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Houghton Mifflin Harcourt (NASDAQ:HMHC)
Q1 2020 Earnings Call
May 07, 2020, 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 scheduled first-quarter earnings call. [Operator instructions] I would now like to hand the call over to Brian Shipman. Please go ahead.

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 May 16, 2020, 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 2020 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 first-quarter 2020 results.

After our prepared remarks, we will open the call to questions. During a Q&A, please limit yourself to one question plus one follow up you may get back into the queue if you have additional questions. Now, I'll turn the call over to Jack.

Jack Lynch -- President and Chief Executive Officer

Thank you Brian and good morning everyone. As COVID-19 impacts every aspect of our work and life, we've seen an immediate surge in demand for our digital solutions from an education system experiencing tremendous disruption. Educators are turning to HMH to support while they adapt to remote learning and plan for the new school year ahead. Our financial strength, our people, our portfolio, our digital platform, our online professional development as well as our technical support position us well for what's ahead.

Why do we believe this? First, all of the work we have done in the last three years has put us in a strong position from a capital, liquidity and balance sheet perspective. Our focus strategy has dramatically enhanced our software capabilities and product differentiation. We recently refinanced and paid down a portion of our debt and extended our maturity, affording us with financial flexibility and an improved balance sheet. As a part of our transformation efforts in late 2019, we also put in place an ongoing value innovation program to streamline our cost structure while aligning our vessels high-impact, high-return opportunities.

Second, we remain strong, resilient and well positioned to support all of our stakeholders, employees, customers and shareholders. Protecting the safety and well-being of our employee community is paramount. For our shareholders, last month, we announced the steps we began taking to mitigate adverse impacts of COVID-19 while strengthening our financial condition and positioning us to renew normal operations when market conditions stabilize. As a reminder, these actions include director, executive and senior leadership salary reductions.

And for the majority of our employees, a four-daywork week with associated labor cost reductions. A freeze on spending not directly tied to near-term billings, reduced inventory purchases, deferral of long-term capital projects not directly contributing to billings in 2020. And borrowing from our asset-backed credit facility as a pre-emptive measure to mitigate against capital market disruptions. Third, for our customers, the pandemic has placed HMH in the important role of trusted partner and a vital source of their teaching and learning resources.

We put in place comprehensive support efforts for educators, students and school districts, navigating the challenges of closures due to the COVID-19 pandemic including free resources for educators, students and their parents, and we've seen significant uptake in response. Assignments through our digital platform, Ed, and have grown dramatically. Technical support calls from customers have grown about 500% and webinars on virtual teaching had a record number of attendees. Fourth, in the immediate term, we see back-to-school driving market demand as administrators plan for the return of students to school, whether that be a continuation of remote virtual learning or back-to-school in the traditional sense.

In either case, instructional materials are a must-have to advance student learning. As you know, from June to September is the period where we generate the lion's share of our billings every year. And we still anticipate that that will be the case for 2020. Fifth, the pandemic has accelerated the market move to digital learning.

Access to digital learning resources is crucial with remote learning. What was once a nice-to-have is now a must-have. Teachers are holding virtual classes from their kitchen tables, using technology such as Zoom and assigning work using HMH's digital platform. Now fluent users of digital solution, we believe that teachers will be reluctant to go back to print instructional materials once they return to the classroom.

Likewise, where the ratio of students to computing devices was once two to one, we are seeing it now shift rapidly to one to one, with a priority school districts are signing now the digital infrastructure. Every student with their own device, as districts increasingly purchase chrome books and iPads to bridge the digital divide. Taken together, this all means that as you look post endemic, HMH will emerge stronger with a digital-first connected offering in which the digital medium will become the central delivery mechanism, affording a new opportunity to empower teachers and bring together all members of the learning community. Today, our digital platform already delivers all of the essential services required for the new realities of teaching and learning: instruction, computer-adaptive assessment and student performance measurements; professional development which will be delivered virtually even after schools reopen; and artificial intelligence-driven programs which will support ongoing practice, personalization and intervention.

The products and services that reside on our platform will create the connected offering, and while print will remain as an add-on option to those who still need the need to keep it. This crisis is troubling in many ways. But what has united us at HMH across our organization is our unwavering commitment to supporting the crisis response. Stabilization and recovering efforts of our customers with connected learning solutions that are effective, engaging and equitable.

I am tremendously proud of our over 3,000 colleagues who've had to work differently, but brought their same dedication, applied to their jobs each and every day. My sincere thanks goes out to them. Now with that context in mind, let's move to our first-quarter results. Our performance is tracking in line versus our current expectations until mid-March, at which point, our billings became impacted by school closures and disruptive purchasing activity.

Just to give you a sense of how that played out, on March 1, 0 schools were closed. Just two weeks later, on March 16, approximately half of schools nationwide were closed. Then a little over a week later on March 25, roughly 90% of schools were closed. Despite the challenging market environment, HMH delivered solid performance and strategic progress in our seasonally smallest quarter.

Just a few highlights. In our Education segment, our core solutions offerings delivered growth of 3% in Q1. This was driven by strong selling performance in the Texas literature adoption. We are very pleased HMH has a leading share with about 75% of the market decisions made.

In California, our science adoption remains on track. Additionally, we are very excited to have more district-level approval in science to the Los Angeles Unified School District which is the second largest school district in the country. We're already receiving orders and expect strong performance. This selling success will drive billings growth in later quarters.

We also had solid bookings during Q1, with shipment delays at the quarter end due to school closures. And with our Extensions offerings, we delivered solid supplemental and intervention performance. As I alluded to earlier, we also experienced significant growth in the digital usage of our online Ed platform. Against that market backdrop, let's move to the numbers.

Our overall education billings were $92 million in Q1, down 20% year over year. Core solution billings, as I just mentioned, were up 3% year over year to $22 million. This growth was driven by our strong performance in Texas and continued progress with other key adoptions including California. Extension billings were $70 million for the quarter.

Supplemental and intervention delivered solid performance, despite shipping delays. However, Heinemann faced a tough comparison to the same period in 2019 which was compounded by shipping delays due to warehouse closures. As for Professional Services, these offerings have also been impacted by COVID-19. That said, we are pleased that our strategy shift to virtual delivery is proving timely, as we have now already converted 20% of our Professional Service engagements to virtual delivery which is a higher-margin model compared to our legacy, face-to-face offerings.

As you heard me say at the beginning of this call, this pandemic has accelerated the move to digital. HMH is well positioned to capitalize on this shift, having advanced our own digital transformation. A few examples. We have grown our SaaS-based Extensions business dramatically by 76% from March 2019 to March 2020.

Our Ed platform usage is accelerating with 314% growth since March 2019. We continue to add to our list of cross-sell core extension wins, leveraging our core solutions footprint to expand into Extensions and capture a greater share of the $276 per student spend each year. These cross-sell wins in Los Angeles; Omaha; Indianapolis, Fairfax County; Pasadena, Texas, are just a few examples of how we are leveraging our go-to-market scale and portfolio breadth. And as we've shared with you last quarter, our newest SaaS-based programs are winning best in show, tech and learning industry awards which are an important industry validation of our new AI-driven programs.

Just recently, Amira and Writable were announced as finalists for the coveted Tony Awards to be announced soon. All this is to say that as our customers change, perhaps the most significant disruption to teaching and learning in their lifetime, we as the learning company, are best positioned to solve their challenges and capture new market demand. Put another way, our status as a trusted partner to schools, teachers and students is more crucial than ever, regardless of the physical or virtual setting at the school. Stepping back, what are those realities in education right now? And how can HMH help? First, learning loss.

As a result of this disruption to their education, students are expected to experience a learning loss of 50% to 70% according to researchers at the Northwest Evaluation Association. For HMH, that means measured loss at the start of the next school year, with our computer-adaptive assessments, it will be especially important this coming year. Next, the learning gap. Students that were already behind coming into this pandemic will now be even further deprived.

As a result, our intervention and adaptive practice solutions will play an important role for a larger portion of the student population. Third, equity for all students. As COVID-19 gave rise for remote learning, it brought into focus a major inequity. 12 million students nationally still have no internet access at home.

And school districts are focused on solving that problem now. That places greater emphasis on our digital platform and on our high-quality digital resources. And finally, teacher professional learning. Clearly, digital learning is here to stay.

But with that, comes new found tools and technologies, and many teachers are still underprepared. So we stand ready to help with our online professional learning solutions. One of the biggest new realities for students and teachers is an accelerated shift to the virtual classroom. We know that for a variety of reasons, many K-12 school districts have been slow to move to one-to-one digital learning.

But what is abundantly clear is that this pandemic will be a tipping point. Districts at all grade levels, elementary, middle school and high school, are increasingly facing new one-to-one computing reality for their students. And we're seeing a number of other key indicators, from increase in WiFi hotspots for students to increasing use of online curriculum in lessons. This is not just for students, teachers too, increasingly will be learning virtually with demand for online professional development and digital infrastructure rising as well.

To put this another way, we have seen a shift over the years. A gradual shift to digital and our business model has evolved accordingly. From the 2000s where you had print programs and digital as a supplement, to where we've been for the last decade in a blended print and digital environment. And now, where we are going, a new connected decade, where education companies will be expected to truly put digital-first with print only available as an add-on.

And the good news is we are already supporting many of our customers on this front as they grapple with a new digital-first environment. Since school closures began, we've been focused on supporting customers with flexible curriculum access and virtual professional development delivery. Expanded technical and customer support resources. Use of AI-driven personalized learning platforms such as Weber, Waggle and Amira, three daily activities and learning tasks built by HMH learning architects and curated at home activities, expert targeted support for superintendents.

All of this, while we continue to host millions of students and teachers accessing HNH curriculum on our digital platforms. So that's our Education segment. Now, let's move on to books and media. Billings for the quarter were $39 million.

This is a very solid result for this segment of our business, given that all brick-and-mortar bookstores closed in March. However, with families staying at home, we experienced increased demand in children's nonfiction, specifically workbooks as well as eBooks. As a result, we delivered strong growth at Amazon of 25% and had particularly strong growth in eBooks to the young readers category which grew 59% in the first quarter. We also had five titles on the New York Times best seller list: Chosen Ones, The Last Book on the Left, Good Night, Little Blue Truck, A Long Walk to Water and The Crossover.

We also launched Two Whats?! and a Wow! Playbook from star podcasters Guy Raz and Mindy Thomas which will be integrated into HMH's K-12 science programs in rapid response to the worldwide school closures to combat some of learning loss. Finally, also in the interest of addressing similar learning loss, we are planning to reintroduce several popular workbook titles for Pre-K to five grade levels. With that, I'd like to hand the call over to Joe.

Joe Abbott -- Chief Financial Officer

Thank you Jack and good morning everyone. Thanks for joining us on the call, and I hope you are all staying healthy and safe during this unprecedented time. In terms of our first quarter, as you all know, it is seasonally our smallest. And until mid-March, business had been trending in line with our expectations for the quarter.

However, once school closings became widespread due to the pandemic, we experienced a significant disruption in operational activity from our customers. This affected purchase decision-making which was, in many cases, delayed as well as our customers' ability to receive shipments from us, for purchases they had already made, as district and school employees transitioned to a work-from-home environment. This ladder effect impacted our ability to bill our customers on a normal timetable. But we have been clearing that backlog through the month of April and into May as many customers have made arrangements to receive shipments.

So with that context in mind, let's take a look at the highlights for this quarter. Our consolidated net sales were down 2% to $190 million in the first quarter compared to the same period a year ago. Billings which we define as net sales, adjusted for the net change in deferred revenue, were down 15% to $131 million. Net loss for the first quarter was $346 million.

An unfavorable change of $229 million compared to the same period in 2019. We took a $262 million impairment charge for goodwill in the quarter which was the primary driver of the unfavorable change. This impairment charge is a direct result of the adverse impact that the COVID-19 pandemic has had on the market price of our common stock. The impairment charge was partially offset by a decrease in selling and administrative costs resulting from our cost reduction actions undertaken in the fall as part of our 2019 restructuring plan, and our mitigating steps this year to reduce discretionary expenses in light of the COVID-19 pandemic as well as lower cost of sales.

Adjusted EBITDA for the first quarter improved by $9 million compared to the same period last year to a loss of $17 million despite the decline in net sales. This improvement was a result of our reduced selling and administrative expenses. Our free cash flow was a usage of $187 million compared to a usage of $212 million during the same period last year. The lower cash usage in the first quarter was due to improvements in working capital driven by higher cash collections and lower inventory purchases, along with reductions in capital expenditures.

Total capital expenditures were $31 million for the quarter compared to $36 million in the same period last year. Moving on to our year-to-date segment results. Education billings were down 20% to $92 million in the first quarter. Within the Education segment, core solutions billings grew 3% to $22 million for the quarter.

We delivered strong selling performance in the Texas literature adoption, with approximately 75% of the market decided. Consistent with our experience in the Texas reading adoption last year, we expect this selling performance will translate into billings in our second and third quarters. Also within the Education segment, billings for our Extensions offerings declined 25% to $70 million for the first quarter. Our supplemental and intervention solutions had a solid quarter.

But this was offset by Heinemann which faced very difficult comparisons from a strong performance in 2019. Heinemann also experienced several shipping delays due to nationwide school closings which affected its performance at the end of March. HMH books and media segment billings decreased 3% to $39 million for the first quarter. This was due to 2019 licensing revenue attributed to the Carmen San Diego series on Netflix which did not repeat in the first quarter of 2020, but is expected later in the year partially offset by strong growth in online book sales, particularly in the young readers eBooks category.

I will now shift gears from our performance in the seasonally small first quarter to spend a few minutes putting into context the decisive steps we have taken to strengthen our financial position in light of the COVID-19 pandemic and the ensuing business disruption as well as to provide you with some additional color about our financial condition and expectations. In October 2019, as you will remember, we announced steps to further simplify our organization, realigning our cost base and reducing our capital intensity to become a leaner and more cash-generative business. We also strengthened our balance sheet through debt reductions and a refinancing to extend our debt maturities. Since then, we've taken several additional actions to protect the financial health of the company and enable us to weather the COVID-19 crisis and emerge stronger thereafter.

These actions announced on March 27 included a significant reduction of operating expenses and enhancements to HMH's balance sheet. We reduced pay for the majority of employees through spending not directly tied to near-term billings, reduced inventory purchasing, temporarily closed fulfillment centers, deferred capital projects and pre-emptively borrowed funds from our asset-backed revolving credit facility we typically accessed during our working capital trough in the second quarter each year. These were all prudent measures to strengthen our financial position in light of the uncertainty posed by the unprecedented steps taken by our customers, representing over 90% of schools in the United States, to transition to a remote learning environment. We have conducted stress testing and scenario planning, and have concluded that if we take no additional action beyond the actions that we announced on March 27, we estimate that our breakeven level of billings, that is the point at which we would generate no free cash flow in 2020, is in a range of $1.23 billion to $1.28 billion.

By way of comparison, in both 2017 and 2018, HMH generated over $1.3 billion of billings, a much higher level than the scenario analysis shows, yet the company consumed $82 million and $73 million of cash in those years, respectively. To be clear, this breakeven billing scenario range does not constitute billings guidance on our part and does not represent the billings outcome we are striving for in 2020. But we are sharing this with you today to quantify the significant improvement in cash flow generation capability that has resulted from our restructuring actions in 2019, along with the additional mitigating actions we announced in March. Looking ahead, we expect and are planning for a recovery this summer as our customers prepare for returning to school this fall, whether in physical classrooms or virtual classrooms.

We have already seen signs that the demand recovery is beginning. Jack mentioned an important science adoption win in the Los Angeles Unified School District and wins in the Texas literature adoption. These decisions were made after waves of school shutdowns had already begun. The second and third quarters are typically the busiest billings quarters for us.

And now that we have entered into this important part of our year, we are learning more every day about the magnitude of the recovery and demand. Now moving on to liquidity. As you know, we typically start each year with significant liquidity to fund the seasonal working capital needs of our business under a range of different scenarios, and 2020 is no exception. We ended 2019 with $296 million in cash and our $250 million asset-backed revolving credit facility was undrawn.

During each of the last two years, we drew liquidity from our asset-backed revolving credit facility and paid it back in a matter of months. For 2020, we had already anticipated doing the same. And as the potential impact of the pandemic became apparent, we decided that pre-emptively drawing $150 million was a prudent step to mitigate unforeseen dislocations in the capital markets that might prevent us from accessing our credit line later in the year. We ended Q1 with $255 million in cash on our balance sheet.

And excluding the cash from borrowing $150 million of our revolver, we had $105 million of operating cash on hand, $21 million more operating cash than we had at the same point last year. So we believe we are entering into the second quarter of 2020 with ample liquidity and financial flexibility to manage our business through the normal, seasonal working capital cycle that we manage through every year and importantly, to capitalize on the longer-term opportunities that Jack spoke to. So with that, I'll now turn it back over to Jack for some closing remarks.

Jack Lynch -- President and Chief Executive Officer

Thanks, Joe. In closing, I'd like to summarize the key points we covered today. First, HMH is in a strong position from a capital, liquidity and balance sheet perspective and remain confident in our long-term strategic direction. As Joe and I both shared with you, all the work we've accomplished over the last two years including the decisive actions taken this year, makes HMH a significantly leaner and more profitable company.

We are leading the market in Texas again and have performed well in early sales efforts across the other adoption opportunities this year. We are confident this momentum will continue into our busiest selling season in the coming months. With schools planning for the fall, we continue to expect back-to-school to be a meaningful demand driver for the instructional materials market this summer. And finally, the pandemic is accelerating the market move to digital learning.

Digital offerings will lead in the next decade and HMH is best positioned across both core and Extensions with a connected solution that is underpinned smart software and puts the educator at the center, something no other company in the industry can match. With that, we'd like to open up the call for questions. Operator?

Questions & Answers:


Operator

[Operator instructions] Our first question comes from Bill Warmington of Wells Fargo. Your line is open.

Bill Warmington -- Wells Fargo Securities -- Analyst

Good morning everyone.

Jack Lynch -- President and Chief Executive Officer

Good morning Bill.

Joe Abbott -- Chief Financial Officer

Good morning Bill.

Bill Warmington -- Wells Fargo Securities -- Analyst

So I think it would be helpful if you could walk us through specifically how the move to digital is going to help Houghton and how that's going to flow through, you think, to billings? And what kind of a timetable?

Jack Lynch -- President and Chief Executive Officer

Yes. Great question, Bill. I think the first thing to say is that we have moved to digital. We have been, for the last 10 years, and the industry has been in this blended environment where you provide a core curriculum or even supplemental, and there's an analog piece to it that's manifested in the print book, and there's a digital piece of it.

So when we talk about digital-first, what we're talking about is digital is the main event. That's what's going to be consumed, especially as every kid in the country has access to a Chromebook or a iPad. And that's -- what the crisis has done is really accelerated that move from two to one, two kids to every device, to one to one. So that's a big driver for our digital instructional materials.

And so the billings we see will be essentially digital and then educators will determine what do I need in printed materials as a supplement to the digital?. Whereas up till now, you would buy a core program and you get the digital and the print materials, even if you didn't use the print materials, you would still get them. So we don't see a significant change in the top line. However, you can imagine that the gross margin will improve as we reduce our reliance on the manufacturing of print materials in the actual production of print materials and distribution of print materials.

So we see a lift in the gross margin and ultimately, in the overall profitability of the company.

Bill Warmington -- Wells Fargo Securities -- Analyst

Got it. And then I think -- I know your -- you guys are not giving guidance going into the fall. You provided some color in terms of what you think could happen. And I thought it might be helpful if you could, broad strokes, give us a sense for what billings might look like under some different recovery scenarios.

As high level as you like, but I think that sort of laid out where you thought the breakeven was which is helpful. And I know you can't predict when the school districts are going to open. But I think you can lay out, like, if this happens then we think we're probably going to come in around here, that would be helpful, I think.

Joe Abbott -- Chief Financial Officer

Yeah. Bill, it's Joe. Yeah, we're not yet at the point where we're able to make a reasonable estimate on where we think this ultimately could play out. But as I said in the remarks there during the call that we certainly are not viewing that breakeven billings level as the level to which we are aspiring this year.

Back-to-school 2020 in the fall is going to be a major demand driver as it is each and every year. That's what we believe and that's what we're preparing for. And as we think about where we're at right now, what we're really focused on is making sure that we're supporting our customers' needs as they're transitioning to a new environment and supporting the way they're thinking about how to return to school in the fall, whether that's in a physical classroom setting or a virtual classroom setting, we have offerings. Therefore, the opportunity for billings across really any situation that we can foresee coming through the next year.

So we're not quite ready to provide estimates on where we might end up. But we do think that back-to-school is going to be an important demand driver.

Bill Warmington -- Wells Fargo Securities -- Analyst

OK. And I also wanted to say congratulations on the California science win, that's a great feather in your cap. I wanted to ask if -- when you expect there to be a resumption of decisions around California science.

Jack Lynch -- President and Chief Executive Officer

Yeah. I think right now, we've seen a resumption. So in Texas for the literature adoption as well as California and the other adoption states, there's been a resumption, if you've -- already of a purchasing behavior.

Bill Warmington -- Wells Fargo Securities -- Analyst

Great. All right. Well thank you very much for the color.

Operator

[Operator instructions] There are no further questions. I'd like to turn the call back over to Jack Lynch for any closing remarks.

Jack Lynch -- President and Chief Executive Officer

OK. Well, thank you everyone for your time and your attention today, and we look forward to talking to you again at the Q2 earnings call. Have a great day.

Operator

[Operator signoff]

Duration: 41 minutes

Call participants:

Brian Shipman -- Senior Vice President, Investor Relations

Jack Lynch -- President and Chief Executive Officer

Joe Abbott -- Chief Financial Officer

Bill Warmington -- Wells Fargo Securities -- Analyst

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