory for anticipated future shipments to meet strong customer demand for our education programs. Partially offsetting the increase in net working capital was a reduction in total capital expenditures. Content development spending was $56 million in the first half of 2019 compared to $60 million for the same period last year. The total capital expenditures were $74 million for the first half of 2019 compared to $83 million for the first half of last year.

And as Jack mentioned, given our strong performance, HMH had in the quarter and on a year-to-date basis, we are raising our billings guidance for 2019. For the full year, we now expect companywide billings to be between $1.53 billion to $1.61 billion, up from our expectation of $1.49 billion to $1.59 billion at the beginning of the year. Our outlook for content development spend and total capital expenditures remains unchanged. We have updated our additional assumptions underlying this revised guidance, and we now expect core solutions billings to grow in a range of 40% to 50%, extensions to grow in the mid-single digits and free cash flow to increase relative to our February expectations.

All other assumptions remain unchanged, including a modest billings decline for HMH Books & Media, despite the strong growth this business exhibited in the first half. And as a reminder, we had a tough second-half comparable for this segment because we benefited from Carmen Sandiego and Orwell licensing income in the second half of last year. Now before I hand the call back to Jack, I want to revisit the key financial trends in our business that we have been highlighting for you over the last several quarters. First, we are executing successfully and seeing the results of our strategy in our adoption share, billings growth and our cash flow fundamentals, enrolling in the second year of executing on this new strategy.

Next, we're continuing to improve our business model and cost structure with enhancements, including the shift to a more software-like development model, which makes our content development spend more efficient, to operational excellent initiatives, which drive savings in our operating costs. Lastly, our multiyear market outlook remains attractive. And we anticipate an elevated level of new adoption spending at least through the year 2022, the year in which Florida will hold its math adoption, and we see growth returning to the open territory. Our extensions portfolio continues to grow.

And the new innovative solutions we have introduced are well positioned to help us drive durable and positive free cash flow through the cycle. And with that, I'll turn the call back over to Jack.

Jack Lynch -- President and Chief Executive Officer

Thank you, Joe. Before we take your questions, I'd like to reiterate the main point of our message this morning. Our strategy is working: number one, our new programs are winning in the market; number two, we are delivering billings growth; number three, billings growth and operational efficiencies are driving free cash flow growth; number four, we have created a durable free cash flow generating business built for the long term. These results make it abundantly clear our customers are now choosing HMH because nearly two years ago, we have identified their needs and then developed highly differentiated and innovative solutions to meet those needs.

Today, we are incredibly proud to support educators and the students they serve while simultaneously fueling the growth of our company. We are truly a double bottom-line business. Now before we take your questions, I'd like to announce that we will be hosting an investor gathering in New York City in October, where we plan to go deeper into our strategy with you. Stay tuned for further details.

Operator, we're now ready to open the line for questions.

Questions & Answers:


Operator

[Operator instructions] Our first question comes from Jeff Goldstein with Morgan Stanley.

Jeff Goldstein -- Morgan Stanley -- Analyst

Hey, guys. Thanks for taking my question. I wanted to follow-up on the commentary for your increase of cash flow relative to your February expectation. Is the right way to think of that is to take the $30 million change in the midpoint of your billings guidance and then apply, I guess, 39% of billings variable cost guidance to that.

So now maybe now you expect about $28 million more free cash flow than you did prior. So one, is that the right way to think about that? And then two, what could drive you to see even greater upside to the current free cash flow expense?

Joe Abbott -- Chief Financial Officer

Jeff, morning, and thanks for the question. Yes, the short answer is yes, that is the appropriate way to think about that. I think you even asked the question a couple of quarters ago, where you'd kind of done the math and came up with about a $75 million free cash flow. Now we're back in February.

So you should be thinking about that as flow through on incremental billings growth that we're indicating with our billings guidance range increase. And typically, we think about our incremental margins are about 60%, 65% on that increased billing. So that's a pretty good estimate that you've come up with there. And the second part of your question was about what could drive free cash flow improvements? And really, it has to do with increases in billings.

We're continuing to obviously work on our cost structure. We talked about sort of operating excellence initiatives and continuing to focus on efficiency with our content development spend. And those efforts will progress through the year, but really the big driver, as we sit here today will be continued performance on the billing side.

Jeff Goldstein -- Morgan Stanley -- Analyst

Great. That was helpful. And then I know you've been expecting an uptick in open territory now that we're more removed from the common core rollout of 2013 and 2014. So have you started to feel that in the quarter? And what type of tailwind would you expect from that in both the back half and the next one to two years though? Essentially, could open territory grow beyond the low single-digits you generally expect for K-12 over the next few years?

Jack Lynch -- President and Chief Executive Officer

Yes. Great question, Jeff. We -- as we predicted, we have seen growth in open territory. And as I indicated in my previous remarks, we have increased our share of open territory for reading by 10 points -- a win rate of 10 points.

And I think that's indicative of overall share gained across the board for the company, not only in Texas, where we got a 56% share. And mind you, not only leading share in K-5 but also leading share in six, eight. We got a leading share in all the other stated options, and we did see a return to growth for open territory, and we're very pleased with our performance in open territory.

Jeff Goldstein -- Morgan Stanley -- Analyst

All right. Thanks for the color.

Operator

Our next question comes from Bill Warmington with Wells Fargo.

Bill Warmington -- Wells Fargo Securities -- Analyst

Good morning, everyone.

Jack Lynch -- President and Chief Executive Officer

Good morning, Bill.

Bill Warmington -- Wells Fargo Securities -- Analyst

So congratulations on the performance in Texas.

Jack Lynch -- President and Chief Executive Officer

Thank you.

Bill Warmington -- Wells Fargo Securities -- Analyst

First question is on leverage. So you paid off the $60 million revolver in July. So you can see the cash coming through there. How you think about where leverage is likely to end up by the end of 2019? Is it something around two times at this point or lower? What are you thinking?

Joe Abbott -- Chief Financial Officer

Well, it has everything to do with your choice of denominator there too, Bill. But I think that -- as we think about it, we do expect our EBITDA metric to continue to improve through the back half of the year. And so what that will do, of course, is drive leverage down from these -- from where we're at here as of the first half. That will -- and we do expect that to continue.

But generally, the other aspect about leverage here is that, as we said, we're going to be applying a generation of free cash flow to deleveraging on a gross basis. And so we'll have our first opportunity is to do that in the second half as we move into our cash generation part of our seasonal cycle.

Bill Warmington -- Wells Fargo Securities -- Analyst

And then my second question is on California Science. If you could talk us through how that -- how the California Science process is going to unfold? And when we should expect to start seeing billings generated from that?

Jack Lynch -- President and Chief Executive Officer

Yes. Bill, on that, as you know, the -- unlike all the other state adoptions, the California Science adoption is a three-year adoption. And right now, we have a leading share in that adoption. But what we've seen is year 1 sales is kind of being delayed to year 2.

And what you see in California is a lot of school districts piloting programs before they make their final decision. So a long ways to go before we're done in California, but we feel good about the product and we feel good about the leading position right now.

Bill Warmington -- Wells Fargo Securities -- Analyst

Well, thank you very much.

Operator

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

George Tong -- Goldman Sachs -- Analyst

Hi. Thanks. Good morning. Follow-up on the California Science adoption. Can you provide some details on or additional granularity on when you might expect in year 2, the benefits of billings to flow through? Is it going to be back-half weighted? Do you think it's going to be a linear ramp just based on what you're seeing so far?

Jack Lynch -- President and Chief Executive Officer

Yes. I mean in terms of the three-year adoption, it will be back-half weighted. Most of -- as in all core adoptions, most of the sales come in Q2 and early Q3 in order for teachers to have the instructional materials for back to school. So yes, be back-half weighted for three years and we would expect it to be Q2 -- heavy Q2, first part of Q3.

George Tong -- Goldman Sachs -- Analyst

Got it. That's helpful. And you mentioned the ELA Texas adoption, 56% market share. Do you have additional market share data on the other categories within the current adoption cycle aside from Texas ELA, K-3 to 8?

Jack Lynch -- President and Chief Executive Officer

Yes. I mean, we have the data on all the other state adoptions. There's ELA adoptions, there's state adoptions, there's mass adoptions. And while we're not going to go through each and every one of them, we feel very good about our leading share at the -- that overall category of state adoptions outside of Texas.

George Tong -- Goldman Sachs -- Analyst

Got it. Thank you.

Operator

And I'm not showing any further questions at this time. I'd like to turn the call back over to Jack Lynch.

Jack Lynch -- President and Chief Executive Officer

OK. Thank you all for your questions. We'll be -- as I mentioned in my prepared remarks, we'll be hosting an investor gathering in New York City. So stay tuned for the details on that.

And thank you very much. Have a great day.

Operator

[Operator signoff]

Duration: 28 minutes

Call participants:

Brian Shipman -- Senior Vice President, Head of Investor Relations

Jack Lynch -- President and Chief Executive Officer

Joe Abbott -- Chief Financial Officer

Jeff Goldstein -- Morgan Stanley -- Analyst

Bill Warmington -- Wells Fargo Securities -- Analyst

George Tong -- Goldman Sachs -- Analyst

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