Houghton Mifflin Harcourt Co (HMHC) Q3 2021 Earnings Call Transcript

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Houghton Mifflin Harcourt Co (HMHC)
Q3 2021 Earnings Call
Nov 4, 2021, 9:30 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Thank you for standing by, and welcome to the HMH Third Quarter 2021 Earnings Conference Call. [Operator Instructions] Please be advised that today's conference may be recorded. [Operator Instructions] I would now like to hand the conference over to your host, Vice President of Investor Relations, Chris Symanoskie.

Chris Symanoskie

Thank you, and good morning, everyone. Before we begin, please note that slides referred to on today's call can be found in the Investor Relations section of our website at hmhco.com. A telephone replay of today's call will be available until November 14, 2021, and the webcast will be available on our website for one year. The company's 10-Q was filed with the SEC earlier this morning, along with its third quarter 2021 earnings press release. HMH encourages you to review the cautionary statements on slide two of today's presentation. Additional information regarding these and other risk factors can be found in the Risk Factors section and elsewhere in the company's quarterly and annual filings with the SEC. Furthermore, please refer to today's press release and the appendix of our slide presentation for a reconciliation of our non-GAAP measures to the most directly comparable GAAP measures. This morning, HMH's President and Chief Executive Officer, Jack Lynch; and HMH Chief Financial Officer, Joe Abbott, will provide an overview of the company's third quarter 2021 results.

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

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

Thanks, Chris, and good morning, everyone. Thank you for joining today. Our business momentum continued into the third quarter as students return to classrooms, and teacher confidence in using education technology to advance student learning is at an all-time high. We're beginning to see the promise of digital learning take hold and the willingness to invest in digital solutions increase, especially as the spending environment for K-12 and instructional materials continues to improve. Our results position HMH for a strong finish to the year and set the stage for continued success next year. In the third quarter of 2021, we delivered an impressive 22% year-over-year increase in billings. Our margins continue to expand, helping us achieve $137 million in trailing 12-month free cash flow, a $36 million improvement compared to Q2 of this year.

Annual recurring revenue, or ARR, from our expanding subscriber base grew 123% as our Digital First, Connected strategy continues to deliver impressive results, and the increase in our net retention rate, or NRR, to 153% was a key driver in our ARR growth, reflecting the depth of our relationships with subscribers and successful cross-selling capabilities and putting us on track to finish 2021 with ARR in a range of 12% to 15% of billings. Furthermore, we remain committed to maintaining an efficient capital structure to closely align with our Digital First, Connected strategy. In the third quarter, our gross leverage ratio remained low at 1.4 times, significantly better than our near-term goal of two times adjusted EBITDA. Our strong balance sheet, combined with improvements in profitability and the dramatic rise in our free cash flow further enhances our financial position and ability to invest in growth and efficiency and create shareholder value.

As a result of our strong third quarter results, and the confidence we have in our Digital First, Connected strategy. We are increasing our full year billings and unlevered free cash flow guidance for the second time this year. And as good as our performance has been this year, we will continue to capitalize on the growth opportunities that lie ahead from cross-selling solutions within our Connected business and increasing our share of the $200 per student spend on instructional materials. Billings growth, coupled with the operating leverage in our business will generate higher free cash flow in the years to come. Underpinning these growth opportunities is a large and growing market for instructional materials, a market with 54 million students, four million teachers, 15,000 schools and $740 billion in annual spending with more than $10 billion spent on instructional materials and services.

At the same time, we believe there is a shift to digital occurring that was accelerated by the pandemic and driven in part by growing teacher confidence in EdTech. This positions HMH incredibly well, especially given our broad presence in over 90% of K-12 schools. Although schools and school districts are still recovering from the pandemic, we are seeing encouraging signs of recovery in spending. Our solutions and strategic advantage can be summed up by the phrase one platform, all students. HMH possesses two major advantages that are difficult for others to replicate. First, few if any companies can offer teachers all of the resources they need to advance learning for all of their students wherever those students may be on the achievement spectrum. From core curriculum to supplemental intervention and services, the breadth of our portfolio is extensive, and each solution is in learning science.

In fact, learning science is one of the major drivers of the overall efficacy of our solutions. Yet this is only part of our advantage, HMH also alleviates a critical pain point in the industry today. The fragmented nature of the point solutions found in many of today's classrooms are inefficient and require an exhausting level of work by teachers. By contrast, HMH solutions powered by artificial intelligence and learning science work in concert with one another on our digital platform. The platform provides educators with easy access to these solutions as well as insights from our computer adaptive assessment, the growth measure to make instructional decisions that help each student achieve their goals. Demand for our comprehensive offerings continues to grow because HMH solutions are proven to work.

They combine the power of evidence-based resources, learning analytics, services and world-class user experience. They are supported by our extensive capabilities in lean agile software development as well as by our skilled team of customer success managers, learning scientists and nearly 2,300 employees working together in a purpose-driven culture. Our authentically purpose-driven culture is a key competitive differentiator, underpinning our success. Building and reinforcing this culture is important because it attracts great talent, drive superior performance, fosters alignment in digital maturity in support of our Digital First, Connected vision. In our annual Gallup survey of employee engagement, we ranked very high among peers as well as among Gallup's larger universe of companies.

This year, we are pleased to rank in the 89th percentile benchmarked against our information services peers for employee engagement overall and higher in engagement dimensions that are important to our culture. And we will continue to work with our managers and employees on initiatives to further our success in building a strong culture with high employee engagement and satisfaction. The bottom line is we have incredibly talented people who are drawn to HMH, not only because of our stated values, but because of what we do. We improved student outcomes. We help the communities we serve, and we strive to do these things in an environmentally sustainable fashion. I want to take this opportunity to thank our amazing employees because they have worked incredibly hard over the last few quarters to fulfill our mission, especially during a time of unprecedented change.

Thank you for making great contributions every day. HMH has a long history of service to teachers, students and the communities in which we live and work. In fact, just this week, we launched our tenth annual volunteer week. In the past two years alone, our employees over 11,700 hours of community service, positively impacting more than 10,500 students. Our mission to drive positive student outcomes is strongly aligned with the United Nations Sustainable Development Goal for, for quality education. Our Board of Directors provides oversight on ESG matters and the Board's diversity exceeds NASDAQ's new listing standards.

Furthermore, we believe our education and training programs for employees are best-in-class, and we surpassed relevant benchmarks on employee engagement according to our most recent Gallup survey. Importantly, HMH also has several companywide diversity, equity and inclusion initiatives underway, including several employee resource groups. These are voluntary employee-led groups whose members joined together based on common interests, backgrounds or demographic factors such as gender, race or ethnicity. At HMH, our ERGs foster a diverse culture of belonging that is aligned with our mission. And on matters of sustainability, our paper sourcing and usage policy, waste management and recycling programs and the development of digital learning solutions means we use fewer natural resources and reduce our reliance on transportation to deliver materials, which benefits the environment.

One of the first things I noticed after joining in 2017, where the HMH employees are deeply committed to advancing student outcomes and to building an equitable, sustainable and brighter future. I highly encourage these efforts and want us to build on that passion. This enthusiasm for building a better future is a key factor in creating our purpose-driven culture in support of our Digital First, Connected strategy. As you have heard me say before, there are three key priorities that guide our team's execution. First, grow Digital First, Connected business. This pillar represents our mix shift to digital, which accelerated in the third quarter after being down slightly in the second quarter due to districts restocking print materials as catch-up for students returning to classroom. Last quarter, we said that we expect to finish the year with Connected sales above 50%.

I'm pleased to report our Connected sales for the trailing 12 months accounted for 51% of our billings and Digital accounted for 41% in the third quarter. Number two, deepen customer engagement increase outcomes. This pillar illustrates a mix shift to recurring revenue, which again grew rapidly in the third quarter, increased demand for our highly effective learning solutions and deep customer engagement drove an acceleration in our ARR growth rate to 123% in the third quarter with a net retention rate of 153%. Number three, optimize our digital transformation. This pillar describes our focus on improving operating margins and free cash flow over time. For the trailing 12 months ended September 30, 2021, our adjusted variable costs were 31% of billings compared to 34% in the same period last year, and adjusted fixed costs were $446 million compared to $481 million in the same period last Number three, optimize our digital transformation.

This pillar describes our focus on improving operating margins and free cash flow over time. For the trailing 12 months ended September 30, 2021, our adjusted variable costs were 31% of billings compared to 34% in the same period last year, and adjusted fixed costs were $446 million compared to $481 million in the same period last year. Let's look at our margin story in a broader context on the next slide. The margin expansion we are now experiencing is largely a result of permanent changes we made to our cost structure in 2019 and 2020 when we restructured to align our cost structure with our Digital First, Connected strategy. These efforts, along with the divestitures of our noncore businesses, lowered our fixed cost by an incredible 34% since 2016. The other driver is that we have a great deal of operating leverage in the business.

We believe that the gross margin on our digital billings is considerably higher than for our print business, high rate in line with what you would observe in other ARR SaaS businesses. Thus growing revenue and billings is going to be a driver of growing EBITDA and free cash flow, respectively. Going forward, as our business shifts to more digital, we expect to see margin uplift in the form of lower variable costs as a percentage of billings and even some opportunity to remove fixed cost that still support the print volume in our business. Last year, we also significantly strengthened our balance sheet by paying down debt with the proceeds from the divestiture of HMH Books & Media. A stronger balance sheet and higher free cash flow gives us the flexibility to invest in organic and inorganic growth while maintaining a healthy gross leverage ratio.

Our digital and business transformation has set the stage for a dramatic increase in our annual recurring revenue. In the third quarter, ARR increased year-over-year by 123% to $120 million or 11% of trailing 12-month billings, and ARR was $43 million higher than just last quarter. Not to mention that our net retention rate was 153% in the third quarter, well above our stated outlook of more than 100%. The size and growth of ARR positions HMH among the largest and fastest-growing digital businesses in the EdTech market. Furthermore, our digital solutions and platform together create tremendous customer loyalty or stickiness. This is because, one, HMH digital solutions are continuingly updated and are based on the latest and learning signs.

Two, our solutions are highly effective and provide measurable increases in student outcomes; and three, all the resources teachers need are delivered on a platform designed to make life easier for them, allowing them more time with students and providing them with actionable insights that advance the learning of all students wherever they may be on the achievement spectrum. This, combined with an engaging and fun learning experience for students create enthusiastic and loyal customers. And again, because of the tremendous amount of operating leverage in our business model, we estimate that every dollar of incremental billings flow through to free cash flow at approximately 65% on average. As we grow our business and as billings continue to recover after the pandemic, we anticipate an increase in free cash flow margin as well. On both slides 14 and 15, you can see a more dramatic fashion why we are so excited about the financial performance of our business.

Now before I provide final remarks, I would like to turn the call over to our CFO, Joe Abbott, who will walk you through our third quarter results and full year guidance in more detail. Joe?

Joe Abbott -- Chief Financial Officer

Thanks, Jack, and good morning, everyone. We continue to generate strong results as we execute on our Digital First, Connected strategy. Total billings were $548 million in the third quarter, up 22% over the prior year. Core Solutions billings were up $15 million or 6% to $269 million, driven by strong open territory demand as a result of the continued market recovery. Extensions billings were up $82 million or 42% to $278 million, driven by strong demand for Heinemann branded solutions as most of our customers return to in-person this fall. Also contributing to the rapid growth in extensions was strong demand for digital supplemental products and virtually delivered professional services as our customers increasingly embrace our digital connected solutions. Turning to our other key financials.

Our net sales increased to $417 million in the third quarter, a year-over-year increase of 26%. On a year-to-date basis, net sales grew 25% and billings grew 21%. Net income from continuing operations for the third quarter was $95 million, an improvement of $107 million compared to the same period in 2020. On a year-to-date basis, net income from continuing operations increased by $431 million year-over-year. Adjusted EBITDA for the third quarter increased to $146 million from $83 million in the same period last year due to robust net sales growth and high operating leverage in our business, made stronger by the actions we took last year to better align our cost structure with our strategy.

As a result, adjusted EBITDA margins expanded to 35%, up from 25% in the third quarter of 2020. Our trailing 12 months free cash flow increased to $137 million at the end of September, up $36 million from $101 million at the end of June. As you know, we typically use cash in the first half of the year and generate cash in the second half of the year. Our year-to-date performance demonstrates that our cost structure is scaling well and is a strong forward-looking indicator of the robust free cash flow we expect to generate this year. Although the market has not yet fully recovered from the COVID-19 pandemic, we believe our Digital First, Connected strategy will result in a more stable, growing recurring revenue stream with higher margins and increasing free cash flow over time.

We continue to manage this robust financial performance with three main priorities. Our first priority is maintaining a strong balance sheet. In the third quarter, our gross leverage ratio improved to 1.4 times adjusted EBITDA for the trailing 12 months ended September 30, 2021. We continue to target a gross leverage ratio under 2.0 times. And while we may add incremental debt from time to time, for example, to fund tuck-in acquisitions, our intent would be to delever to below our 2.0 times target quickly thereafter. As you may recall, we received a ratings upgrade from Fitch and one from Moody's earlier this year as well in recognition of the significant improvement in our profitability and capital structure. We see additional opportunities to improve our capital structure by reducing our cost of debt. our $303 million in senior secured notes, which carry a 9% coupon, become callable in February 2022, and we will be monitoring marketing conditions for the right time to refinance.

And lastly, we still plan to reserve approximately $275 million of our year-end cash balance to meet our seasonal working capital needs, which supplements our asset-backed liquidity facility. Our second priority is to invest in growth. We plan to invest a mid-teens percentage of our total billings and product development activities to further extend our leadership position and organic growth. We plan to add to that organic growth with growth from small tuck-in acquisitions of complementary or solutions that can leverage our comprehensive business platform and dynamic sales force. HMH's strong balance sheet and high free cash flow positions us well to do this. And our third priority is investing for efficiency. We intend to fund projects that we expect to help us deliver greater customer success and/or achieve operational efficiencies. We are currently taking steps to further reduce our real estate footprint.

And we have a three-year back-office automation project underway that will modernize the technology we use to serve customers and streamline operational processes that are used to deliver digital connected solutions. For the second time this year, we are raising our full year guidance. This update is a direct result of our strong year-to-date performance and how we expect to perform in Q4. We now anticipate billings for the full year to be between $1.075 billion and $1.095 billion, which is 20% to 22% growth compared to 2020, up from our prior expectation of $980 million to $1.02 billion. We continue to expect that over 50% of our billings will be derived from sales of connected products and services this year. We're also raising our unlevered free cash flow outlook to 17% to 19% of 2021 billings, up from our prior 12% to 14% range, which reflects the high degree of operating leverage in our business and our increased billings guidance.

As our business continues to grow, we expect our unlevered free cash flow margin to expand along with that growth. And finally, we remain on track to deliver annualized recurring revenues of 12% to 15% of 2021 billings. We expect to achieve a net retention rate of over 100%, which will contribute to the growth in our ARR. All in all, during the third quarter and year-to-date 2021, we continue to realize the benefits of our strengthened financial position along with the successful execution of our strategy. We have a strong balance sheet, a disciplined approach to capital allocation and high operating leverage, and we continue to make great progress on rapidly growing ARR. And with that, I'd like to hand it back over to Jack for closing remarks.

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

Thank you, Joe. As outlined in our declaration of culture, a statement of values we call, Our Stand, HMH's double bottom line approach and culture of innovation are key components of our success, helping teachers unlock the learning potential of their students. As a learning technology company, we believe HMH is distinctly different from core curriculum publishers and from the many supplemental point solution companies with whom we compete. HMH has a truly unique opportunity to expand market share in this very large and growing market because our connected solutions are unique and effective at improving student outcomes.

And our clear three-point business strategy we call Digital First, Connected focuses on shifting our revenue mix to digital and building recurring revenue while expanding margins. Furthermore, we're committed to maintaining a strong balance sheet and free cash flow generation to complement organic growth and enable flexibility for tuck-in acquisitions to augment strong organic growth in the years to come. Our efforts to become the leading EdTech platform in K-12 education are clearly gaining traction. We believe we are creating a durable and consistent business that creates value for all of our stakeholders. We hope you will continue to join us on this important journey.

Now I'd like to open up the lines for questions.

Questions and Answers:

Operator

[Operator Instructions] Our first question comes from the line of George Tong of Goldman Sachs. Your line is open.

George Tong -- Goldman Sachs -- Analyst

Hi, thanks. Good morning. Apologies if I missed this, but could you tell us how much in connected sales you generated in the quarter?

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

Yes. George, we don't break out connected sales right now. But I think it's fair to say that the biggest driver of growth is our connected sales, which are essentially our core supplemental intervention and services solutions or as we said today, 51% of our portfolio where we can cross-sell among the various solutions in order to capture a greater share of that $200 per student spend on instructional materials each year.

George Tong -- Goldman Sachs -- Analyst

Got it. And then as it relates to billings, can you elaborate on where the upside came from in the quarter? And then how we should think about billings over the medium term?

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

Yes. I think the thing that we're really proud of in terms of our performance this year is that, across the board, we've seen incredible growth in each of our lines of business. So I think if you were to look at core or extensions, you're going to see really good growth in both categories, phenomenal growth in extensions. In terms of continued growth, as you know, George, it's our custom to provide guidance in February at our Q4 earnings call. That said, we expect to continue to capitalize on the growth opportunities that lie ahead from cross-selling within our Connected business and increasing that share of the $200 per student spend on the instructional materials. So if you look at billings growth and couple that with the operating leverage in our business, we will generate higher free cash flow in the years to come.

George Tong -- Goldman Sachs -- Analyst

Got it. Thank you. Very helpful.

Operator

Thank you. [Operator Instructions] Our next question comes from Jason Bazinet of Citi.

Jason Bazinet -- Citi -- Analyst

So I just had a high-level question. You can correct me if I'm wrong, but when I think about your company in the past, the EBITDA margins weren't phenomenal. And I always assume that was because it's a high fixed cost, a lot of development costs upfront. And so there's always this incentive for you and your competitors to discount as you're going into a particular pitch because the marginal costs were low.

And so my question is, as we move to this new environment, where we have a much leaner cost structure and the variable costs go down, can you just give us a little bit of color in terms of where do you think you are in terms of your cost structure vis-a-vis peers? And how would you characterize sort of pricing discipline in the industry? Because what I'm trying to get at is how much of this can investors sort of underwrite is durable as opposed to the benefits of all the good things you're doing, ultimately accruing to your customers with lower prices as opposed to shareholders with higher cash flow and higher margins.

Joe Abbott -- Chief Financial Officer

Yes. Great question, Jason. I think as Jack said in his remarks on the call that we see a 65% flow-through rate on incremental billings growth. And that's largely a reflection of the operating leverage in the business. You're right. There is opportunity for us to continue to see margin accretion just as billings grow. But one of the questions I think you're asking is, is that a durable cost structure that we've put in place to align to our strategy. And the answer is yes. So that was the other piece of what Jack said, which is these are permanent changes and that's changes that were designed to align to a business that is now a learning technology company.

And we believe we've got the right amount of investment in our organic product development as well as the fixed cost to support the business to continue to scale and grow as we progress through this. Now pricing discipline, as you were asking about the ability for us to continue to see that, we see great price realization in our business. We have adopted value-based pricing which has been a big -- has had a big part in our ability to move forward with a digital-first pricing approach as our customers demand more of the digital solutions. We are charging for those digital solutions. And so that's been very successful for us. And we believe that, that also is a very durable trend that we've seen in our business.

Jason Bazinet -- Citi -- Analyst

Thank you.

Operator

At this time, I'd like to turn the call back over to Chris Symanoskie for closing remarks. Sir?

Chris Symanoskie

Thank you, operator. Well, that will conclude our call for today. We thank you for your participation and for your interest in HMH. Have a great day.

Operator

[Operator Closing Remarks]

Duration: 33 minutes

Call participants:

Chris Symanoskie

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

Joe Abbott -- Chief Financial Officer

George Tong -- Goldman Sachs -- Analyst

Jason Bazinet -- Citi -- Analyst

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