Houghton Mifflin Harcourt (HMHC) Q3 2019 Earnings Call Transcript

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Houghton Mifflin Harcourt (HMHC)
Q3 2019 Earnings Call
Oct 31, 2019, 8:30 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Houghton Mifflin Harcourt third-quarter earnings conference call. [Operator instructions] Please be advised that today's conference is being recorded. [Operator instructions] I would now like to hand the conference over to your speaker today, Brian Shipman. Thank you.

Please go ahead, sir.

Brian Shipman -- Senior Vice President, 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 November 10, 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 third-quarter 2019 earnings press release.

Before we discuss our results, I encourage you to review the cautionary statement on Slide 2 for our customary disclosures. Further information can be found in our regular SEC filings. In addition, please refer to the appendix in our slide presentation for a reconciliation of our non-GAAP measures to the most directly comparable GAAP measures, which is also posted to the HMH Investor Relations website. 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 third-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. Good morning, everyone. Today, Joe and I will overview our third-quarter 2019 results, which we previewed at our investor update on October 17. In short, HMH achieved record billings growth for the third quarter and year to date, with 31% growth in billings companywide for the quarter and 26% year to date.

Our billings guidance was raised for the second time this year at our investor update. To reiterate that guidance, for 2019, we expect to generate billings of $1.59 billion to $1.62 billion. By business, we expect core solutions billings growth of 40% to 50% and extensions billings growth in the low teens. For HMH books and media, we expect to be down high single digits for the year, and we expect to generate $100 million to $120 million of free cash flow for 2019.

We will apply that free cash flow to improve our balance sheet, paying down our debt and giving us the strategic flexibility to invest for higher growth. OK, that's the summary for the quarter and our guidance for the year. Now our segment-specific results. First, within our education segment, core solutions billings were up 50% to $412 million in Q3 and up 48% to $705 million year to date.

This increase was driven by the continued performance of our Into programs, both in Texas and nationwide. On extensions, billings were up 25% to $287 million in Q3 and 14% to $559 million year to date driven in large part by continued double-digit growth at Heinemann, as well as strong performance from our service offerings. That's the education segment. For HMH books and media, billings decreased 29% to $48 million in Q3, with a decline of 10% to $127 million on a year-to-date basis.

We had a difficult comparison due to onetime benefits of $16 million in Orwell licensing income in the third quarter of 2018, as we stated in the last quarter. Still, we expect growth in the low single digits for HMH books and media long term. And the fundamentals of the business remain solid, with a focus on brand building and award-winning multimedia content. Just this quarter, for example, Good Night, Little Blue Truck debuted at No.

1 on the New York Times Children's Picture Books best-seller list. Now before I hand the call over to Joe, I'd like to quickly touch on the key points of our strategy that I shared with you at our investor update two weeks ago. First, you heard that we continue to make great progress on enhancing and extending the core. Our next-generation products released to the market this year have a leading share in all of the adoptions taking place in 2019, including a 56% share in the Texas ELA adoption.

We also drove very strong growth in our extensions business, where we expect to see billings growth in the low teens in 2019. Second, we shared with you our vision for delivering integrated solutions for our customers and how that opportunity can drive further growth in our extensions portfolio as we cross-sell from core to extensions of the core to the same customer base and capture a greater share of the $276 spend per student. Finally, operational excellence. Two weeks ago, we shared several actions we've taken to accelerate our strategy, including an 8% workforce reduction, net of additions and the implementation of a software-like development model, which will result in a 20% decrease in plain content development spend each year going forward.

We believe that the combination of these actions will make HMH a faster-growing, more-profitable company now and into the future for the benefit of our customers, students and shareholders. Now Joe will take you through the Q3 and year-to-date financial highlights.

Joe Abbott -- Chief Financial Officer

Thanks, Jack, and good morning, everyone. In the third quarter, we delivered positive free cash flow of $358 million, consistent with our seasonal pattern of free cash flow. And as we enter our fourth quarter, our second-largest cash-collection quarter historically, we are reaffirming the guidance we established at our investor update, which is $100 million to $120 million in free cash flow for the full-year 2019. A leading indicator of free cash flow growth is our accounts receivable balance, which at the end of the third quarter was nearly $82 million higher than at the same point last year.

We generated approximately $35 million of free cash flow in Q4 2018, and we expect collection of our higher receivable balance, net of cash expenditures to result in Q4 2019 free cash flow of $82 million to $102 million, which brings us to our guidance of $100 million to $120 million for the full year. As we have said, we plan to apply that free cash flow to improve our balance sheet, paying down our debt and giving us the strategic flexibility to invest for higher growth. Now moving on to the financial highlights of the third quarter. Our consolidated net sales grew 10% to $566 million in the third quarter and grew 7% to $1.149 billion for the first nine months of 2019.

Total company billings grew 31% to $747 million in the third quarter, reflecting strong growth of our education segment and partially offset by a decline in our HMH books and media segment. Education billings were up 39% to $699 million in the third quarter, driven by core solutions billings growth of 50% and extensions billing growth of 25%. HMH books and media segment billings decreased 29% to $48 million for the quarter. Year to date, billings grew 26% to $1.39 billion, with education segment billings growing 31%, driven by core solutions billings of 48% and extensions billings growth of 14%.

HMH books and media segment billings decreased 10% in the first nine months. Income from continuing operations for the third quarter was $69 million, an unfavorable change of $15 million compared to Q3 of 2018. This is related to our incurrence of cost of sales and selling and administrative expenses associated with the heavy billings volume in the third quarter. Adjusted EBITDA for the third quarter declined $11 million to $149 million and declined $20 million to $169 million on a year-to-date basis due to the same factors impacting net income.

Our free cash flow year to date was $18 million, compared to a usage of $108 million during the same period of last year. Consistent with our historical seasonal patterns, the third quarter was our largest free cash flow-quarter of the year. As I mentioned earlier, we expect Q4 to be another strong positive free cash flow-quarter, putting us on track to achieve our guidance of $100 million to $120 million of free cash flow for the full year. Content-development spending was $82 million in the first nine months of 2019, compared to $92 million for the same period last year.

And total capital expenditures, inclusive of content development spend were $109 million for the first nine months of 2019, compared to $134 million for the same period last year. As Jack mentioned, given the strong performance HMH has had this year, we are today reiterating our updated guidance for 2019, which we raised for the second time this year at our October 17 investor update. For the full year, we now expect companywide billings to be between $1.59 billion to $1.62 billion, which we've raised twice since we issued our original guidance in February. Our outlook for content development spend and total capital expenditures is now at the bottom half of our original guidance ranges for these metrics.

We expect extensions to grow in the low teens and HMH books and media to decline in the high single digits. All other assumptions underlying our guidance remain unchanged. This strong guidance for the year reflects our continued confidence in the progress we have made and we'll continue to make on our strategy to transform HMH. Our focus is on creating extraordinary value for our customers, while simultaneously reducing costs.

This value innovation approach is driving our free cash flow growth by delivering solutions that our customers need the most and eliminating and reducing the aspects of our legacy business model that are no longer valued. To that end, as you know, we took significant actions to create stickiness in our business and commit to a continuous development model while reducing costs. We announced an 8% net position reduction at our investor update on October 17, as well as a 20% reduction in previously planned content development spend over the next three years. While our shift from episodic to continuous development enables greater leverage of our content development spend, it also tightens the linkage between HMH and our customers through constant feedback and iteration, increasing the value we deliver over time, and we expect increased value delivery to be rewarded with deeper, stickier customer relationships and a higher share of our customers in structural materials investment.

To help our investors model the impact of the significant improvements we have made, on October 17, we provided a near-term outlook for the key financial metrics that drive free cash flow. With a dramatically improved free cash flow engine, we are excited by our enhanced opportunities to capitalize on the healthy, elevated levels of new adoption spending ahead in the next three years in market sizes that we consider to be mid-cycle. To reiterate our expectations, we expect that the next three years, 2020 through 2022, will yield financial results in the ranges shown under the mid-cycle column. The trough and peak columns fill in the picture with a pro forma view of how our strategy has improved free cash flow at all points in the new adoption cycle.

This is the baseline, and we expect that baseline to improve as we continue to execute our value innovation approach. By the time we reach the next trough or peak, we anticipate substantially better free cash flow and free cash flow margins that are shown here. With that, I'll now turn the call back to Jack.

Jack Lynch -- President and Chief Executive Officer

Thank you, Joe. Before we take your questions, I'd like to summarize the points from this morning. Our continued execution of our strategy drove strong billings growth and free cash flow in Q3 and year to date. We are reaffirming the billings guidance we shared with you two weeks ago of $1.59 billion to $1.62 billion for 2019, including the expectation of $100 million to $120 million in free cash flow for the year.

With that free cash flow, our first priority is to pay down our debt and strengthen our balance sheet to increase our strategic flexibility to invest for higher growth. By executing on our strategy, we're transforming HMH and creating a more-profitable company with lower free cash flow variability and an improved balance sheet, a double bottom-line business producing more impact for students and greater returns for our shareholders. OK, before going to questions, I'd like to turn it back to Joe for an update about our refinancing plans. Joe?

Joe Abbott -- Chief Financial Officer

Thanks, Jack. At our investor meeting on October 17, we told you that we intended to be proactive about refinancing our existing term loan. We now expect to launch a refinancing transaction with a lender call to be scheduled in the next couple of days. Additional details for potential lenders will be forthcoming from the banks arranging our refinancing.

Naturally, completion of a refinancing in the near term will be subject to market and other customary conditions. We will now open up the lines to take your questions. Operator?

Questions & Answers:

Operator

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

Jeff Goldstein -- Morgan Stanley -- Analyst

On the new long-term free cash flow guidance that you now have out there, maybe you could just expand on internally what you did to derive those figures. And so really, what gives you the confidence that post the recently announced cost restructuring, you'll be able to hit those targets that you've now laid out?

Joe Abbott -- Chief Financial Officer

Jeff, it's Joe. Well, the way we have compiled those really is by looking at the resulting reductions that we've made to the cost structure, net of the investments that we've made, that's represented in the 8% net position reduction that we talked about on the investor call and earlier this morning, as well as the planned reduction in our content development spend, which gets you to the product development spend number. So those are the figures. We've taken the actions on the position and elimination that we've already discussed.

That's already occurred. And so that's why we feel very good and very confident about the forecast and the guidance that we put out there in the mid-cycle column over the next three years.

Jeff Goldstein -- Morgan Stanley -- Analyst

OK. That's helpful. And then, we used to hear in the past about the potential threat to your business from more open-sourced offering. Can you just update us on if you see any pressure from that? Or is it still just mostly the larger players who are the biggest competitive threat? So just any thoughts on the overall competitive environment would be helpful.

Jack Lynch -- President and Chief Executive Officer

Yes. Yes, I think the way to think about open source relative to our existing competition is that open source is typically used to augment programs like ours and like our competitors in the classroom. We rarely see open source being used as a replacement. So within core curriculum, there's three major players in core -- in that core curriculum category.

There's a number of other smaller players in that category. But the three companies, including ourselves, make up a majority of that particular category.

Operator

Our next question comes from Bill Warmington from Wells Fargo.

Bill Warmington -- Wells Fargo Securities -- Analyst

Just wanted to ask a question about the extensions business and the double-digit growth there. Maybe you could talk a little bit about what's actually driving that organic growth in extensions and whether M&A is an option to supplement that growth going forward. And how comfortable do you feel with double-digit as -- double-digit growth in extensions as a target over the next two to three years?

Jack Lynch -- President and Chief Executive Officer

Yes, Bill, great question. We've guided long term, low- to mid-single-digit growth for extensions. And for the last two years, we've outperformed that guidance. We would expect long term that we would have low- to mid-single-digit growth in extensions.

And from our standpoint, the growth that you saw this year is largely as a result of Heinemann and in particular, their new program Fountas & Pinnell Classroom, which has performed incredibly well, not only in Texas as a supplement in the adoption, but also nationwide. In terms of M&A and how do we capture a larger share of that $6 billion, it is a highly fragmented category, extensions, and we do believe that we'll be able to grow our share of it organically, but we have not ruled out an inorganic growth. And we certainly see M&A as an opportunity to expand our share of what we see as a very exciting, faster-growing and more-profitable category.

Bill Warmington -- Wells Fargo Securities -- Analyst

And then as a follow-up question, I wanted to ask about what your thoughts were on debt outstanding and total leverage by the end of December?

Joe Abbott -- Chief Financial Officer

Well, Bill, it's Joe. Based on where we are in the process right now, it'd be inappropriate for us to provide additional detail at this point in time. We'll provide you more updates when we get toward the end of our refinancing process. But as we've said, our intention with the free cash flow generation is to continue to use that to reduce the gross debt level over time.

And that is unchanged.

Operator

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

Blake Johnson -- Goldman Sachs -- Analyst

This is Blake on for George. You mentioned that you are planning on reducing variable costs and fixed costs through ongoing connection to the teacher and standardization of your material. Can you go into some specific details about some initiatives there and how you plan to bring those costs down?

Jack Lynch -- President and Chief Executive Officer

Yes. What we're referring to there specifically is customer acquisition cost on the variable cost side, the more stickiness and the relationships that we create with our customers, more of an opportunity for renewals as opposed to really going out and needing to acquire new customers at every new sales opportunity. So that's just an example of one of the value innovation outcomes that we anticipate through the changes we've made in our business. From a fixed cost perspective, as you can imagine, as we continue to standardize the business and improve our operational efficiency, we're going to have the opportunity, of course, to reduce our fixed cost base.

So that's really what that's referring to in those two areas. And it goes along with the value innovation approach that we discussed at length in our investor update on October 17.

Blake Johnson -- Goldman Sachs -- Analyst

Great. I appreciate that. And then just regarding the extensions business, you mentioned that extensions growth was partially driven by strong cross-selling activity. Can you quantify how much of the growth was a result of cross-selling from core customers? And what your specific initiatives are there as well?

Jack Lynch -- President and Chief Executive Officer

Yes. We haven't disclosed what percentage of our revenues are generated through cross-selling. I think it is something that in the future, we will take a look at because we are very focused, obviously, on cross-selling from the core to extensions and capturing a larger share of that $276 spend. We have an overall share of that addressable market, that $11 billion market in the low teens.

And we feel we have a very strong position in core that we can leverage to grow our extensions category, which, as you know, is 10% of a $6 billion market. So right now, we haven't disclosed what percent is through cross-selling, but clearly, our aim is to focus on the cross-selling activity.

Operator

This concludes our Q&A session. At this time, I'd like to turn the call over to Jack Lynch, president and CEO, for closing remarks. Please go ahead, sir.

Jack Lynch -- President and Chief Executive Officer

Thank you, everyone, for your time today. We look forward to speaking with you again at our Q4 call in February. Thank you.

Operator

[Operator signoff]

Duration: 25 minutes

Call participants:

Brian Shipman -- Senior Vice President, 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

Blake Johnson -- Goldman Sachs -- Analyst

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