Houghton Mifflin Harcourt's (HMHC) CEO Linda Zecher on Q2 2014 Results - Earnings Call Transcript

Aug.14.14 | About: HMH Holdings (HMHC)

Houghton Mifflin Harcourt Company (NASDAQ:HMHC)

Q2 2014 Earnings Conference Call

August 14, 2014, 8:30 AM ET

Executives

Rima Hyder - VP, IR

Linda Zecher - CEO

Eric Shuman - EVP & CFO

Analysts

Peter Appert - Piper Jaffray

Andre Benjamin - Goldman Sachs

Trace Urdan - Wells Fargo

Drew Crum - Stifel

Jeff Silber - BMO Capital Markets

Jason Bazinet - Citi

Operator

Good morning, and welcome to Houghton Mifflin Harcourt Second Quarter 2014 Earnings Call. I would like to inform you that this call is being recorded for broadcast, and that all participants are in listen-only mode.

I would now like to introduce Rima Hyder, Vice President, Investor Relations for Houghton Mifflin Harcourt. Ms. Hyder, you may now begin.

Rima Hyder

Before we begin, I would like to point out that the slides we will reference during the course of this presentation can be accessed via the Investor Relations section of the Houghton Mifflin Harcourt website at www.hmhco.com.

A replay of today's call will be available via phone and on our website later today until August 28. We filed our financial statements in our Quarterly Report on Form 10-Q with the U.S. Securities and Exchange Commission earlier this morning, along with our second quarter earnings release.

After our prepared remarks, we will open the call for questions from investors. To be fair to everyone, please limit your questions to one, plus a follow-up. You may get back into the queue if you have additional questions.

Before we discuss our results, I encourage all listeners to review the legal notice on slide two, which explains the risks of forward-looking statements and the use of non-GAAP financial measures. Additionally, please refer to our Form 10-K and 10-Q for a discussion of risk factors that could cause actual results to differ materially from these forward-looking statements.

Our slide presentation and discussions on this call will include certain non-GAAP financial measures. For such measures, reconciliations to the most directly comparable GAAP measures are in the appendix of the presentation.

This non-GAAP information should be considered supplemental in nature and should not be considered in isolation, or as a substitute, for the related financial information prepared in accordance with GAAP. In addition, these non-GAAP financial measures may not be the same as similarly entitled measures reported by other companies.

This morning Linda Zecher, Houghton Mifflin Harcourt's President and Chief Executive Officer, will provide an overview of the company's second quarter 2014 results, followed by the presentation of financial results by Eric Shuman, HMH's Executive Vice President and Chief Financial Officer.

I will now turn the call over to the Chief Executive Officer of Houghton Mifflin Harcourt, Linda Zecher.

Linda Zecher

Thank you, Rima, and thank you, everyone for joining us today. This morning we released our second quarter results, which are a clear testament to our ongoing leadership within the K-12 education market. With our high season underway, increased penetration and adoption markets in open territories enabled us to deliver strong growth.

Net sales and adjusted EBITDA for the second quarter of 2014 were up 11% and 12%, respectively, compared to the second quarter of 2013. Year-to-date orders, as of June 30, were 40% higher, compared to the first half of 2013, another proof point of our growth trajectory and ability to command new business wins.

In addition to our top line growth this quarter, increased orders have led to $114 million net increase in our deferred revenues since the first quarter of 2014. This deferred revenue is recognized over a longer period of time, providing us with a solid base for future growth. It also reflects our successful efforts to rapidly increase the balance of compelling digital content within our education programs.

As we continue to add to our line of best-in-class technology, such as the recent introduction of the HMH Player for Google Chrome and the Apple iPad, we expect this encouraging shift towards higher recurring revenues to continue, giving us stability and resilience in various market conditions and enhancing pipeline visibility.

Within our education segment, the positive trends we saw last quarter materialized into meaningful contracts and sales in the second quarter. As you remember, in the first quarter of this year, HMH captured approximately 50% market share among adoption school districts that had selected content providers.

I’m pleased to say that we had maintained that share through the second quarter, and now that 90% of adoption districts have selected providers, our 50% share is off a much larger base. Our addressable market size is on pace to exceed the $3 billion we initially estimated with the new adoption market being greater than $900 million, further adding to our optimism.

Overall state funding for education is on the rise. The National Association of State Budget Officers, or NASBO, stated that, as of July 1, 39 states have called for increases in K-12 funding. This is expected to yield a net funding increase of approximately $11 billion.

NASBO also reports that fewer states implemented mid-year budget cuts in fiscal year 2014, compared to 2013. This increase in funding is having a positive impact for HMH in the form of strong results in key states such as Texas, California and Florida, including wins in almost all of the large school districts in these states.

In particular, we had strong performance in K-12 math and science in Texas, secondary math and literature in Florida, and K-12 math in California. Moving forward, we are seeing additional solid demand and opportunity in Texas where our social studies, math and science programs are all well positioned to capture the market this year and next. We have also been pleased with our progress in open territories for the growth in states, including Illinois, Washington, and Connecticut.

Trade Publishing reported the second highest Q2 revenues, only slightly down against the second quarter of 2013 when we reported the highest-ever Q2 net sales in the history of HMH. The change in 2014 quarterly net sales are a reflection of the strong 2013 front-list sales from Francona and the residual sales from The Hobbit and the Life of Pi.

While comparable sales have not occurred in 2014 to-date, we are optimistic about our strong line up of trade titles for the fall like What If? by Randall Munroe, Better Homes and Garden, and Weight Watcher Cookbooks, and my favorite, The Little Blue Truck Christmas Edition.

Also, as I mentioned last quarter, we are very much looking forward to the release of The Giver movie. Through June of this year, The Giver by Lois Lowry has been a top-selling title in both print and e-book formats, and we anticipate continued strong tie-in sales. We expect this, combined with other upcoming front-list titles, to support Trade Publishing revenues in the coming quarters.

Looking ahead, the strength of our content will enable us to continue capitalizing on the nice tailwind created by the increase in our addressable markets. While the vast majority of our growth in the coming quarters will be from our K-12 education business, we are actively pursuing opportunities to enhance our presence in complementary areas, including consumer and early childhood, while continuing to innovate in the digital space in support of the learning transformation.

Ultimately, these combined efforts should enable us to create stronger and more diversified revenue streams over the long term.

Within the consumer space, we are harnessing the depth and breadth of our content to create meaningful at-home learning experiences for parents and students. Our success in the classroom makes us a natural choice for consumers. Our progress so far validates this strategy.

Since the launch of GO Math! Academy in the second quarter, we have continued to build our consumer learning portfolio. In the next few quarters, we will be releasing additional products that continue to enhance our offerings. And with the acquisition of Channel One News, which I will discuss further in a few moments, we are seeing increasing opportunities to leverage our content and multiple media modalities.

In addition to leveraging our education content, we’re also using our iconic brands to bring new engaging digital experiences to lifelong learners. For example, in May, Curious George and the Firefighters was made available as part of the Tribal Nova iRead With series for the Apple iPad. This interactive app encourages the collaborative reading experience and language development for parents and kids.

Further advancing our digital evolution, we have recently finalized the acquisitions of digital content provider, Channel One News and ePortfolio company SchoolChapters. Channel One has a 25-year pedigree in producing digital content for the K-12 sector, including 87 Telly awards and multiple Peabody awards.

CJ Kettler, the CEO of Channel One News, brings decades of media and consumer experience to HMH. She is truly committed to helping students be informed, digital savvy citizens. As a media industry leader, CJ has held senior positions with household names, including Oxygen Media, MTV Networks, and CBS.

Given her experience and passion for this space, moving forward, CJ will assume responsibility for HMH’s direct-to-consumer efforts. Bringing together HMH’s world-class education content with Channel One’s expert video and cross-media projection capabilities, we will be able to better develop and distribute relevant content via new modes of delivery and most effectively reach students, teachers, and parents.

As you may already know, we have had the partnership with SchoolChapters since 2013, and we recently deepened this relationship by acquiring the platform. SchoolChapters is a leading player in the growing e-portfolio market. This cloud-based, file-sharing and storage application allows you to easily capture, organize and share classroom documentation for credentials, assessment, and parent communication.

The addition of SchoolChapters to our digital offering reinforces our commitment to leveraging technology to provide comprehensive solution to consumers and institutions that strengthen all aspects of the learning continuum.

Another important area of growth and diversification is the early childhood space. In May, we acquired personalized learning platform, Curiosityville, which will act as the foundation for our early childhood effort moving forward in both the institutional and consumer markets. Through lovable characters such as Pablo the frog, Rosie the mouse and Ruby the cat, Curiosityville subscription-based learning content imparts valuable development skills on children as young as age three.

The Learning Tree, which is Curiosityville’s proprietary data collection analytics engine, provides feedback and recommendations to help foster lifelong learners from the earliest ages and to better prepare children for classroom learning.

Curiosityville’s founder and CEO, Susan Magsamen, is a learning expert and award-winning writer with over 30 years of experience creating programs that bring academic research to practice, which we view as key to gaining share in this attractive category. The demand within early childhood represents hundreds of millions of dollars in spending at the institutional and consumer levels each year.

Bolstering our footprint in this space should create new revenue opportunities and complements our existing content line up. Our unwavering focus on innovation in the digital space is a common thread to our core business and our growth initiatives.

As the way students access information and learn continue to evolve, our goal is to make engaging and adaptive content available to students and teachers regardless of the device they are using.

In June, we launched the HMH Player for Google Chrome and the Apple iPad. This new app was immediately voted Best In Show by the International Society for Technology in Education at this year’s Annual Conference of 14,000 educators.

The HMH Player combines the simplicity of an e-reader with the power of quality interactive content, creating a new category for our industry. Districts considering providing students with their own device or having them bring their own device into classrooms will now be able to do so without the pain and frustration they experience today.

The HMH Player enables districts to ensure their students can benefit from fully interactive standards-aligned core curriculum online and offline. It enables educators to easily customize and assign lessons to students in their devices, and it allows teachers to easily attach and share additional resources like YouTube videos and other consumable media into their daily lessons.

Through built-in collaboration tools, teachers and students are able to benefit from one-to-one environments in a way that will impact learning outcomes rather than simply increase the amount of technology in the classroom. We look forward to expanding the app functionality and integration with all newly developed digital content and to other operating systems.

We also announced a strategic collaboration with Microsoft through which we will optimize our content for Windows 8 users, as well as develop a new e-textbook. By continuing to introduce innovative applications, and broadening the acceptability of our digital content, we are leading the charge in a profound learning transformation.

In conclusion, we set a remarkable pace in the second quarter, and we look forward to maintaining this momentum in the second half of the year as we work towards meeting our targets for 2014 and positioning ourselves for long-term growth and success.

With that, I will turn the call over to Eric to walk you through our financial results. Eric.

Eric Shuman

Thank you, Linda, and good morning, everyone.

As Linda has stated, we had strong momentum through the first half of the year, and are very pleased with our progress thus far.

We reported increased net sales and adjusted EBITDA for the second quarter, as compared to 2013 results. As you can see on slide 10, net sales for the second quarter were $402 million, up $39 million, or 11%, from $363 million in the second quarter last year. The increase was largely driven by new adoption sales in Texas, California, and Florida.

Also in the second quarter of 2014, billings, or gross revenue, increased 31% quarter-over-quarter and deferred revenue, which is revenue invoiced during the period but recognized in future years, increased $114 million since the first quarter of 2014.

The main reason for the higher deferred revenue is the higher digital components and print workbooks associated with the increased adoption sales. This is a clear indicator of the strong sales season we are experiencing this year.

And as Linda has already stated, for June 30 of this year purchase orders are up 40% as compared to the same period last year.

Adding to the strong net sales in the second quarter of 2014 versus 2013, we had an increase of $5 million in net sales in our Assessment business due to the launch of a new addition of the Woodcock Johnson program. Offsetting the increases were lower net sales of $6 million of Professional Services, primarily due to the timing of when these services are delivered, which is typically in the third quarter.

For example, our learning and leadership center, which provides consulting services for schools, had the highest orders ever in the second quarter of 2014. These orders will be invoiced over the coming months and recognized as net sales.

Within the second quarter total net sales, our Education segment was $365 million, compared to $324 million in the second quarter last year. This increase was driven by the strong domestic education market above which I just spoke.

Sales within our Trade segment declined only $2 million from $39 million to $37 million, and as Linda has already stated, these net sales represented the second highest Q2 net sales for this segment.

For the first six months of 2014, our net sales were $556 million, a $26 million or 5% increase over the first six months of 2013, due to the second quarter drivers.

Moving to slide 14, we reported operating income for the second quarter of 2014 of $18 million, compared to a loss of $6 million in the same quarter last year. The $24 million improvement was primarily driven by the increase in our net sales, coupled with $9 million positive impact from cost of sales, excluding pre-publication and publishing rights amortization. This positive impact was due to a 2% margin improvement primarily from a base of product mix carrying lower product costs, which benefited from larger print runs.

Additionally, there was a $7 million reduction in impairment costs and a $7 million reduction in net amortization related to publishing rights, prepublication and other intangible assets, due to our use of accelerated amortization methods. Partially offsetting the operating income was a $19 million increase in selling and administrative costs, primarily due to higher commissions associated with the increase in net sales, higher labor cost to support the adoptions in 2014, and technology-related costs to support ongoing digital initiatives.

We report an operating loss for the first six months of the year of $122 million, an improvement of $13 million or almost 10%, as compared to the same period in 2013. The year-to-date operating loss improvement was impacted by the same factors as the second quarter.

For the second quarter of 2014, we reported net income of $12 million, compared to a net loss of $14 million last year. The $26 million improvement was primarily due to the same drivers impacting the operating income, along with reduced interest expense as a result of our debt refinancing.

For the first six months of the year, we reported a net loss of $135 million, a $17 million improvement from a net loss of $152 million last year, impacted by the same drivers as the second quarter.

Our adjusted EBITDA in the second quarter was $109 million as compared to adjusted EBITDA of $97 million in the second quarter of 2013. This increase was mainly due to the increase in net sales, partially offset by higher cost of sales and selling and administrative costs.

Adjusted EBITDA for the first six months of the year was $56 million as compared to $65 million last year, primarily impacted by the first quarter losses, partially offset by the favorable second quarter results.

A detailed reconciliation of our GAAP results to adjusted EBITDA is included in the appendix to this presentation as well in our earnings release.

We ended the first half of the year in 2014 with cash and cash equivalents and short-term investments of $193 million, compared with $213 million for the same period in 2013. We used $132 million of cash in operating activities, $21 million less than the $152 million of cash used in the same period last year, primarily due to favorable working capital changes. We typically use cash in the first two quarters of the year due to the seasonality of our business.

In closing, we are very pleased with our second quarter results and look forward to updating you on our progress in the near future.

With that, we’ll now open the line for Q&A. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Peter Appert of Piper Jaffray.

Peter Appert - Piper Jaffray

The results are impressive, so congratulations. Linda, on the strength in the adoption market you’re seeing, do you attribute that just to the fact that the states are feeling more flush and the budgets are being increased? Or do you think some of it might be pull forward just in terms of timing of expenses, or perhaps coming at the expense of next year’s adoption market? And then, related to that, do you have a preliminary thought about what you are thinking about the 2015 adoption market? Thanks.

Linda Zecher

Primarily, we think it’s really due to pent-up demand and the fact that states are flushed with cash on education. But at the same time, we do think that there is some pull forward. We have seen some of that. Of course, our biggest impact on the market really is in Texas and California, and we are still really evaluating 2015 and what that’s going to look like, but there has been a little bit pull forward I think from ‘15 into ‘14. And we’re not really giving - and we’re still evaluating what ’15 is going to look like, so we’re not really prepared to give you numbers on that just yet.

Peter Appert - Piper Jaffray

If I could ask one follow-up, the new order metric you gave, I’m not sure I understand what that is, what does that 40% increase represent?

Eric Shuman

It represents purchase orders, the dollar value of purchase orders we received in the first six months this year versus the dollar value of purchase orders we received in the first six months of last year.

Peter Appert - Piper Jaffray

So would that flow through then to -- would that suggest then that the revenue performance this year might be meaningfully higher than the guidance you had provided earlier in the year?

Eric Shuman

Our guidance remains 5% to 8%, Peter.

Operator

Thank you for your question. The next question comes from Andre Benjamin of Goldman Sachs.

Andre Benjamin - Goldman Sachs

I was wondering if you could tell me a little bit about how we should be modeling the impact of some of your recent acquisitions, the three you talked about in the call being the news channel, the platform and the cloud-based application to organize credentials, the impact on margins? I’m not really sure what the margins were relative to your current business. And then, maybe a little bit on the investment needed going forward.

Eric Shuman

These were small strategic acquisitions, so I wouldn’t anticipate them having a significant impact this year, Andre.

Linda Zecher

I think the biggest thing here is that they are really just adding to our portfolio of products and especially in the area of consumer where we’re driving our consumer revenue and we think that this is going to have an impact down the road.

Andre Benjamin - Goldman Sachs

Maybe a bit more on, as you’ve been adding these capabilities to your M&A, maybe some thoughts on where you think you are in terms of -- what inning you might be in, if you feel like you’re still early on and continue to add capabilities, or do you feel like you are further along and you could be getting to the point where you have what you need in order to be competitive going forward?

Linda Zecher

I think we’re competitive right now and where we need to be in our core business and our core base of business. What we’re really looking at from an acquisition standpoint is how we can go into adjacent markets such as early childhood and into consumer, and those are two growth initiatives that I’ve talked about in the past.

So I think we’re adding to that portfolio. We are always looking at new opportunities to accelerate that growth, but right now we feel really good about the acquisitions that we’ve made, so they are a good foundation for us going forward.

Operator

The next question comes from Trace Urdan of Wells Fargo.

Trace Urdan - Wells Fargo

The first question, not very sexy, but can you speak to whether the proportion of deferred revenue that you saw in the quarter, which we understand was driven by the higher digital adoptions, whether you would anticipate that being kind of a good run rate as you look through the rest of the year?

Linda Zecher

We feel pretty good about the deferred revenue right now, because it’s really recognition of the technology that we’re shipping with our content and how that’s being really adopted by our customers, we feel pretty good about that.

We think that’s going to be a similar run rate moving forward. I would say that we’re not really giving guidance obviously on our digital content or deferred revenue, but we do feel that’s probably a pretty good metric of where we’re going to be.

Trace Urdan - Wells Fargo

And then, I’m wondering if it would be possible to kind of get a baseline on The Giver and kind of what that might look like with respect to the movie tie-ins, based on what you saw with the performance of The Hobbit and the Life of Pi?

Linda Zecher

We don’t really give guidance on that either, but I’ll tell you that the review so far I think on The Giver have been somewhat mixed. But I think the great news has been every one that has seen the movie has said that the book is better and they like the book a lot better. We’ve had solid shipments on the book, The Giver, so we’re feeling pretty good about that.

Trace Urdan - Wells Fargo

I’m just trying to understand whether it might be material difference or not if it performs well?

Linda Zecher

I don’t think it will be material. I think that it’s not going to change our guidance if that’s your question.

Operator

Thank you. The next question comes from Drew Crum of Stifel.

Drew Crum - Stifel

So, Linda, I wanted to ask you about how you are feeling about the open territory states as you look to the second half? That component of the market is down 1% year-to-date. Your referenced some pretty favorable industry metrics from NASBO. You guys are obviously outperforming there. How are you thinking about that component of the market in the second half? And then, for Eric, can you give us an update on how you are thinking about plate spend for 2014? It looks like you’re tracking below where you were this time a year ago. Thanks.

Linda Zecher

So, let me start with open territory, as you identified, open territory is down about 1%, but that of course does not include New York City and so that could be a big swing in that market. We’re actually flat, so we’re a little bit ahead of the market right now, and feeling pretty good about where we are moving forward for the rest of the year.

As for plate spend, we haven’t really changed our guidance on plate spend and we are tracking a little bit below where we were, but we’re pretty much on target with what we thought we’re going to do.

Eric Shuman

We’ll spend within the range that we gave guidance on.

Operator

Thank you. The next question comes from Jeff Silber of BMO Capital Markets.

Jeff Silber - BMO Capital Markets

Just a follow-up on the last question, can you just remind us what portion of your education revenues come from your adoptions versus open territories?

Linda Zecher

Hold on just a second, let’s get the numbers. So you are asking what portion of revenues for year to date?

Jeff Silber - BMO Capital Markets

Well, just generally, it doesn’t have to be an exact number, just from a modeling perspective.

Eric Shuman

Thus far this year, about 60% of our revenues have come from adoption revenues.

Jeff Silber - BMO Capital Markets

And how does that compare roughly to last year? And also, I’m just wondering how your 50% market share compares to last year as well?

Eric Shuman

Last year, it represented about 40% of our total revenues.

Jeff Silber - BMO Capital Markets

And then on the market share question, what market share did you have roughly at this point last year?

Eric Shuman

In adoption states at this time last year, we were about 37%.

Jeff Silber - BMO Capital Markets

So sizable increase so far this year?

Eric Shuman

Yes.

Linda Zecher

Yes.

Jeff Silber - BMO Capital Markets

And then, just one other quick follow-up. You mentioned the deferred revenue and since the percentage of digital is increasing, they would be recognized and provide you more recurring revenue over time, roughly what’s the time frame that you are going to be recognizing this revenue over?

Eric Shuman

Six to eight years.

Operator

Thank you for your question. (Operator Instructions) The next question comes from Jason Bazinet of Citi.

Jason Bazinet - Citi

Just a question for Mr. Shuman. Given that the -- I think you indicated in the beginning of the call that the size of the total market, previously you said it was about $3 billion for the industry, do you think it’s going to be bigger than that? And you talked a little bit about your market share moving up, I guess my question is in light of that, what’s causing you to sort of hold your guidance for the year constant, or in other words, are there some headwinds out there?

Eric Shuman

No, it’s not headwinds. It’s that the amount of technology revenue that districts are buying is exceeding what we had anticipated, so therefore the amount of deferred revenue is going to be greater.

Operator

Thank you. I would now like to turn the call over to Linda Zecher for closing remarks.

Linda Zecher

Thank you very much. We really appreciate everyone taking time to join us today on the call. We look forward to seeing some of you at future meetings. If you have any questions related to the results, do not hesitate to contact Rima and our Investor Relations department. So, operator, with that, ends today’s call, so thank you all very much.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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