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Houghton Mifflin Harcourt
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HMHC 2018-12-31
Item 1. Business
Item 1A. Risk Factors
Item 1B. Unresolved Staff Comments
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Mine Safety Disclosures
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters And
Item 6. Selected Financial Data
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 8. Financial Statements and Supplementary Data
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A. Controls and Procedures
Item 9B. Other Information
Item 10. Directors, Executive Officers and Corporate Governance
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholders Matters
Item 13. Certain Relationships and Related Transactions
Item 14. Principal Accounting Fees and Services
Item 15. Exhibits, Financial Statement Schedules
Item 16. Form 10-K Summary
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Houghton Mifflin Harcourt Earnings 2018-12-31

HMHC 10K Annual Report

Balance SheetIncome StatementCash Flow

10-K 1 d652820d10k.htm 10-K 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

 

 

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, or

For the fiscal year ended December 31, 2018

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 001-36166

 

 

Houghton Mifflin Harcourt Company

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   27-1566372

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

125 High Street

Boston, MA 02110

(617) 351-5000

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

Common Stock, $0.01 par value   The Nasdaq Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act: None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ☒    No  ☐

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ☐    No  ☒

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit such files).    Yes  ☒    No  ☐

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ☒

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer      Accelerated filer  
Non-accelerated filer   ☐      Smaller reporting company  
Emerging growth company       

If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

The aggregate market value of the voting stock held by non-affiliates of the Registrant as of June 30, 2018, was approximately $787.5 million.

The number of shares of common stock, par value $0.01 per share, outstanding as of February 1, 2019 was 123,665,925.

Documents incorporated by reference and made a part of this Form 10-K:

The information required by Part III of this Form 10-K, to the extent not set forth herein, is incorporated herein by reference from the Registrant’s Definitive Proxy Statement for its 2019 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2018.

 

 

 


Table of Contents

Table of Contents

 

          Page(s)  

Special Note Regarding Forward-Looking Statements

     3  

PART I

     

Item 1.

   Business      4  

Item 1A.

   Risk Factors      12  

Item 1B.

   Unresolved Staff Comments      23  

Item 2.

   Properties      23  

Item 3.

   Legal Proceedings      23  

Item 4.

   Mine Safety Disclosures      24  

PART II

     

Item 5.

   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      24  

Item 6.

   Selected Financial Data      26  

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      28  

Item 7A.

   Quantitative and Qualitative Disclosures About Market Risk      59  

Item 8.

   Financial Statements and Supplementary Data      60  

Item 9.

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure      119  

Item 9A.

   Controls and Procedures      119  

Item 9B.

   Other Information      120  

PART III

     

Item 10.

   Directors, Executive Officers and Corporate Governance      120  

Item 11.

   Executive Compensation      120  

Item 12.

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      120  

Item 13.

   Certain Relationships and Related Transactions, and Director Independence      120  

Item 14.

   Principal Accounting Fees and Services      120  

PART IV

     

Item 15.

   Exhibits, Financial Statement Schedules      121  

Item 16.

   Form 10-K Summary      126  

SIGNATURES

     127  


Table of Contents

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

The statements contained herein include forward-looking statements, which involve risks and uncertainties. These forward-looking statements can be identified by the use of forward-looking terminology, including the terms “believes,” “estimates,” “projects,” “anticipates,” “expects,” “could,” “intends,” “may,” “will,” “should,” “forecast,” “intend,” “plan,” “potential,” “project,” “target” or, in each case, their negative, or other variations or comparable terminology. Forward-looking statements include all statements that are not statements of historical facts. They include statements regarding our intentions, beliefs or current expectations concerning, among other things, our results of operations; financial condition; liquidity; prospects, growth and strategies; our competitive strengths; the industry in which we operate; the impact of new accounting guidance and tax laws; expenses; effective tax rates; future liabilities; the outcome and impact of pending or threatened litigation; decisions of our customers; education expenditures; population growth; state curriculum adoptions and purchasing cycles; the impact of dispositions, acquisitions and other investments; our share repurchase program; the timing, structure and expected impact of our operational efficiency and cost-reduction initiatives and the estimated savings and amounts expected to be incurred in connection therewith; and potential business decisions. We derive many of our forward-looking statements from our operating budgets and forecasts, which are based upon many detailed assumptions. We caution that it is very difficult to predict the impact of known factors, and, of course, it is impossible for us to anticipate all factors that could affect our actual results. All forward-looking statements are based upon information available to us on the date of this report.

By their nature, forward-looking statements involve risks and uncertainties because they relate to events and depend on circumstances that may or may not occur in the future. We caution you that forward-looking statements are not guarantees of future performance and that actual results may differ materially from those made in or suggested by the forward-looking statements contained herein. In addition, even if actual results are consistent with the forward-looking statements contained herein, those results or developments may not be indicative of results or developments in subsequent periods.

Important factors that could cause actual results to vary from expectations include, but are not limited to: changes in state and local education funding and/or related programs, legislation and procurement processes; changes in state academic standards; industry cycles and trends; the rate and state of technological change; state requirements related to digital instructional materials; changes in product distribution channels and concentration of retailer power; changes in our competitive environment, including free and low-cost open educational resources; periods of operating and net losses; our ability to enforce our intellectual property and proprietary rights; risks based on information technology systems and potential breaches of those systems; dependence on a small number of print and paper vendors; third-party software and technology development; possible defects in digital products; our ability to identify, complete, or achieve the expected benefits of, acquisitions; unanticipated consequences of the recently completed disposition of our Riverside clinical and standardized testing business; our ability to execute on our long-term growth strategy; increases in our operating costs; exposure to litigation; major disasters or other external threats; contingent liabilities; risks related to our indebtedness; future impairment charges; changes in school district payment practices; a potential increase in the portion of our sales coming from digital sales; risks related to doing business abroad; changes in tax law or interpretation; management and personnel changes; timing, higher costs and unintended consequences of our operational efficiency and cost-reduction initiatives; and other factors discussed in the “Risk Factors” section of our Annual Report on Form 10-K (this “Annual Report”). In light of these risks, uncertainties and assumptions, the forward-looking events described herein may not occur.

We undertake no obligation, and do not expect, to publicly update or publicly revise any forward-looking statement, whether as a result of new information, future events or otherwise, except as required by law. All subsequent written and oral forward-looking statements attributable to us or to persons acting on our behalf are expressly qualified in their entirety by the cautionary statements contained herein.

 

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Item 1. Business

As used in this Annual Report, the terms “we,” “us,” “our,” “HMH” and the “Company” refer to Houghton Mifflin Harcourt Company, formerly known as HMH Holdings (Delaware), Inc., and its consolidated subsidiaries, unless otherwise expressly stated or the context otherwise requires.

Our Company

Houghton Mifflin Harcourt Company is a global learning company committed to delivering integrated solutions that engage learners, empower educators and improve student outcomes. We serve over 50 million students and three million teachers in more than 150 countries worldwide.

HMH focuses on the kindergarten through 12th grade (“K-12”) market and, in the United States, we are a market leader. We specialize in comprehensive core curriculum, supplemental and intervention solutions, as well as provide ongoing support in professional learning, coaching and technical services for educators and administrators. HMH offerings are rooted in learning science, and we work with research partners, universities and third-party organizations as we design, build, implement and iterate our offerings to maximize their effectiveness. We are purposeful about innovation, leveraging technology to create engaging and immersive experiences designed to deepen learning experiences for students and to extend teachers’ capabilities so that they can focus on making meaningful connections with their students.

HMH’s diverse portfolio enables us to help ensure that every student and teacher has the tools needed for success. We are able to build deep partnerships with school districts and leverage the scope of our offerings to provide holistic solutions at scale with the support of our far-reaching sales force and talented field-based specialists and consultants. We provide print, digital and hybrid solutions that are tailored to a district’s needs, goals and technological readiness.

For nearly two centuries, HMH’s Trade Publishing division has brought renowned and awarded children’s, fiction, nonfiction, culinary and reference titles to readers throughout the world. Our distinguished author list includes ten Nobel Prize winners, forty-eight Pulitzer Prize winners, and fifteen National Book Award winners. We are home to popular characters and titles such as Curious George, Carmen Sandiego, The Lord of the Rings, The Whole 30, The Best American Series, the Peterson Field Guides, CliffsNotes, and The Polar Express, and published distinguished authors such as Philip Roth, Temple Grandin, Tim O’Brien, Amos Oz, Kwame Alexander, Lois Lowry, and Chris Van Allsburg.

On October 1, 2018, we completed the previously announced sale of all the assets, including intellectual property, used primarily in our Riverside clinical and standardized testing business (“Riverside Business”).

Market Overview

HMH operates predominantly within the U.S. K-12 Education market, which represents over $600 billion of total spending annually, and specifically within the U.S. market for K-12 instructional materials and services, which we estimate to be approximately $11.0 billion in size. Internationally, we export and sell K-12 English language education products to premium private schools that utilize the U.S. curriculum, located primarily in Asia, the Pacific, the Middle East, Latin America, the Caribbean and Africa. We also participate in the U.S. Trade publishing market, which is estimated to be approximately $16.0 billion according to the Association of American Publishers.

The U.S. Education market comprises approximately 13,600 K-12 public school districts, 132,900 public and private schools, 3.7 million teachers and 56.6 million total student enrollment across public, private and charter schools. From Fall 2016 to Fall 2026, total elementary and secondary school enrollment, a major long-term driver of growth in the K-12 Education market, is projected to increase by 2% to 56.8 million students, according to the National Center for Education Statistics.

 

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The primary sources of funding for public schools in the U.S. are state and local tax collections, with Federal funding accounting for approximately 9% of public education spending nationally. Consequently, general or localized economic conditions as well as legislative and political decisions which affect the ability of state and school districts to raise revenue through tax collections can have a significant impact on spending and growth in the K-12 Education market. Public K-12 education has been, and remains, a high priority for political leaders, accounting for more than one-fifth of all state and local government spending.

Education policy and curriculum choices have traditionally been local prerogatives in the U.S., but Federal law and policy also play an important role. The Elementary and Secondary Education Act, reauthorized in 2015 by the Every Student Succeeds Act (“ESSA”), requires that states, as a condition to receiving Federal education funds, adopt challenging academic content standards, administer annual student tests aligned to those standards, develop systems of accountability tied to specific goals for student achievement, and take measures to identify and support low performing schools. ESSA gives states more flexibility than they had under prior law, but still requires standards-based, largely assessment-driven accountability with a focus on the achievement of students in all demographic subgroups.

One important change brought about by ESSA is that states are now permitted to use growth in student achievement as measured by statewide assessments, in addition to grade-level proficiency, as an academic indicator for purposes of accountability. Instructional solutions that incorporate interim assessments and data analytics to help monitor student performance in real time can be especially useful in states that incorporate student growth as a significant element of their accountability systems. Other changes brought about by ESSA include a greater emphasis on English language learners, with progress towards English proficiency now a required element of state accountability plans, a requirement that products and solutions paid for with Federal education funds have evidence of effectiveness, and new requirements and expectations for Federally funded educator professional learning programs. The new law also gives states and school districts greater flexibility in how they spend Federal dollars and how they demonstrate that Federal funds are used to supplement and not supplant state and local spending.

Title I, the largest program within ESSA, and other ESSA programs also provide targeted funding for specific activities, such as early childhood education, school improvement, dropout prevention, and before- and after-school programs. The Individuals with Disabilities Education Act (“IDEA”) governs how states and public agencies provide early intervention, special education and related services to children with disabilities. In addition, school districts in many states are now able to spend educational funds on “instructional materials” that include core and supplemental materials, computer software, digital media, digital courseware, and online services.

Academic content standards, which are grade-level expectations for student learning, are established at the state level. States generally review and revise standards in each of the various subject areas every six to eight years, and the revision or adoption of new standards typically gives rise to the need for new instructional materials and services aligned to the new or revised standards. A large percentage of states have adopted the Common Core State Standards (“CCSS”) in English language arts and mathematics or standards largely based on the Common Core, and, as of December 2018, nineteen states had adopted Next Generation Science Standards (“NGSS”). Both the CCSS and NGSS are products of state-led collaborations. The adoption of these standards has led to greater uniformity among states, but has not completely eliminated differences or the need for customized state-specific instructional materials.

Market Segments

Core Curriculum

In the U.S., K-12 core curriculum programs provides educational content and assessments to over 56.6 million students across approximately 132,900 public and private elementary and secondary schools. Core

 

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programs cover curriculum standards in a particular subject and include a comprehensive offering of teacher and student materials necessary to conduct the class throughout the year. Products and services include students’ print and digital offerings and a variety of supporting materials such as teacher’s editions, formative assessments, supplemental materials, whole group instruction materials, practice aids, educational games and services.

Core curriculum programs traditionally have been the primary resource for classroom instruction in most K-12 academic subjects, and as a result, enrollment trends are a major driver of industry growth. Although economic cycles may affect short-term buying patterns, school enrollments, a driver of growth in the educational content industry, are highly predictable and are expected to trend upward over the longer term.

Demand for core curriculum programs is also affected by changes in state curriculum standards, which drive instruction, assessment, and accountability in each state. A significant change in state curriculum standards requires that assessments, teacher training programs, and instructional materials be revised or replaced to align to the new standards, which historically has driven demand for new comprehensive curriculum programs.

In the U.S., core instructional material programs are typically selected and purchased at the school district level and, in some cases, at the individual school level. In nineteen states, before districts make their selections, programs are first evaluated at the state level for alignment to state academic standards and other criteria. These states are commonly referred to as “adoption states,” while states that do not have a state level review process are called “open states” or “open territory.” In some adoption states, districts are required to select materials from the state-adopted list; in others the state list is just a recommendation, and districts are free to purchase and use whatever materials they choose, whether or not adopted by the state. Adoption states typically review materials in the various subject areas on a six- to eight-year cycle. School districts in those states tend to follow the state review cycle and replace core programs in the year or years immediately following state adoption. In open states, each individual school or school district evaluates and purchases materials independently, typically according to a five- to ten-year cycle. As a result, in individual adoption states, purchases of core instructional materials in a particular subject area tend to be clustered in a window of one to three years, while in individual open territory states they may be spread over several years.

The following map illustrates the current adoption and open territory states:

 

 

LOGO

The formal determination whether to approve a program for state adoption is typically made by the state board of education or chief state school officer, informed by recommendations by one or more instructional materials review committees comprised of educators, curriculum specialists, and or subject area experts. The district level selection process varies but, in both adoption and open states, usually entails presentation to and evaluation by a committee of educators. State level evaluations typically focus primarily on alignment to state academic standards, whereas local evaluators consider, in addition to standards alignment, more subjective factors such as ease of use and suitability for particular student populations. Providers of instructional content often, although not always, customize their programs for particular states, including both adoption and open

 

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states, to strengthen alignment to state standards and assessments and/or to address specific needs and preferences of students and educators in a state.

The student population in adoption states represented approximately 48% of the U.S. public school elementary and secondary school-age population. A number of adoption states, and a few open territory states, provide categorical state funding for instructional materials; that is, funds that cannot be used for any purpose other than to purchase instructional content or, in some cases, technology equipment used to deliver instruction. In some states, categorical instructional materials funds can be used only for the purchase of materials on the state-approved list. In states that do not provide categorical state instructional materials funding, districts pay for materials primarily out of general purpose state formula aid and/or local funds.

Supplemental

Supplemental resources encompass a wide variety of targeted solutions that enrich learning and support student achievement beyond core curriculum. Supplemental resources can be print and/or digital, and can include workbooks, test-prep materials, software, games and apps. Many teachers augment their core curriculum with supplemental resources for additional practice and personalized instruction around particular areas of need, such as writing or vocabulary. Supplemental materials are purchased by individual teachers, schools and districts whose purchases are not tied to adoption schedules and who use funding from local, state and federal sources.

Intervention

Intervention solutions are generally purchased by individual schools or districts. Demand for intervention materials is significant and growing in the United States. In the latest NAEP (National Assessment of Educational Progress) assessments conducted in 2017, more than 60 percent of public school students performed below proficiency in both literacy and mathematics. These students are strong candidates for intervention programs that are focused on improving outcomes and ensuring students perform at grade level. As demand for digital content and personalized learning solutions is growing, traditional distinctions between core, supplemental and intervention materials and assessments are blurring.

Intervention products and services are funded through state and local funding as well as federal funding allocations pursuant to the ESSA and IDEA. Title I provides funding to schools and school districts with high concentrations of students from low income families and is often used to purchase intervention products and services.

Professional Learning

The professional learning market segment includes consulting and support services to assist individual schools and school districts in raising student achievement, implementing new programs and technology effectively, developing effective teachers, principals and leaders, as well as school and school-district turnaround and improvement solutions. We believe all districts and schools contract for some level of professional services. These services may include support for up-front training, in-classroom coaching, institutes, author workshops, professional learning communities, leadership development, technical support and maintenance, and program management.

Professional learning is directly addressed in ESSA. ESSA restructured Title II, the section of the law addressing teacher quality, and eliminated federal “highly qualified teacher” requirements. ESSA prohibits U.S. Department of Education mandates and incentives to evaluate teachers based on student test scores, which in recent years have channeled resources and attention to the development of educator evaluation systems, measurement tools, and related training. Title II now focuses instead on the role of the profession in improving student achievement, including new requirements to ensure professional development is not only sustained (“no one-day workshops”), but also “job-embedded,” “data-driven,” and “personalized.” It is expected that school districts will

 

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need to focus their applications for teacher training to ensure teacher alignment with high quality standards, as well as priorities for funds to low-performing schools where comprehensive support and improvement plans are in place. There are also significant funding opportunities for professional learning as part of state programs, especially in states where they have consolidated program funding and want solutions that are “evidence-based.”

The professional learning services segment, which is relatively fragmented in the United States, is expected to grow as the transition to digital learning in classrooms increases the need for technology training and implementation support for educators. We believe that the use of interim data, differentiation, teacher content knowledge (in mathematics) and the use of technology in the classroom are the areas in which teachers and leaders are most seeking support. Also, demand for teacher training and professional development opportunities tied to the implementation of new or revised standards at the state level is expected to continue. In addition, the need for new teacher development over the next several years is expected to grow as we continue to see the “greening” of the teaching force, with approximately 360,000 new teachers hired every year and approximately 33% of teachers leaving within their first five years in the profession.

Trade Publishing

The Trade Publishing market includes children’s, fiction, nonfiction, culinary and reference titles. While digital formats have gained some traction in this market, print remains the primary format in which trade books are produced and distributed. In recent years, ebook sales in the industry have declined while the market overall grew.

Our Products and Services

HMH is organized along two reporting segments: Education and Trade Publishing. Our primary segment measures are net sales and Adjusted EBITDA. The Education segment is our largest business, representing approximately 85%, 86% and 87% of our total net sales for the years ended December 31, 2018, 2017 and 2016, respectively.

Education

Our Education segment provides integrated solutions that engage learners, empower educators and improve student outcomes. The principal customers for our Education products are K-12 school districts, which purchase core curriculum, supplemental and intervention solutions and professional learning services.

The Education segment net sales and Adjusted EBITDA were $1,122.7 million and $210.6 million, $1,146.5 million and $223.9 million, and $1,126.4 million and $194.6 million for the years ended December 31, 2018, 2017 and 2016, respectively. Our Education offerings consist of the following:

 

   

Core Solutions: Our core curriculum offerings include education programs in disciplines including reading, math, social studies and science that serve as primary sources of classroom instruction. HMH’s core programs are created to provide educators with the resources needed to align with state standards and support students in their mastery of the subject matter, resulting in positive outcomes and competency. HMH’s market-leading programs within this space include Journeys for reading, Collections for literature, Go Math! for math, and Science Dimensions and Science Fusion for Science. Several new core programs are planned for 2019: Into Reading, Into Literature, and Into Math.

 

   

Supplemental Solutions: HMH’s supplemental offerings include a variety of targeted solutions that enrich learning and support student achievement beyond the core curriculum. Supplemental resources can be print and/or digital, and can include workbooks, test-prep materials, software, games and apps. Many teachers augment core curriculum with supplemental resources that can provide additional practice for their students and further personalize learning instruction to support student growth in essential areas such as writing or vocabulary. HMH’s offerings in the supplemental space include

 

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Steck-Vaughn language arts, math and GED prep workbooks, Saxon Phonics and Spelling, Rigby Leveled Readers, and our popular “Classroom Reading Libraries,” which provide individually-curated collections of “just-right” books to strengthen literacy development and foster independent reading.

 

   

Intervention Solutions: Intervention solutions also address curricular needs outside of the core disciplines, supporting student achievement for those with unique needs, such as English language learners, a growing population, and students performing below grade level. Our intervention solutions support struggling learners through comprehensive offerings, including market-leading products such as MATH 180, READ 180 Universal, System 44 and iRead. The products within this area generate net sales and earnings that do not vary greatly with the adoption cycle and require significantly less capital investment than the development of a core curriculum program.

 

   

Professional Services: HMH brings together its world-renowned authors and education experts to work directly with K-12 educators and administrators to build instructional excellence, cultivate leadership and provide school districts with the comprehensive support they need to raise student achievement. Offerings include ongoing curriculum support and expertise in professional development, technical services, coaching, and strategic consulting from trusted names like the International Center for Leadership in Education (ICLE) and Math Solutions®.

 

   

Heinemann: Heinemann provides professional resources and educational services for teachers, kindergarten through college. Heinemann is the leading professional publisher for educators, and features well-known and respected authors such as Irene Fountas, Gay Su Pinnell, Lucy Calkins, and Jennifer Serravallo, who support the practice of teachers through books, videos, workshops, online courses, and most recently through explicit teaching materials.

Trade Publishing

Our Trade Publishing segment, founded in 1832, primarily develops, markets and sells consumer books in print and digital formats and licenses book rights to other publishers and electronic businesses in the United States and abroad. The principal distribution channels for Trade Publishing products are retail stores (both physical and online) and wholesalers. Reference materials are also sold to schools, colleges, libraries, office supply distributors and other businesses.

Our Trade Publishing segment offers an extensive library of general interest, young readers and reference works that include well-known characters and brands. Our award-winning general interest titles include literary fiction, culinary, and non-fiction in hardcover, ebook and paperback formats, including the Mariner Books paperback line. Among the general interest properties are the popular J.R.R. Tolkien titles, the prolific The Best American Series and major cookbook brands such as Betty Crocker and Better Homes and Gardens in addition to recent best sellers including the How to Cook Everything series and Whole30. In young readers publishing, our list addresses a broad age group and includes recognized characters and titles such as Curious George and Martha Speaks, Five Little Monkeys, Gossie & Friends, Polar Express, Little Blue Truck, and many more. We also publish novels for young adults, a growing genre, including titles from Lois Lowry, author of The Giver, and Kwame Alexander. Most recently, our Trade Publishing business launched the series Carmen Sandiego on Netflix as part of our strategy to expand our content across media platforms.

For the years ended December 31, 2018, 2017 and 2016, Trade Publishing net sales and Adjusted EBITDA were approximately $199.7 million and $21.9 million, $180.6 million and $12.1 million, and $165.6 million and $6.3 million, respectively.

Seasonality

Approximately 85% of our net sales for the year ended December 31, 2018 were derived from our Education segment, which is a markedly seasonal business. Schools conduct the majority of their purchases in

 

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the second and third quarters of the calendar year in preparation for the beginning of the school year. Thus, over our latest three completed fiscal years, approximately 67% of consolidated net sales were realized in the second and third quarters. Sales of K-12 instructional materials are also cyclical, with some years offering more sales opportunities than others. The amount of funding available at the state level for educational materials also has a significant effect on year-to-year net sales. Although the loss of a single customer would not have a material adverse effect on our business, schedules of school adoptions and market acceptance of our products can materially affect year-to-year net sales performance.

Competition

We sell our products in highly competitive markets. In these markets, product quality, innovation and customer service are major differentiating factors between companies. Other factors affecting competition include: (i) competitive pricing, sampling and gratis costs; (ii) digitization and innovative delivery; and (iii) educational effectiveness of the program. In addition to national curriculum publishers, we also compete with a variety of specialized or regional publishers that focus on select disciplines and/or geographic regions in the K-12 market. There are also multiple competitors in the Trade Publishing, supplemental and assessment segments offering content that school districts increasingly are using as part of their core classroom instructional materials. In addition, school districts in many states are able to spend educational funds on “instructional materials” that include core and supplemental materials, computer software, digital media, digital courseware, and online services. Our larger competitors in the educational market include Pearson Education, Inc., McGraw Hill Education, Cengage Learning, Inc., Scholastic Corporation, Curriculum Associates, LLC, Benchmark Education, LLC, Accelerate Learning, Inc., and Amplify Education, Inc. Also competing in our market as a substitute are open educational resources. These resources are free, digital solutions that range from supplemental resources to full Core Solutions programs.

Printing and binding; raw materials

We outsource the printing and binding of our products, with approximately 49% of our printing requirements handled by one major supplier. We have procurement agreements that provide volume and scheduling flexibility and price predictability. We have a longstanding relationship with these parties. Approximately 14% of our printed materials (consisting primarily of teacher’s editions and other ancillary components) are printed outside of the United States and approximately 86% of our printed materials (including most student editions) are printed within the United States. Paper is one of our principal raw materials. We purchase our paper primarily through one paper merchant and also directly through suppliers for limited product types. We maintain various agreements that protect against supply availability and unbound price increases. We manage our paper supply concentration by having primary and secondary sources and staying ahead of dramatic market changes.

Distribution

We operate three distribution facilities from which we coordinate our own distribution process: one each in Indianapolis, Indiana; Geneva, Illinois; and Troy, Missouri. We also utilize select suppliers to assist us with coordinating the distribution process for a limited number of product types. Additionally, some adoption states require us to use in-state textbook depositories for educational materials sold in that particular state. We utilize various delivery firms, such as United Parcel Service Inc., FedEx Freight, etc., to facilitate the principally ground transportation of products.

Employees

As of December 31, 2018, we had approximately 3,600 employees, none of which were covered by collective bargaining agreements. These employees are substantially located in the United States with 197 employees located outside of the United States. We believe that relations with employees are generally good.

 

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Intellectual property

Our principal intellectual property assets consist of our trademarks and copyrights in our content. Substantially all of our publications are protected by copyright, whether registered or unregistered, either in our name as the author of a work made for hire or the assignee of copyright, or in the name of an author who has licensed us to publish the work. Ownership of such copyrights secures the exclusive right to publish the work in the United States and in many countries abroad for specified periods: in the United States, in most cases, either 95 years from publication or for the author’s life plus 70 years, but in any event a minimum of 28 years for works published prior to 1978 and 35 years for works published thereafter. In most cases, the authors who retain ownership of their copyright have licensed to us exclusive rights for the full term of copyright. Under U.S. copyright law, for licenses granted by an author during or after 1978, such exclusive licenses are subject to termination by the author or certain of the author’s heirs for a five year period beginning at the end of 35 years after the date of publication of the work or 40 years after the date of the license grant, whichever term ends earlier.

We do not own any material patents, franchises or concessions, but we have registered certain trademarks and service marks in connection with our publishing businesses. We believe we have taken, and take in the ordinary course of business, appropriate available legal steps to reasonably protect our intellectual property in all material jurisdictions.

Environmental matters

We generally contract with independent printers and binders for their services, and our operations are generally not otherwise affected by environmental laws and regulations. However, as the owner and lessee of real property, we are subject to environmental laws and regulations, including those relating to the discharge of hazardous materials into the environment, the remediation of contaminated sites and the handling and disposal of wastes. It is possible that we could face liability, regardless of fault, and can be held jointly or severally liable, if contamination were to be discovered on the properties that we own or lease or on properties that we have formerly owned or leased. We are currently unaware of any material environmental liabilities or other material environmental issues relating to our properties or operations and anticipate no material expenditures for compliance with environmental laws or regulations.

Additional information

We are headquartered in Boston, Massachusetts. Our corporate website is www.hmhco.com. We make available our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports, as well as other information, free of charge through our corporate website under the “Financial Information” link located at: ir.hmhco.com, as soon as reasonably practicable after being filed with or furnished to the Securities and Exchange Commission (the “SEC”). The information found on our website or any other website we refer to in this Annual Report is not part of this Annual Report or any other report we file with or furnish to the SEC.

 

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Item 1A. Risk Factors

Our business and results of operations may be adversely affected by changes in federal, state and local education funding, and changes in legislation and public policy.

A majority of our sales are to public school districts in the United States, most of which rely primarily on a combination of local tax revenues and state legislative appropriations for general operating funds and to pay for purchases of goods and services, including instructional materials. Funding for public schools at both the state and local levels can be affected by tax collections, which are typically sensitive to general economic conditions, and by political and policy choices made by state and local governments. A reduction in funding levels, whether due to an economic downturn or legislative action, or a failure of projected funding increases to materialize, can constrain resources available to school districts for making purchases of instructional materials and adversely affect our business and results of operations.

Some states, including a majority of adoption states, provide dedicated state funding for the purchase of instructional content and/or classroom technology, and expenditures for instructional materials in those states tend to be highly dependent on appropriation of those funds. If dedicated funding is not appropriated, or if the amount is substantially less than anticipated or legislative action is taken to lift restrictions on the use of those funds, then purchases of instructional materials may be significantly reduced and our net sales may be adversely impacted.

In addition, many school districts, including most large urban districts, receive substantial federal funding through Title I of the Elementary and Secondary Education Act (“ESEA”), the Individuals with Disabilities Act (“IDEA”), and other federal education programs. These funds supplement state and local funding and are used primarily to serve specific populations, such as low-income students and families, students with disabilities, and English language learners as well as to support programs to improve the quality of instruction, including educator professional learning. The funding of these programs is subject to Congressional appropriation. A significant reduction in appropriation levels could have an adverse effect on our sales, particularly sales of intervention and professional learning products and services.

Federal and state legislative and policy changes can also affect our business. For example, changes to federal education law in the Every Student Succeeds Act (“ESSA”) give states greater latitude in how they approach assessment and accountability, support and improvement of low performing schools, as well as accounting for the expenditure of federal program funds. The changes in ESSA also provided for new requirements regarding evidence of effectiveness of educational products and services purchased with federal funds. The changes in ESSA and state legislation and administrative policy decisions on matters such as assessment and accountability, curriculum and intervention with respect thereto could affect demand for our products.

State instructional materials adoptions, which account for a significant portion of our net sales of K-12 instructional materials, are highly cyclical and pose significant inherent risks that could materially impact our results of operations.

Due to the revolving and staggered nature of “predetermined” state adoption schedules, sales of K-12 instructional materials have traditionally been cyclical, with some years offering more and/or larger sales opportunities than others. Since a large portion of our sales are derived from state adoptions, our overall results can be materially affected from year to year by the adoption schedule, particularly in large adoption states. For example, over the next few years adoptions are scheduled or have already begun in one or more of the primary subjects of reading, language arts and literature, social studies, science and mathematics in, among other states, California, Florida and Texas, which are the three largest adoption states. Our failure to secure approval for our programs or perform according to our expectations in larger new adoption opportunities could materially and adversely affect our net sales for the year of the adoption and in subsequent years.

 

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In any state adoption, there is the inherent risk that one or more of our programs will not be approved by a particular state board of education or other adopting authority. While school districts in most adoption states are not precluded from purchasing materials that have not been approved by the state, in many cases, exclusion of a program on the state-adopted list can materially and adversely impact our ability to compete effectively at the school district level. Moreover, even if our program is approved by the state, we face significant competition and there is no guarantee that school districts will select our program or that we will be able to capture a meaningful share of the sales in such state.

State adoptions can be delayed, postponed or cancelled—sometimes with little or no warning and after we have made significant investments in anticipation of the adoption—due to various reasons, such as funding shortfalls, delays in development and approval of state academic standards and specifications, competing priorities or school readiness. In addition, individual school districts may decline to purchase new programs in accordance with the state’s adoption schedule. A substantial delay, postponement or cancellation of a larger adoption opportunity can adversely affect the amount and timing of our net sales return on investment for the affected product, our business and our results of operations.

Further, the timing of the legislative appropriations process in most states is such that it is often impossible to know with certainty whether implementation of an adoption will be funded until after products have been submitted for review. By that time, investments have been made for product development and substantial expenses incurred for sales, marketing and other costs. If the legislature in a state that provides dedicated funding for instructional materials decides not to appropriate those funds or appropriates substantially less than anticipated, due to a revenue shortfall or other reasons, or if the legislature lifts restrictions on use of those funds, then implementation of that adoption could be substantially compromised or delayed and our net sales and return on investment could be adversely affected.

Changes in state academic standards could affect our market and require investment in development of new programs or modifications to our existing programs and any delays or controversies in the implementation of such standards could impact our results of operations.

States may adopt new academic standards or revise existing standards, which may affect our market and require investment in the development of new programs or modifications to our existing programs offered for sale in states that adopt such changes. Delays or controversies in the implementation of the adoption of new or revised academic standards may result in insufficient lead time before the deadline to submit instructional materials for an adoption. As a result, we may have to invest more than planned in order to complete product development or make the modifications in the compressed timeframe to bring our program into alignment with the new or revised standards, which could adversely affect our return on investment. Alternatively, we may determine that completing product development or making the modifications within the available timeframe is not practicable, and elect not to participate in the adoption, forgoing what might have been a significant sales opportunity which could materially and adversely affect our net sales for the year of the adoption and subsequent years.

We may not be able to execute on our long-term growth strategy or achieve expected benefits from actions taken in furtherance of our strategy, which could materially and adversely affect our business, financial condition and results of operations and/or our growth.

If we are not able to execute on our long-term growth strategy or achieve expected benefits from our actions in furtherance of our strategy, it could materially and adversely affect our business, financial condition and results of operations and/or our growth. In any event, actions taken in furtherance of our strategy, such as transitioning to new business models or entering into new market segments could adversely impact our cash flow and our business in unforeseen ways.

 

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Our investments in new products, service offerings, platforms and/or technologies could impact our profitability.

We operate in highly competitive markets that continue to change to adapt to customer needs. These needs include an increasing demand for integrated learning solutions. In order to address these needs, we are investing in new products, new technology and infrastructure, and a new common platform to integrate our products, services and solutions. These investments may be less profitable than what we have experienced historically, may consume substantial financial resources and/or may divert management’s attention from existing operations, all of which could materially and adversely affect our business, results of operations and financial condition.

We rely on third-party software and technology development as part of our digital platform.

We rely on third parties for some of our software and technology development. For example, some of the technologies and software that compose our instruction and assessment technologies are developed by third parties. We rely on those third parties for the development of future components and modules. Thus, we face risks associated with technology and software product development and the ability of those third parties to meet our needs and their obligations under our contracts with them. In addition, we rely on third parties for our internet-based product hosting. The loss of one or more of these third-party partners, a material disruption in their business or their failure to otherwise perform in the expected manner could cause disruptions in our business that may materially and adversely affect our results of operations and financial condition.

Defects in our digital products and platforms could cause financial loss and reputational damage.

In the fast-changing digital marketplace, demand for innovative technology has generally resulted in short lead times for producing products that meet customer needs. Growing demand for innovation and additional functionality in digital products increases the risk that our digital products and platforms may contain flaws or corrupted data that may only become apparent after product launch, particularly for new products and platforms and new features for existing products and platforms that are developed and brought to market under tight time constraints. Problems with the performance of our digital products and platforms could result in liability, loss of revenue or harm to our reputation.

Changes in product distribution channels and concentration of retailer power may restrict our ability to grow and affect our profitability in our Trade Publishing segment.

Distribution channels such as online retailers and ecommerce sites, digital delivery platforms, expanding social media, digital discovery and marketing platforms, combined with the increased concentration of retailer power, pose threats and provide opportunities to traditional consumer publishing models of our Trade Publishing segment, potentially impacting both sales volume and profitability. The reduction in “brick and mortar” booksellers, the resulting concentration of power held by our largest retailers, and the increased concentration of consumer book spending on best-selling titles could negatively affect our business, financial condition and results of operations.

We operate in a highly competitive environment where the risks from competition are intensified due to rapid changes in our markets and industry; as a result we must continue to adapt to remain competitive.

We operate in highly competitive markets. The risks of competition are intensified in the current environment where investment in new technology is ongoing and there are rapid changes in the products and services our customers are seeking and our competitors are offering, as well as new technologies, sales and distribution channels. In addition to national curriculum publishers, we compete with a variety of specialized or regional publishers that focus on select disciplines and/or geographic regions in the K-12 market. There are multiple competitors in the Trade Publishing segment and supplemental market offering content that school districts increasingly are using as part of their core classroom instructional materials. Our larger competitors in

 

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the educational market include Pearson Education, Inc., McGraw Hill Education, Cengage Learning, Inc., Scholastic Corporation, Curriculum Associates, LLC, Benchmark Education, LLC, Accelerate Learning, Inc., and Amplify Education, Inc. Some of these established competitors may have greater resources and less debt than us and, therefore, may be able to adapt more quickly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sale of their products and services than we can. Also competing in our market as a substitute are open educational resources. In addition, the market shift toward digital education solutions has induced both established technology companies and new start-up companies to enter certain segments of our market. These new competitors have the possible advantage of not needing to transition from a print business to a digital business. In addition, many established technology companies have substantial resources that they could devote to developing or acquiring digital educational products and/or content and, distributing their own and/or aggregated educational content to the K-12 market, which could negatively affect our business, financial condition and results of operations. There is also a risk of further disintermediation, which is the occurrence of state, district and other customers contracting directly with technology companies, enabling technology companies to develop direct relationships with our customers, and accordingly, have significant influence over access to and, pricing and distribution of digital and print education materials. We may not be able to adapt as needed to remain competitive in the market given the foregoing factors.

The availability of free and low-cost open education resources could adversely affect our net sales and exert downward pressure on prices for our education products.

In the K-12 market, we face growing competition from free, openly licensed content, often referred to as open education resources (“OER”). Free or low-cost OER content is typically delivered via the internet, and in some cases print versions and related services are available for purchase. A number of states support the use of OER by providing curated resources and others, including New York, Louisiana, Michigan and Texas, are funding development of OER or have done so in the past. Twenty states have signed on to the U.S Department of Education’s GoOpen campaign, which seeks to support users of OER and promote coordination and sharing of OER among states. In addition, in recent years there have been initiatives by not-for-profit organizations such as the Gates Foundation and the Hewlett Foundation to develop educational content that can be “open sourced” and made available to educational institutions for free or nominal costs. The increased availability of free and low-cost OER could negatively affect our customers’ perception of the value of our content, reduce demand for our educational products, and/or exert downward pressure on prices for our products, and adversely impact our net sales.

Our operating results fluctuate on a seasonal and quarterly basis and our business has historically been dependent on our results of operations for the third quarter.

Our business is seasonal. Approximately 85% of our net sales for the year ended December 31, 2018 were derived from our Education segment, which is a markedly seasonal business. Purchases of K-12 products are typically made in the second and third quarters of the calendar year in preparation for the beginning of the school year. We typically realize a significant portion of net sales during the third quarter, making third-quarter results material to full-year performance. This sales seasonality affects operating cash flow from quarter to quarter. We typically incur a net cash deficit from all of our activities through the middle of the third quarter of the year. We cannot be sure that our second and third quarter net sales will continue to be sufficient to fund our business and meet our obligations or that they will be higher than our net sales for our other quarters or in the prior-year periods. In the event that we do not derive sufficient net sales for the second and third quarter, we may have a liquidity shortfall and be unable to fund our business and/or meet our debt service requirements and other obligations.

Our net sales, operating profit or loss and net cash provided or used by operations are impacted by the inherent seasonality of the academic calendar. As purchases of K-12 products are typically made in the second and third quarters of a given calendar year, changes in our customers’ ordering patterns may impact the

 

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comparison of results between a quarter and the same quarter of the prior year, between a quarter and the prior consecutive quarter or between a fiscal year and the prior fiscal year, which can make it difficult for us to forecast the timing of customer purchases and assess our financial performance until late in the year.

Our history of operations includes periods of operating and net losses, and we may incur operating and net losses in the future. Such losses may impact our liquidity.

For the years ended December 31, 2018, 2017 and 2016, we generated operating losses of $90.5 million, $135.1 million and $322.7 million, respectively, and net losses of $94.2 million, $103.2 million and $284.6 million, respectively. If we continue to suffer operating and net losses, our liquidity may suffer and we may not be able to fund our business and/or meet our debt service requirements and other obligations. Furthermore, the market price of our common stock may decline significantly.

Our ability to enforce our intellectual property and proprietary rights may be limited, which may harm our competitive position and materially and adversely affect our business and results of operations.

Our products are largely comprised of intellectual property content delivered through a variety of media, including print, digital and web-based media. We rely on a combination of copyright, trademark and other intellectual property laws and rights as well as employee agreements and other contracts to establish and protect our proprietary rights in our products and technology. However, our efforts to protect our intellectual property and proprietary rights may not be sufficient and we cannot make assurances that our proprietary rights will not be challenged, invalidated or circumvented. Moreover, we conduct business in certain other countries where the extent of effective legal protection for intellectual property rights is uncertain. It is possible we could be involved in expensive and time-consuming litigation to maintain, defend or enforce our intellectual property.

Furthermore, despite the existence of copyright and trademark protection under applicable laws, third parties may nonetheless violate our intellectual property rights, and our ability to remedy such violations, including in certain foreign countries where we conduct or seek to conduct business, may be limited. In addition, the copying and distribution of content over the Internet creates additional challenges for us in protecting our proprietary rights. If we are unable to adequately protect and enforce our intellectual property and proprietary rights, our competitive position may be harmed, and our business and financial results could be materially and adversely affected.

Failure to comply with privacy laws or adequately protect personal data could cause financial loss and reputational damage.

Across our businesses we hold large volumes of personal data, including that of employees, customers and students. We are subject to a wide array of different privacy laws, rules, regulations and standards in the U.S. as well as in foreign jurisdictions where we conduct business, including but not limited to (i) the Children’s Online Privacy Protection Act and state student data privacy laws in connection with personally identifiable information of students, (ii) the Payment Card Industry Data Security Standards in connection with collection of credit card information from customers, and (iii) various EU data protection and privacy laws, including a comprehensive General Data Privacy Regulation that became effective in May 2018.

There has been increased public attention regarding the use of personal information and data transfer, accompanied by legislation and regulations intended to strengthen data protection, information security and consumer and personal privacy. The law in these areas continues to develop and the changing nature of privacy laws in the U.S., the European Union and elsewhere could impact our processing of personal and sensitive information of our employees, vendors and customers.

Continued privacy concerns may result in new or amended laws and regulations. Our brands and customer relationships are important assets. Future laws and regulations with respect to the collection, compilation, use,

 

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and publication of information and consumer privacy could result in limitations on our operations, increased compliance or litigation expense, adverse publicity, reputational damage to our brands and customer relationships, potential cancellation of existing business and diminished ability to compete for future business. It is also possible that we could be prohibited from collecting or disseminating certain types of data, which could affect our ability to meet our customers’ needs.

We are subject to risks based on Information Technology systems. A major breach in security or information technology system failure could interrupt the availability of our internet-based products and services, result in corruption and/or loss of data, cause liability or reputational damage to our brands and business and/or result in financial loss.

Our business is dependent on information technology systems to support our complex operational and logistical arrangements across our businesses. We provide software and/or internet-based products and services to our customers. We also use complex information technology systems and products to support our business activities, particularly in infrastructure and as we move our products and services to an increasingly digital delivery platform.

We face several technological risks associated with software and/or internet-based product and service delivery in our educational businesses, including with respect to information technology capability, reliability and security, enterprise resource planning, system implementations and upgrades. Failures of our information technology systems and products (including because of operational failure, natural disaster, computer virus or hacker attacks) could interrupt the availability of our internet-based products and services, result in corruption or loss of data or breach in security and result in liability, reputational damage to our brands and/or adversely impact our operating results.

While we have policies, processes, internal controls and cybersecurity mechanisms in place intended to ensure the stability of our information technology, provide security from unauthorized access to our systems and maintain business continuity, no mechanisms are entirely free from the risk of failure and we have no guarantee that our security mechanisms will be adequate to prevent all possible security threats. Our brand, reputation, especially in the K-12 market, and consequently our operating results may be adversely impacted by unanticipated system failures, corruption, loss of data and/or breaches in security.

Failure to prevent or detect a malicious cyber-attack on our information technology systems could result in liability, reputational damage, loss of revenue and/or financial loss.

Cyber-attacks and hackers are becoming more sophisticated and pervasive. Our business is dependent on information technology systems to support our complex operational and logistical arrangements across our businesses. We provide software and/or internet-based products and services to our customers. We also use complex information technology systems and products to support our business activities, particularly in infrastructure and as we move our products and services to an increasingly digital delivery platform. Across our businesses we hold large volumes of personal data, including that of employees, customers and students.

Efforts to prevent cyber-attacks and hackers from entering our systems are expensive to implement and may limit the functionality of our systems. Individuals try to gain unauthorized access to our systems and data for malicious purposes, and our security measures may fail to prevent such unauthorized access. Cyber-attacks and/or intentional hacking of our systems could adversely affect the performance or availability of our products, result in loss of customer data, adversely affect our ability to conduct business, or result in theft of our funds or proprietary information, the occurrence of which could result in liability, reputational damage, loss of revenue and/or financial loss.

 

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We are dependent on a small number of third parties to print and bind our products and to supply paper, a principal material for our products. If we were to lose our relationship with our key print vendor and/or paper merchant, our business and results of operations may be materially and adversely affected.

We outsource the printing and binding of our products and currently rely on one key third-party print vendor that handles approximately 49% of our printing requirements, and we expect a small number of print vendors will continue to account for a substantial portion of our printing requirements for the foreseeable future. The loss of, or a significant adverse change in our relationship with our key print vendor could have a material adverse effect on our business and cost of sales.

In addition, we purchase paper, a principal raw material for our print products, primarily through one paper merchant. Further, paper merchants, including our paper merchant, rely on paper mills to produce the paper that they broker. There can be no assurance that our relationships with our print vendor and/or paper merchant will continue or that their business or operations will not be affected by disruptions in the industries that they rely on, including a disruption in the paper mill industry, major disasters or other external factors. The loss of our key print vendor and/or paper merchant, a material change in our relationship with them, a material disruption in their business or their failure to otherwise perform in the expected manner could cause disruptions in our business that may materially and adversely affect our results of operations and financial condition.

We may not be able to identify and complete any future acquisitions or achieve the expected benefits from any future acquisitions, which could materially and adversely affect our business, financial condition and results of operations and/or our growth.

We have at times used acquisitions as a means of expanding our business and technologies, and expect that we will continue to do so in the future as part of our capital allocation strategy. We may be unable to identify suitable acquisition opportunities and, even if we were able to do so, we may not be able to finance or complete any such future acquisition on terms satisfactory to us. Further, we may not be able to successfully integrate acquisitions into our existing business, achieve anticipated operating advantages and/or realize anticipated cost savings or other synergies. The acquisition and integration of businesses involve a number of risks, including: use of available cash, issuance of equity or debt securities, incurrence of new indebtedness or borrowings under our revolving credit facility to consummate the acquisition and/or integrate the acquired business; diversion of management’s attention from operations of our existing businesses and those of the acquired business to the integration; integration of complex systems, technologies and networks into our existing systems; difficulties in the assimilation and retention of employees; unexpected costs, delays or other risks related to transition support services provided under any transition services agreement that may be executed as part of the acquisition. These transactions may create multiple and overlapping product lines that are offered, priced and supported differently, which could cause customer confusion and delays in service. The demands on our management related to the increase in our size after an acquisition also may have potential adverse effects on our operating results.

If we are unable to finance or complete any future acquisition on terms satisfactory to us (or at all) and/or we are unable to successfully integrate any acquisitions into our existing business, achieve anticipated operating advantages and/or realize anticipated cost savings or other synergies from any such acquired business, it could materially and adversely affect our business, financial condition and results of operations.

If we are unable to attract, retain and focus a strong leadership team, a dynamic sales force, software engineers and other key personnel, it could have an adverse effect on our business and ability to remain competitive, financial condition and results from operations.

Our success depends, in part, on our ability to continue to attract, focus and retain a strong leadership team, a dynamic sales force, software engineers and other key personnel at economically reasonable compensation levels. We operate in highly competitive industry segments that continue to change to adapt to customer needs and technological advances and in which there is intense competition for experienced and highly effective

 

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personnel. If we are unable to timely attract and retain key personnel with relevant skills for our evolving industry segments it could adversely affect our business and ability to remain competitive, financial condition and results of operations.

In addition, our business results depend largely upon the experience and knowledge of local market dynamics and long-standing customer relationships of our sales personnel. Our inability to attract, retain and focus effective sales and other key personnel at economically reasonable compensation levels could materially and adversely affect our ability to operate profitably and grow our business.

If we fail to maintain strong relationships with our authors, illustrators and other creative talent, as well as to develop relationships with new creative talent, our net sales and results of operations could be adversely affected.

Our Trade Publishing business and certain aspects of our K-12 business are highly dependent on maintaining strong relationships with the authors, illustrators and other creative talent who produce books and other products sold to our customers. We operate in a number of highly visible industry segments where there is intense competition for successful authors, illustrators and other creative talent. Any overall weakening of these relationships, or the failure to develop successful new relationships, could have an adverse effect on our net sales and results of operations.

Our major operating costs and expenses include employee compensation as well as paper, printing and binding costs and expenses for product-related manufacturing, and a significant increase in such costs and expenses could have a material adverse effect on our profitability.

Our major operating costs and expenses include employee compensation as well as paper, printing and binding costs for product-related manufacturing.

We offer competitive salary and benefit packages in order to attract and retain the employees required to grow and expand our businesses. Compensation costs are influenced by general economic and business factors, including those affecting the cost of health insurance, payout of commissions and incentive compensation and post-retirement benefits, as well as trends specific to the employee skillsets we require.

Paper is one of our principal raw materials. Paper prices fluctuate based on the worldwide demand for and supply of paper in general and for the specific types of paper we use. The price of paper may fluctuate significantly in the future, and changes in the market supply of, or demand for paper, could affect delivery times and prices. Paper mills and other suppliers may consolidate or there may be disruptions in their industry and as a result, there may be future shortfalls in quality and quantity supplies necessary to meet the demands of the entire marketplace, including our demands. As a result, we may need to find alternative sources for paper from time to time. In addition, we have extensive printing and binding requirements. We outsource the printing and binding of our books, workbooks and other printed products to third parties, typically under multi-year contracts. Increases in any of these operating costs and expenses could materially and adversely affect our business, profitability, financial condition and results of operations. Further, higher energy costs and other factors affecting the cost of publishing, transporting and distributing our products could adversely affect our financial results.

We also have other significant operating costs, and unanticipated increases in these costs could adversely affect our operating margins. Our inability to absorb the impact of increases in paper, printing and binding costs and other costs of publishing, transporting and distributing our products or any strategic determination not to pass on all or a portion of these increases to our customers could adversely affect our business, financial condition and results of operations.

Exposure to litigation could have a material effect on our financial position and results of operations.

In the ordinary course of business, we are involved in legal actions, claims litigation and other matters arising from our business operations and face the risk that additional actions and claims will be filed in the future.

 

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Litigation alleging infringement of copyrights and other intellectual property rights, particularly with respect to proprietary photographs and images, is common in the educational publishing industry. While management does not expect any of the existing legal actions and claims arising from our business operations to have a material adverse effect on our results of operations, financial position or cash flows, due to the inherent uncertainty of the litigation process, the costs of pursuing or defending against any particular legal proceeding, or the resolution of any particular legal proceeding could have a material effect on our financial position and results of operations.

We have insurance in such amounts and with such coverage and deductibles as management believes is reasonable. However, our coverage for certain business lines has been exhausted and there can be no assurance that our liability insurance for other business lines will cover all events or that the limits of such coverage will be sufficient to fully cover all potential liabilities thereunder.

Operational disruption to our business caused by a major disaster or other external threats could restrict our ability to supply products and services to our customers.

Across all our businesses, we manage complex operational and logistical arrangements including distribution centers, data centers and large office facilities. Failure to recover from a major disaster (such as fire, flood or other natural disaster) or other external threat (such as terrorist attacks, strikes, weather or political unrest or other external factors) at a key center or facility could affect our business and employees, disrupt our daily business activities and/or restrict our ability to supply products and services to our customers.

We are subject to contingent liabilities that may affect liquidity and our ability to meet our obligations.

In the ordinary course of business, we issue performance-related surety bonds and letters of credit posted as security for our operating activities, some of which obligate us to make payments if we fail to perform under certain contracts in connection with the sale of instructional materials and assessment programs. The surety bonds are partially backstopped by letters of credit. As of December 31, 2018, our contingent liability for all letters of credit was approximately $24.3 million, of which $0.1 million were issued to backstop $4.4 million of surety bonds. The letters of credit reduce the borrowing availability on our revolving credit facility, which could affect liquidity and, therefore, our ability to meet our obligations. We may increase the number and amount of contracts that require the use of letters of credit, which may further restrict liquidity and, therefore, our ability to meet our obligations in the future.

Our substantial level of indebtedness could adversely affect our financial condition and results of operations.

As of December 31, 2018, we had approximately $772.0 million ($763.6 million, net of discount and issuance costs) outstanding under our term loan facility and no amounts outstanding under our revolving credit facility. Our substantial outstanding indebtedness could have important consequences, including the following:

 

   

our high level of indebtedness could make it more difficult for us to satisfy our obligations;

 

   

our high level of indebtedness could adversely impact our credit rating;

 

   

the restrictions imposed on the operation of our business under the agreements governing such indebtedness may hinder our ability to take advantage of strategic opportunities to grow our business and to make attractive investments;

 

   

our ability to obtain additional financing for working capital, capital expenditures, product development, debt service requirements, restructuring, acquisitions or general corporate purposes may be impaired, which could be exacerbated by volatility in the credit markets;

 

   

we must use a substantial portion of our cash flow from operations to pay principal and interest on our indebtedness, which will reduce the funds available to us for operations, working capital, capital expenditures and other purposes;

 

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our high level of indebtedness could place us at a competitive disadvantage compared to our competitors that may have proportionately less debt;

 

   

our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate may be limited;

 

   

our failure to satisfy our obligations under the agreements governing our indebtedness could result in an event of default, which could result in all of our debt becoming immediately due and payable and could permit our secured lenders to foreclose on our assets securing such indebtedness;

 

   

our high level of indebtedness makes us more vulnerable to economic downturns and adverse developments in our business and industry; and

 

   

we may be vulnerable to interest rate increases, as certain of our borrowings bear interest at variable rates. A 1% increase or decrease in the interest rate will change our interest expense by approximately $7.7 million on an annual basis for our term loan facility and $2.5 million on an annual basis for our revolving credit facility, assuming it is fully drawn.

Any of the foregoing could have a material adverse effect on our business, financial condition, results of operations, prospects and ability to satisfy our obligations. In addition, we may incur substantial additional indebtedness in the future. The terms of the agreements governing our existing indebtedness do not, and any future debt may not, fully prohibit us from doing so. If new indebtedness is added to our current indebtedness levels, the related risks that we now face could substantially intensify.

We expect to refinance our debt.

As of December 31, 2018, we had approximately $772.0 million ($763.6 million, net of discount and issuance costs) outstanding under our term loan facility which matures on May 29, 2021. We expect to refinance all or a portion of our outstanding debt prior to maturity. There is a risk that we may not be able to refinance existing debt or that the terms of any refinancing may not be as favorable as the terms of our existing debt. Furthermore, if prevailing interest rates or other factors at the time of refinancing result in higher interest rates upon refinancing, then the interest expense relating to that refinanced indebtedness would increase. In addition, changes by any rating agency to our outlook or credit rating could negatively affect our debt and increase the interest amounts we pay on future debt. These risks could adversely affect our financial condition and results of operations.

We may not be able to generate sufficient cash to service all of our indebtedness and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful.

Our ability to make scheduled payments or to refinance our debt obligations and to fund planned capital expenditures and other growth initiatives depends on our financial and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We may not be able to maintain a level of cash flow from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness or to fund our other liquidity needs.

If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay capital expenditures, sell assets, seek additional capital or seek to restructure or refinance our indebtedness. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations. In the absence of such operating results and resources, we could face substantial liquidity problems and might be required to sell material assets or operations to attempt to meet our debt service and other obligations. Our term loan facility and revolving credit facility have certain restrictions on our ability to use the proceeds from asset sales. We may not be able to consummate those asset sales to raise capital or sell assets at prices that we believe are fair and proceeds that we do receive may not be adequate to meet any debt service obligations then due.

 

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We may record future goodwill or additional indefinite-lived intangibles impairment charges related to our reporting units, which could have a material adverse impact on our results of operations.

We test our goodwill and indefinite-lived intangibles asset balances for impairment during the fourth quarter of each year, or more frequently if indicators are present or changes in circumstances suggest that impairment may exist. In evaluating the potential for impairment of goodwill and indefinite-lived intangible assets, we make assumptions regarding estimated net sales projections, growth rates, cash flows and discount rates. Although we use consistent methodologies in developing the assumptions and estimates underlying the fair value calculations used in our impairment tests, these estimates are uncertain by nature and can vary from actual results. Declines in the future performance and cash flows of the business or small changes in other key assumptions may result in future impairment charges, which could have a material adverse impact on our results of operations.

A change from up-front payment by school districts for multi-year programs and actions taken in furtherance of our long-term growth strategy could adversely affect our cash flow.

In keeping with the past practice of payments, school districts typically pay up-front when buying multi-year programs. If school districts changed their payment practices to spread their payments to us over the term of a program, our cash flow could be adversely affected. Further, as we execute on our long-term growth strategy, actions taken in furtherance of our strategy, such as transitioning to new business models could adversely impact our cash flow and our business in unforeseen ways.

The shift to sales of greater digital content or an increase in consumable print core programs may affect the comparability of our revenue to prior periods and cause increases or decreases in our sales to be reflected in our results of operations on a delayed basis.

Our customers typically pay for purchased products up-front; however, we recognize a significant portion of our time-based digital sales over their respective terms, as required by Generally Accepted Accounting Principles in the United States. As a result, an increase in the portion of our sales coming from digital sales may impact the comparison of our revenue results for a period with the same prior-year or consecutive period. Further, sales of consumable print core programs typically result in net sales being recognized over longer periods similar to time-based digital products. As more product offerings move to a consumable print format, more revenue will be deferred and recognized over a longer period of time.

Another effect of recognizing revenue from digital and consumable print core program sales over their respective terms is that any increases or decreases in sales during a particular period may not translate into proportional increases or decreases in revenue during that period. Consequently, deteriorating sales activity may be less immediately observable in our results of operations.

We face risks of doing business abroad.

We conduct business in a number of regions outside of the U.S., including emerging markets in South America, Asia and the Middle East. Accordingly, we face exposure to the risks of doing business abroad, including, but not limited to, longer customer payment terms in certain countries; increased credit risk; difficulties in protecting intellectual property, enforcing or terminating agreements and collecting receivables under certain foreign legal systems; compliance under local privacy laws, rules, regulations and standards; the need to comply with U.S. Foreign Corrupt Practices Act and local laws, rules and regulations; and in some countries, a higher risk of political instability, economic volatility, terrorism, corruption, and social and ethnic unrest.

Although we are committed to conducting business in a legal and ethical manner in compliance with local and international statutory requirements and standards applicable to our business, there is a risk that our management, employees or representatives may take actions that violate applicable laws and regulations prohibiting the making of improper payments for the purposes of obtaining or keeping business, including laws such as the U.S. Foreign Corrupt Practices Act or the UK Bribery Act. Responding to investigations is costly and

 

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requires a significant amount of management’s time and attention. In addition, investigations may adversely impact our reputation, or lead to litigation and financial impacts.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

Our principal executive office is located at 125 High Street, Boston, Massachusetts 02110. The following table describes the approximate building areas in square feet, principal uses and the years of expiration on leased premises of our significant operating properties as of December 31, 2018. We believe that these properties are suitable and adequate for our present and anticipated business needs, satisfactory for the uses to which each is put, and, in general, fully utilized.

 

Location   Expiration
year
    Approximate area     Principal use of space     Segment used by  

Owned Premises:

       

Indianapolis, Indiana

    Owned       491,779       Warehouse       All segments  

Troy, Missouri

    Owned       575,000       Office and warehouse       Education  

Leased Premises:

       

Orlando, Florida (a)

    2029       250,842       Office       Education  

Evanston, Illinois

    2027       111,398       Office       Education  

Geneva, Illinois

    2022       485,989       Office and warehouse       Education  

Boston, Massachusetts (Corporate office)

    2033       194,946       Office       All segments  

Portsmouth, New Hampshire

    2019       25,145       Office       Education  

New York, New York

    2025       31,815       Office       Education  

New York, New York

    2027       101,841       Office       All segments  

Austin, Texas

    2028       87,570       Office       Education  

Dublin, Ireland

    2025       28,994       Office       Education  

Orlando, Florida

    2021       25,400       Warehouse      
Corporate Records
Center

 

St Charles, Illinois

    2024       26,029       Office       Education  

In addition, we lease several other offices that are not material to our operations and, in some instances, are partially or fully subleased. Portions of certain properties listed above are also subleased.

 

(a)

Effective October 2019, lease square footage will be reduced to approximately 111,000.

Item 3. Legal Proceedings

We are involved in legal actions, claims, litigation and other matters incidental to our business. Litigation alleging infringement of copyrights and other intellectual property rights, particularly with respect to proprietary photographs and images, is common in the educational publishing industry.

While management believes there is a reasonable possibility we may incur a loss associated with the existing legal actions, claims and litigation, we are not able to estimate such amount, but we do not expect any of these matters to have a material adverse effect on our results of operations, financial position or cash flows. We have insurance in such amounts and with such coverage and deductibles as management believes is reasonable. However, there can be no assurance that our liability insurance will cover all events or that the limits of such coverage will be sufficient to fully cover all potential liabilities thereunder.

 

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Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and

Issuer Purchases of Equity Securities

Market information. Our common stock is listed on the Nasdaq Global Select Market (“Nasdaq”) under the symbol “HMHC”.

Holders. As of February 1, 2019, there were approximately 5 stockholders of record of our common stock, one of which was Cede & Co., a nominee for The Depository Trust Company. All of our common stock held by brokerage firms, banks and other financial institutions as nominees for beneficial owners are considered to be held of record by Cede & Co., who is considered to be one stockholder of record. A substantially greater number of holders of our common stock are “street name” or beneficial holders, whose shares of common stock are held of record by banks, brokers and other financial institutions. Because such shares of common stock are held on behalf of stockholders, and not by the stockholders directly, and because a stockholder can have multiple positions with different brokerage firms, banks and other financial institutions, we are unable to determine the total number of stockholders we have.

Dividends. We have never paid or declared any cash dividends on our common stock. At present, we intend to retain our future earnings, if any, to fund operations, the growth of our business and, as appropriate, execute our share repurchase program. Our future decisions concerning the payment of dividends on our common stock will depend upon our results of operations, financial condition and capital expenditure plans, as well as other factors as our board of directors, in its discretion, may consider relevant, and the extent to which the declaration or payment of dividends may be limited by agreements we have entered into or cause us to lose the benefits of certain of our agreements. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”

Performance Graph. The graph below matches the cumulative return of holders of the Company’s common stock with the cumulative returns of the Dow Jones Publishing index, the S&P 500 index, the Nasdaq Composite index, the Russell 2000 index, and a Peer Group index of certain public companies in the educational space, comprised of Pearson PLC, Scholastic Corporation, K-12 Inc., and John Wiley & Sons, Inc. The Russell 2000 index was included as the Company was added to that index during 2014. The graph assumes that the value of the investment in the Company’s common stock, in each index (including reinvestment of dividends) was $100 on November 14, 2013 and tracks it through February 1, 2019. All prices reflect closing prices on the last day of trading at the end of each period. Notwithstanding any general incorporation by reference of this Annual Report into any other document, the information contained in the graph shall not be deemed to be “soliciting material” or to be “filed” with the SEC or subject to Regulation 14A or 14C under the Exchange Act of 1934, as amended (the “Exchange Act”) or to the liabilities of Section 18 of the Exchange Act, except: (i) as expressly required by applicable law or regulation; or (ii) to the extent that the Company specifically requests that such information be treated as soliciting material or specifically incorporates it by reference into a filing under the Securities Act of 1933, as amended, or the Exchange Act.

 

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LOGO

The stock price performance shown on the graph is not necessarily indicative of future price performance. Information used in the graph was obtained from a source we believe to be reliable, but we do not assume responsibility for any errors or omissions in such information.

Recent sales of unregistered securities. There have been no sales of unregistered securities by the Company in the three year period ended December 31, 2018.

Issuer Purchases of Equity Securities

There were no purchases of equity securities in the fourth quarter of 2018 and for the year ended December 31, 2018. Our Board of Directors previously authorized the repurchase of up to $1.0 billion in aggregate value of the Company’s common stock through December 31, 2018. As of December 31, 2018, when this repurchase authorization expired, there was approximately $482.0 million remaining under this authorization.

 

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Item 6. Selected Financial Data

The following table summarizes the consolidated historical financial data of Houghton Mifflin Harcourt Company. We derived the consolidated historical financial data as of December 31, 2018 and 2017 and for the years ended December 31, 2018, 2017, and 2016 from our audited consolidated financial statements included in this Annual Report. We derived the consolidated historical financial statement data as of December 31, 2015 and 2014 and for the years ended December 31, 2015 and 2014 from our consolidated financial statements for such years, which are not included in this Annual Report. The sale of the Riverside Business is considered a Discontinued Operation and accordingly, all results of the Riverside Business have been removed from continuing operations for all periods presented. Historical results for any prior period are not necessarily indicative of results to be expected in any future period. The data set forth in the following table should be read together with the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes thereto.

 

     Years Ended December 31,  
     2018 (4) (6) (7)     2017 (4) (6)     2016 (4) (6)     2015 (4) (6)     2014 (6)  

Operating Data:

          

Net sales

   $ 1,322,417     $ 1,327,029     $ 1,291,978     $ 1,319,416     $ 1,279,210  

Cost and expenses:

          

Cost of sales, excluding publishing rights and
pre-publication amortization

     581,467       588,518       578,317       582,411       544,511  

Publishing rights amortization

     34,713       46,238       61,351       81,007       105,624  

Pre-publication amortization

     109,257       119,908       121,866       112,892       120,767  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cost of sales

     725,437       754,664       761,534       776,310       770,902  

Selling and administrative

     649,295       636,326       681,170       655,887       585,989  

Other intangible asset amortization

     26,933       29,248       26,375       22,038       12,170  

Impairment charge for pre-publication costs, intangible
assets, investment in preferred stock, and fixed
assets (1)

     —       3,980       130,205       —       1,679  

Restructuring (2)

     4,657       37,775       —       —       —  

Severance and other charges (3)

     6,821       177       15,371       4,146       6,679  

Gain on sale of assets

     (201     —       —       —       —  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating loss

     (90,525     (135,141     (322,677     (138,965     (98,209
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other income (expense)

          

Retirement benefits non-service income

     1,280       3,486       4,253       2,787       2,649  

Interest expense

     (45,680     (42,805     (39,181     (32,254     (18,495

Interest income

     2,550       1,338       518       209       250  

Loss on extinguishment of debt

     —       —       —       (3,051     —  

Change in fair value of derivative instruments

     (1,374     1,366       (614     (2,362     (1,593

Income from transition services agreement

     1,889       —       —       —       —  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss from continuing operations before taxes

     (131,860     (171,756     (357,701     (173,636     (115,398

Income tax expense (benefit) for continuing operations

     5,597       (51,419     (51,556     (20,411     4,823  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss from continuing operations

     (137,457     (120,337     (306,145     (153,225     (120,221
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Earnings from discontinued operations, net of tax

     12,833       17,150       21,587       19,356       8,730  

Gain on sale of discontinued operations, net of tax

     30,469       —         —         —         —    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from discontinued operations, net of tax

     43,302       17,150       21,587       19,356       8,730  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

   $ (94,155   $ (103,187   $ (284,558   $ (133,869   $ (111,491
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss per share attributable to common stockholders

          

Basic and diluted:

          

Continuing operations

   $ (1.11   $ (0.98   $ (2.50   $ (1.12   $ (0.85

Discontinued operations

     0.35       0.14       0.18       0.14       0.06  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

   $ (0.76   $ (0.84   $ (2.32   $ (0.98   $ (0.79
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average shares outstanding Basic and diluted

     123,444,943       122,949,064       122,418,474       136,760,107       140,594,689  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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     Years Ended December 31,  
     2018 (4) (6) (7)     2017 (4) (6)     2016 (4) (6)     2015 (4) (6)     2014 (6)  

Balance Sheet Data (as of period end):

          

Cash, cash equivalents and short-term investments

   $ 303,198     $ 235,428     $ 306,943     $ 432,403     $ 743,345  

Working capital

     218,586       126,567       209,982       384,912       750,779  

Total assets (5)

     2,495,124       2,439,830       2,604,307       2,976,759       2,834,779  

Debt (short-term and long-term) (5)

     763,649       768,194       772,738       777,283       235,265  

Stockholders’ equity

     768,470       795,193       880,040       1,198,321       1,759,680  

Statement of Cash Flows Data:

          

Net cash provided by (used in):

          

Operating activities

     104,084       104,748       111,785       311,906       467,500  

Investing activities

     427       (193,895     (106,117     (667,739     (346,684

Financing activities

     (4,124     (7,330     (37,960     106,104       19,529  

Other Data:

          

Capital expenditures:

          

Pre-publication capital expenditures

     123,403       131,282       118,603       100,465       111,633  

Property, plant, and equipment capital expenditures

     53,741       55,092       103,152       77,183       59,177  
Depreciation and intangible asset amortization      142,819       146,535       162,193       168,787       184,283  

 

(1)

Primarily represents tradenames and to a lesser extent software and program development costs, along with a preferred stock investment.

(2)

Represents cash and noncash charges incurred as a result of our 2017 Restructuring Plan.

(3)

Represents severance and real estate charges not part of our 2017 Restructuring Plan.

(4)

Includes the results of our acquisition of the EdTech business from May 29, 2015 through December 31, 2018.

(5)

2014 through 2015 include the retrospective adoption of new guidance for the recognition and measurement of debt issuance costs effective for annual reporting periods beginning after December 15, 2015.

(6)

The sale of the Riverside Business, which was effective October 1, 2018, is considered a Discontinued Operation and accordingly, all results of the Riverside Business have been removed from continuing operations for all periods presented.

(7)

The 2018 amounts have been impacted by the January 1, 2018 adoption of the new revenue standard. Please refer to the Note 2 included in Item 8. for further details.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis is intended to facilitate an understanding of our results of operations and financial condition and should be read in conjunction with our consolidated financial statements and the related notes thereto included elsewhere in this Annual Report. The following discussion and analysis of our financial condition and results of operations contains forward-looking statements about our business, operations and industry that involve risks and uncertainties, such as statements regarding our plans, objectives, expectations and intentions. Actual results and the timing of events may differ materially from those expressed or implied in such forward-looking statements due to a number of factors, including those set forth under “Risk Factors” and elsewhere in this Annual Report. See “Risk Factors” and “Special Note Regarding Forward-Looking Statements.”

Overview

We are a global learning company, committed to delivering integrated solutions that engage learners, empower educators and improve student outcomes. We serve over 50 million students and three million teachers in more than 150 countries worldwide. In the United States, we are a leading provider of K-12 educational content by market share. We believe our long-standing reputation and trusted brand enable us to capitalize on consumer and digital trends in the education market through our existing and developing channels. Furthermore, our trade and reference materials, including adult and children’s fiction and non-fiction books, have won industry awards such as the Pulitzer Prize, Newbery and Caldecott medals and National Book Award.

Recent Developments

Sale of Clinical and Standardized Testing Business and Discontinued Operations

On October 1, 2018, we completed the previously announced sale of all the assets, including intellectual property, used primarily in our Riverside clinical and standardized testing business (“Riverside Business”) for cash consideration received of $140.0 million, subject to final working capital adjustment, and the purchaser’s assumption of all liabilities relating to the Riverside Business subject to specified exceptions. Net proceeds from the sale after the payment of transaction costs were approximately $135.0 million with a post-tax book gain on sale of approximately $30.5 million.

The sale of the Riverside Business is considered a Discontinued Operation due to its relative size and strategic rationale, and accordingly, all results of the Riverside Business have been removed from continuing operations for all periods presented, including from discussions of total net sales and other results of operations. On the balance sheet, all assets and liabilities transferring to the acquirer have been classified as Assets of discontinued operations or Liabilities of discontinued operations. The results of the Riverside Business were previously reported in our Education segment.

Key Aspects and Trends of Our Operations

Business Segments

We are organized along two business segments: Education and Trade Publishing. Our Education segment is our largest segment and represented approximately 85%, 86% and 87% of our total net sales for the years ended December 31, 2018, 2017 and 2016. Our Trade Publishing segment represented approximately 15%, 14% and 13% of our total net sales for the years ended December 31, 2018, 2017 and 2016. The Corporate and Other category represents certain general overhead costs not fully allocated to the business segments, such as legal, accounting, treasury, human resources and executive functions.

Net Sales

We derive revenue primarily from the sale of print and digital content and instructional materials, trade books, multimedia instructional programs, license fees for book rights, content, software and services, consulting

 

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and training. We primarily sell to customers in the United States. Our net sales are driven primarily as a function of volume and, to a certain extent, changes in price. Our net sales consist of our billings for products and services, less revenue that will be deferred until future recognition along with the transaction price allocation adjusted to reflect the estimated returns for the arrangement. Deferred revenues primarily derive from online interactive digital content, digital and online learning components along with undelivered work-texts, workbooks and services. The work-texts, workbooks and services are deferred until control is transferred to the customer, which often extends over the life of the contract, and our hosted online and digital content is typically recognized ratably over the life of the contract. The digitalization of education content and delivery is driving a shift in the education market. As the K-12 educational market transitions to purchasing more digital, personalized education solutions, we believe our ability now or in the future to offer embedded assessments, adaptive learning, real-time interaction and student specific personalization of educational content in a platform- and device-agnostic manner will provide new opportunities for growth. An increasing number of schools are utilizing digital content in their classrooms and implementing online or blended learning environments, which is altering the historical mix of print and digital educational materials in the classroom. As a result, our business model includes integrated solutions comprised of both print and digital offerings/products to address the needs of the education marketplace. The level of revenues being deferred can fluctuate depending upon the mix of product offering between digital and non-digital products, the length of programs and the mix of product delivered immediately or over time.

Core curriculum programs, which typically represent the most significant portion of our Education segment net sales, cover curriculum standards in a particular K-12 academic subject and include a comprehensive offering of teacher and student materials required to conduct the class throughout the school year. Products and services in these programs include print and digital offerings for students and a variety of supporting materials such as teacher’s editions, formative assessments, supplemental materials, whole group instruction materials, practice aids, educational games and professional services. The process through which materials and curricula are selected and procured for classroom use varies throughout the United States. Currently, nineteen states, known as adoption states, review and approve new programs usually every six to eight years on a state-wide basis. School districts in those states typically select and purchase materials from the state-approved list. The remaining states are known as open states or open territories. In those states, materials are not reviewed at the state level, and each individual school or school district is free to procure materials at any time, although most follow a five-to-ten year replacement cycle. The student population in adoption states represents approximately 48% of the U.S. elementary and secondary school-age population. Some adoption states provide “categorical funding” for instructional materials, which means that those state funds cannot be used for any other purpose. Our core curriculum programs, primarily in adoption states, typically have higher deferred sales than other parts of the business. The higher deferred sales are primarily due to the length of time that our programs are being delivered, along with greater component and digital product offerings. A significant portion of our Education segment net sales is dependent upon our ability to maintain residual sales, which are subsequent sales after the year of the original adoption, and our ability to continue to generate new business by developing new programs that meet our customers’ evolving needs. In addition, our market is affected by changes in state curriculum standards, which drive instruction, assessment and accountability in each state. Changes in state curriculum standards require that instructional materials be revised or replaced to align to the new standards, which historically has driven demand for core curriculum programs.

We also derive our Education segment net sales from supplemental products that target struggling learners through comprehensive intervention solutions aimed at raising student achievement by providing solutions that combine technology, content and other educational products, as well as consulting and professional development services. We also offer products targeted at assisting English language learners.

In international markets, we predominantly export and sell K-12 books to premium private schools that utilize the U.S. curriculum, which are located primarily in Asia, the Pacific, the Middle East, Latin America, the Caribbean and Africa. Our international sales team utilizes a global network of distributors in local markets around the world.

 

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Our Trade Publishing segment sells works of fiction and non-fiction in the General Interest and Young Reader’s categories, dictionaries and other reference works. While print remains the primary format in which trade books are produced and distributed, the market for trade titles in digital format, primarily ebooks generally represents approximately 8%-10% of our annual Trade Publishing net sales.

Factors affecting our net sales include:

Education

 

   

state or district per student funding levels;

 

   

federal funding levels;

 

   

the cyclicality of the purchasing schedule for adoption states;

 

   

student enrollments;

 

   

adoption of new education standards;

 

   

state acceptance of submitted programs and participation rates for accepted programs;

 

   

technological advancement and the introduction of new content and products that meet the needs of students, teachers and consumers, including through strategic agreements pertaining to content development and distribution; and

 

   

the amount of net sales subject to deferrals which is impacted by the mix of product offering between digital and non-digital products, the length of programs and the mix of product delivered immediately or over time.

Trade Publishing

 

   

consumer spending levels as influenced by various factors, including the U.S. economy and consumer confidence;

 

   

the publishing of bestsellers along with obtaining recognized authors;

 

   

film and series tie-ins to our titles that spur sales of current and backlist titles, which are titles that have been on sale for more than a year; and

 

   

market growth or contraction.

State or district per-student funding levels, which closely correlate with state and local receipts from income, sales and property taxes, impact our sales as institutional customers are affected by funding cycles. Most public school districts, the primary customers for K-12 products and services, are largely dependent on state and local funding to purchase materials.

We monitor the purchasing cycles for specific disciplines in the adoption states in order to manage our product development and to plan sales campaigns. Our sales may be materially impacted during the years that major adoption states, such as Florida, California and Texas, are or are not scheduled to make significant purchases. For example, Florida adopted social studies materials in 2016, for purchase in 2017 and adopted Science materials in 2017 for purchase in 2018.Texas adopted Reading/English Language Arts materials in 2018 for purchase in 2019. California adopted history social science materials in 2017 for purchase in 2018 and continuing through 2020 and adopted Science materials in 2018 for purchase in 2019 and continuing through 2021. Both Florida and Texas, along with several other adoption states, provide dedicated state funding for instructional materials and classroom technology, with funding typically appropriated by the legislature in the first half of the year in which materials are to be purchased. Texas has a two-year budget cycle, and in the 2018 legislative session appropriated funds for purchases in 2018 and 2019. California funds instructional materials in part with a dedicated portion of state lottery proceeds and in part out of general formula funds, with the minimum

 

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overall level of school funding determined according to the Proposition 98 funding guarantee. We do not currently have contracts with these states for future instructional materials adoptions and there is no guarantee that our programs will be accepted by the state (for example, our K-8 social science materials were not adopted in California in 2017).

Long-term growth in the U.S. K-12 market is positively correlated with student enrollments, which is a driver of growth in the educational publishing industry. Although economic cycles may affect short-term buying patterns, school enrollments are highly predictable and are expected to trend upward over the longer term. From 2015 to 2027, total public school enrollment, a major long-term driver of growth in the K-12 Education market, is projected to increase by 3% to 52.1 million students, according to the National Center for Education Statistics.

As the K-12 educational market purchases more digital solutions, we believe our ability to offer embedded assessments, adaptive learning, real-time interaction and student specific personalized learning and educational content in a platform- and device-agnostic manner will provide new opportunities for growth.

Our Trade Publishing segment is heavily influenced by the U.S. and broader global economy, consumer confidence and consumer spending. As the economy continues to recover, both consumer confidence and consumer spending have increased.

While print remains the primary format in which trade books are produced and distributed, the market for trade titles in digital format, primarily ebooks, has developed over the past several years, as the industry evolved to embrace new technologies for developing, producing, marketing and distributing trade works. We continue to focus on the development of innovative new digital products which capitalize on our strong content, our digital expertise and the consumer demand for these products.

In the Trade Publishing segment, annual results can be driven by bestselling trade titles. Furthermore, backlist titles can experience resurgence in sales when made into films or series. In the past years, a number of our backlist titles such as The Hobbit, The Lord of the Rings, Life of Pi, The Handmaid’s Tale, The Polar Express, The Giver and The Time Traveler’s Wife have benefited in popularity due to movie or series releases and have subsequently resulted in increased trade sales.

We employ several pricing models to serve various customer segments, including institutions, government agencies, consumers and other third parties. In addition to traditional pricing models where a customer receives a product in return for a payment at the time of product receipt, we currently use the following pricing models:

 

   

Pay-up-front: Customer makes a fixed payment at time of purchase and we provide a specific product/service in return;

 

   

Pre-pay Subscription: Customer makes a one-time payment at time of purchase, but receives a stream of goods/services over a defined time horizon; for example, we currently provide customers the option to purchase a multi-year subscription to textbooks where for a one-time charge, a new copy of the work text is delivered to the customer each year for a defined time period. Pre-pay subscriptions to online textbooks are another example where the customer receives access to an online book for a specific period of time; and

 

   

Pay-as-you-go Subscription: Similar to the pre-pay subscription, except that the customer makes periodic payments in a pre-described manner.

Cost of sales, excluding publishing rights and pre-publication amortization

Cost of sales, excluding publishing rights and pre-publication amortization, include expenses directly attributable to the production of our products and services, including the non-capitalizable costs associated with

 

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our content and platform development group. The expenses within cost of sales include variable costs such as paper, printing and binding costs of our print materials, royalty expenses paid to our authors, gratis costs or products provided at no charge as part of the sales transaction, and inventory obsolescence. Also included in cost of sales are labor costs related to professional services and the non-capitalized costs associated with our content and platform development group. We also include amortization expense associated with our customer-facing software platforms. Certain products such as trade books and products associated with our renowned authors carry higher royalty costs; conversely, digital offerings usually have a lower cost of sales due to lower costs associated with their production. Also, sales to adoption states usually contain higher cost of sales. A change in the sales mix of our products or services can impact consolidated profitability.

Publishing rights and Pre-publication amortization

A publishing right is an acquired right that allows us to publish and republish existing and future works as well as create new works based on previously published materials. As part of our March 9, 2010 restructuring, we recorded an intangible asset for publishing rights and amortize such asset on an accelerated basis over the useful lives of the various copyrights involved. This amortization will continue to decrease approximately 25% annually through March of 2023.

We capitalize the art, prepress, manuscript and other costs incurred in the creation of the master copy of our content, known as the pre-publication costs. Pre-publication costs are primarily amortized from the year of sale over five years using the sum-of-the-years-digits method, which is an accelerated method for calculating an asset’s amortization. Under this method, the amortization expense recorded for a pre-publication cost asset is approximately 33% (year 1), 27% (year 2), 20% (year 3), 13% (year 4) and 7% (year 5). We utilize this policy for all pre-publication costs, except with respect to our Trade Publishing segment’s consumer books, which we generally expense such costs as incurred, and the acquired content of our 2015 acquisition, which we amortize over 7 years using an accelerated amortization method. The amortization methods and periods chosen best reflect the pattern of expected sales generated from individual titles or programs. We periodically evaluate the remaining lives and recoverability of capitalized pre-publication costs, which are often dependent upon program acceptance by state adoption authorities.

Selling and administrative expenses

Our selling and administrative expenses include the salaries, benefits and related costs of employees engaged in sales and marketing, fulfillment and administrative functions. Also included within selling and administrative costs are variable costs such as commission expense, outbound transportation costs (approximately $33.8 million for the year ended December 31, 2018) and depository fees, which are fees paid to state-mandated depositories that fulfill centralized ordering and warehousing functions for specific states. Additionally, significant fixed and discretionary costs include facilities, telecommunications, professional fees, promotions, sampling and advertising along with depreciation.

Other intangible asset amortization

Our other intangible asset amortization expense primarily includes the amortization of acquired intangible assets consisting of tradenames, customer relationships, content rights and licenses. The tradenames, customer relationships, content rights and licenses are amortized over varying periods of 6 to 25 years. The expense for the year ended December 31, 2018 was $26.9 million.

Interest expense

Our interest expense includes interest accrued on our term loan facility along with, to a lesser extent, our revolving credit facility, capital leases, the amortization of any deferred financing fees and loan discounts, and payments in connection with interest rate hedging agreements. Our interest expense for the year ended December 31, 2018 was $45.7 million.

 

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Results of Operations

Consolidated Operating Results for the Years Ended December 31, 2018 and 2017

 

(dollars in thousands)   Year
Ended
December 31,
2018
    Year
Ended
December 31,
2017
    Dollar
change
    Percent
Change
 

Net sales

  $ 1,322,417     $ 1,327,029     $ (4,612     (0.3 )% 

Costs and expenses:

       

Cost of sales, excluding publishing rights and pre-publication amortization

    581,467       588,518       (7,051     (1.2 )% 

Publishing rights amortization

    34,713       46,238       (11,525     (24.9 )% 

Pre-publication amortization

    109,257       119,908       (10,651     (8.9 )% 
 

 

 

   

 

 

   

 

 

   

 

 

 

Cost of sales

    725,437       754,664       (29,227     (3.9 )% 

Selling and administrative

    649,295       636,326       12,969       2.0

Other intangible asset amortization

    26,933       29,248       (2,315     (7.9 )% 

Impairment charge for pre-publication costs

    —       3,980       (3,980     NM  

Restructuring

    4,657       37,775       (33,118     (87.7 )% 

Severance and other charges

    6,821       177       6,644       NM  

Gain on sale of assets

    (201     —       (201     NM  
 

 

 

   

 

 

   

 

 

   

 

 

 

Operating loss

    (90,525     (135,141     44,616       33.0
 

 

 

   

 

 

   

 

 

   

 

 

 

Other income (expense):

       

Retirement benefits non-service income

    1,280       3,486       (2,206     (63.3 )% 

Interest expense

    (45,680     (42,805     (2,875     (6.7 )% 

Interest income

    2,550       1,338       1,212       90.6

Change in fair value of derivative instruments

    (1,374     1,366       (2,740     NM  

Income from transition services agreement

    1,889       —       1,889       NM  
 

 

 

   

 

 

   

 

 

   

 

 

 

Loss from continuing operations before taxes

    (131,860     (171,756     39,896       23.2

Income tax expense (benefit)

    5,597       (51,419     57,016       NM  
 

 

 

   

 

 

   

 

 

   

 

 

 

Net loss from continuing operations

  $ (137,457   $ (120,337   $ (17,120     (14.2 )% 
 

 

 

   

 

 

   

 

 

   

 

 

 

Income from discontinued operations, net of tax

    12,833       17,150       (4,317     (25.2 )% 

Gain on sale of discontinued operations, net of tax

    30,469       —       30,469       NM  
 

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

  $ (94,155   $ (103,187   $ 9,032       8.8
 

 

 

   

 

 

   

 

 

   

 

 

 

NM = not meaningful

Net sales for the year ended December 31, 2018 decreased $4.6 million, or 0.3%, from $1,327.0 million in 2017 to $1,322.4 million. The net sales decrease was driven by a $23.8 million decrease in our Education segment, partially offset by a $19.2 million increase in our Trade Publishing segment. Within our Education segment the net sales decrease was primarily due to lower net sales from Core Solutions, which declined by $57.0 million from $595.0 million in 2017 to $538.0 million. The primary drivers of the decrease in Core Solutions sales were decreases in sales relating to disciplines reaching the end of their product lifecycle that are scheduled to be replaced in 2019 with newer programs. Net sales within our science discipline, which is a new program, increased year over year offsetting some of the older program declines. Also contributing to the decline in Core Solutions sales was the non-recurrence of the $5.0 million one-time fee we recognized in 2017 in connection with the expiration of a distribution agreement. Partially offsetting the decrease in our Core Solutions sales was an increase in sales from our Extensions businesses, which primarily consist of our Heinemann brand, intervention and supplemental products as well as professional services. Extensions businesses net sales increased $33.0 million from $551.0 million in 2017 to $584.0 million in 2018 primarily driven by higher Heinemann net sales. The primary driver of the increase in our Heinemann net sales was sales of the Fountas &

 

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Pinnell Classroom product, which was introduced in the third quarter of 2017 and additional product launches during the third quarter of 2018. Within our Trade Publishing segment, the increase was primarily due to licensing revenue driven by a new agreement pertaining to our classic backlist titles 1984 and Animal Farm. There was also additional licensing revenue associated with the new Netflix original series, Carmen Sandiego. The increase was partially offset by a decrease in ebook sales of $3.0 million.

Operating loss for the year ended December 31, 2018 favorably changed by $44.6 million from a loss of $135.1 million in 2017 to a loss of $90.5 million, due primarily to the following:

 

   

A $33.1 million lower charge in 2017 associated with our 2017 Restructuring Plan, which was substantially completed prior to 2018,

 

   

A $24.5 million reduction in amortization expense related to publishing rights, pre-publication and other intangible assets, primarily due to our use of accelerated amortization methods for publishing rights amortization along with a decline in pre-publication amortization attributed to the timing of product releases,

 

   

Our cost of sales, excluding publishing rights and pre-publication amortization, decreased $7.1 million in 2018, of which $5.0 million is attributed to improved profitability as our cost of sales, excluding publishing rights and pre-publication amortization, as a percentage of net sales decreased to 44.0% from 44.3% due to product mix,

 

   

A reduction in impairment charge for pre-publication costs of $4.0 million. In 2017, we impaired $4.0 million of pre-publication costs for certain products that will not have sales in future periods,

 

   

Partially offsetting the favorable change in operating loss was a $13.0 million increase in selling and administrative costs, due to an increase of $6.5 million in net labor costs related to higher employee benefit and medical expenses as well as planned merit increases offset by actions taken under the 2017 Restructuring Plan; an increase in variable expenses such as samples, commissions and depository fees of $6.6 million, an increase in discretionary costs of $3.5 million related to travel and entertainment, promotion expense and professional fees along with higher depreciation expense of $3.0 million. Offsetting the increase in selling and administrative costs was lower IT expenses of $6.4 million relating to maintenance contracts, hardware and telecommunications, and facilities, and

 

   

A $6.6 million increase in severance and other charges as the majority of such expenses during 2017 were in connection with our 2017 Restructuring Plan and were included within the restructuring line item.

Retirement benefits non-service income for the year ended December 31, 2018 changed unfavorably by $2.2 million due to the lowering of the expected return on plan assets assumption in the calculation of net periodic benefit cost in 2018.

Interest expense for the year ended December 31, 2018 increased $2.9 million from $42.8 million in 2017 to $45.7 million, primarily due to an increase in interest on the term loan facility of $6.3 million due to an increase in variable interest rates, offset by a reduction of $3.4 million of net settlement payments on our interest rate derivative instruments during 2018.

Interest income for the year ended December 31, 2018 increased $1.2 million from $1.3 million in 2017 to $2.5 million, primarily due to increases in interest rates on our investments and higher investment balances.

Change in fair value of derivative instruments for the year ended December 31, 2018 unfavorably changed by $2.7 million from a gain of $1.4 million in 2017 to a loss of $1.4 million in 2018. The change in fair value of derivative instruments was related to foreign exchange forward contracts executed on the Euro that were unfavorably impacted by the stronger U.S. dollar against the Euro.

 

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Income from transition services agreement for the year ended December 31, 2018 was $1.9 million and was related to transition service fees under the transition services agreement with the purchaser of the Riverside Business whereby we provide certain support functions for a period of up to 18 months from the disposition date in the fourth quarter of 2018.

Income tax expense for the year ended December 31, 2018 increased $57.0 million, from a benefit of $51.4 million in 2017 to an expense of $5.6 million in 2018. The 2018 income tax expense was primarily related to movement in the deferred tax liability associated with tax amortization on indefinite-lived intangibles, and state and foreign taxes. The 2017 income tax benefit was partially offset by movement in the deferred tax liability associated with tax amortization on indefinite-lived intangibles, and state and foreign taxes. For both periods, the income tax benefit was impacted by certain discrete tax items including the accrual of potential interest and penalties on uncertain tax positions. Including the effects of these discrete items, the effective tax rate was (4.2)% and 29.9% for the years ended December 31, 2018 and 2017.

Consolidated Operating Results for the Years Ended December 31, 2017 and 2016

 

(dollars in thousands)    Year
Ended
December 31,
2017
    Year
Ended
December 31,
2016
    Dollar
change
    Percent
Change
 

Net sales

   $ 1,327,029     $ 1,291,978     $ 35,051       2.7

Costs and expenses:

        

Cost of sales, excluding publishing rights and pre-publication amortization

     588,518       578,317       10,201       1.8

Publishing rights amortization

     46,238       61,351       (15,113     (24.6 )% 

Pre-publication amortization

     119,908       121,866       (1,958     (1.6 )% 
  

 

 

   

 

 

   

 

 

   

 

 

 

Cost of sales

     754,664       761,534       (6,870     (0.9 )% 

Selling and administrative

     636,326       681,170       (44,844     (6.6 )% 

Other intangible asset amortization

     29,248       26,375       2,873       10.9

Impairment charge for pre-publication costs and intangible assets

     3,980       130,205       (126,225     (96.9 )% 

Restructuring

     37,775       —       37,775       NM  

Severance and other charges

     177       15,371       (15,194     (98.8 )% 
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating loss

     (135,141     (322,677     187,536       58.1
  

 

 

   

 

 

   

 

 

   

 

 

 

Other income (expense):

        

Retirement benefits non-service income

     3,486       4,253       (767     (18.0 )% 

Interest expense

     (42,805     (39,181     (3,624     (9.2 )% 

Interest income

     1,338       518       820       NM  

Change in fair value of derivative instruments

     1,366       (614     1,980       NM  
  

 

 

   

 

 

   

 

 

   

 

 

 

Loss from continuing operations before taxes

     (171,756     (357,701     185,945       52.0

Income tax benefit

     (51,419     (51,556     137       0.3
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss from continuing operations

   $ (120,337   $ (306,145   $ 185,808       60.7
  

 

 

   

 

 

   

 

 

   

 

 

 

Income from discontinued operations, net of tax

     17,150       21,587       (4,437     (20.6 )% 
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

   $ (103,187   $ (284,558   $ 181,371       63.7
  

 

 

   

 

 

   

 

 

   

 

 

 

NM = not meaningful

Net sales for the year ended December 31, 2017 increased $35.1 million, or 2.7%, from $1,292.0 million in 2016 to $1,327.0 million. The net sales increase was driven by a $20.1 million increase in our Education segment

 

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and a $15.0 million increase in our Trade Publishing segment during 2017. Within our Education segment, the increase was primarily due to greater sales from our Extension businesses, which primarily consist of Heinemann, intervention, supplemental and assessment products as well as professional services. Extension businesses net sales for 2017 increased $28.0 million from $523.0 million in 2016 to $551.0 million primarily driven by higher Heinemann and supplemental net sales in 2017. The primary drivers of the increase in our Heinemann net sales were sales of Classroom Libraries along with the introduction of Fountas & Pinnell Classroom product. The primary drivers of the increase in our supplemental net sales were sales of custom book bundles. Also, within our Extension businesses, intervention net sales declined year over year, offsetting a portion of the above increases. Partially offsetting the increase in our Extension businesses net sales were lower Core Solutions sales, inclusive of international sales, which declined by $8.0 million from $603.0 million in 2016 to $595.0 million in 2017. The primary drivers of the decrease in our Core Solutions business were lower Reading and Math program net sales in open territory states, lower Math program sales in adoption states and lower sales from our international business, primarily due to a large Department of Defense order in 2016 not repeated in 2017. Partially offsetting the decrease in Core Solutions net sales was a $5.0 million one-time fee we recognized in 2017 in connection with the expiration of a distribution agreement. Within our Trade business, the increase was primarily due to sales of the Whole30 series and Tim Ferriss’ Tribe of Mentors and Tools of Titans, stronger ebook sales, such as The Handmaid’s Tale and 1984, and backlist print title sales, such as The Polar Express and The Giver, along with a lower product return rate and higher subrights income.

Operating loss for the year ended December 31, 2017 favorably changed by $187.5 million from a loss of $322.7 million in 2016 to a loss of $135.1 million, due primarily to the following:

 

   

A reduction in Impairment charge for pre-publication costs and intangible assets of $126.2 million. In 2016, we incurred an impairment charge pertaining to certain tradenames within the education business due to a strategic decision to gradually migrate away from specific imprints, primarily Holt McDougal, and our various supplemental brands, in favor of branding our products under the HMH and Houghton Mifflin Harcourt names. In 2017, we impaired $4.0 million of pre-publication costs for products that will not have sales in future periods,

 

   

An increase in net sales of $35.1 million,

 

   

A $44.8 million decrease in selling and administrative costs primarily due to lower professional fees of $18.9 million (of which $10.0 million relates to legal settlement costs for copyright litigation during the prior year period coupled with a net $3.6 million insurance reimbursement during 2017), a reduction of internal and outside labor related costs of $16.9 million, and lower discretionary expense such as promotion and travel and entertainment expenses of $15.7 million, all largely due to actions taken under the 2017 Restructuring Plan. Additionally, variable expenses such as samples, transportation and depository fees were $7.4 million lower in 2017, and fixed costs and depreciation were $6.3 million lower. The decrease in selling and administrative costs was partially offset by $16.9 million of higher commission expense and annual incentive plan compensation due to greater achievement of targeted levels than in the prior-year period, and $5.0 million of higher office lease cost due to the expiration of favorable office leases,

 

   

A $14.2 million net reduction in amortization expense related to publishing rights, pre-publication and other intangible assets, primarily due to our use of accelerated amortization methods for publishing rights amortization, partially offset by the amortization of certain previously unamortized tradenames, due to a change in estimate of their useful lives during the fourth quarter of 2016,

 

   

A $15.2 million reduction in severance and other charges as the majority of such expenses during 2017 were under our 2017 Restructuring Plan and have been included within the restructuring line item,

 

   

Partially offsetting the favorable change in operating loss was a $37.8 million charge associated with our 2017 Restructuring Plan, which includes severance and termination benefits of $16.2 million, real estate consolidation costs of $5.0 million, implementation costs of $7.5 million and an impairment charge related to a certain long-lived asset included within property, plant, and equipment of $9.1 million, and

 

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Our cost of sales, excluding publishing rights and pre-publication amortization, increased $10.2 million of which $15.7 million is attributed to higher sales volume offset by $5.6 million of improved profitability as our cost of sales, excluding publishing rights and pre-publication amortization, as a percentage of net sales decreased to 44.3% from 44.8% due to product mix, increased Trade ebook sales, and a $5.0 million one-time fee we recognized associated with the expiration of distribution agreement that did not carry any cost of sales.

Retirement benefits non-service income for the year ended December 31, 2017 changed unfavorably by $0.8 million due to the increase in amortization of net loss in the calculation of net periodic benefit cost in 2017.

Interest expense for the year ended December 31, 2017 increased $3.6 million, or 9.2%, from $39.2 million in 2016 to $42.8 million, primarily due to $4.1 million of net settlement payments on our interest rate derivative instruments during 2017, offset by the lower outstanding balance on our term loan facility.

Interest income for the year ended December 31, 2017 increased $0.8 million from $0.5 million in 2016 to $1.3 million, primarily due to increases in interest rates on our investments.

Change in fair value of derivative instruments for the year ended December 31, 2017 favorably changed by $2.0 million from a loss of $0.6 million in 2016 to a gain of $1.4 million in 2017. The change in fair value of derivative instruments was related to foreign exchange forward contracts executed on the Euro that were favorably impacted by the weaker U.S. dollar against the Euro.

Income tax benefit for the year ended December 31, 2017 decreased $0.2 million, from a benefit of $51.6 million in 2016 to a benefit of $51.4 million in 2017. The 2017 income tax benefit was primarily related to the following effects of U.S. tax reform:

 

   

A $31.5 million benefit related to the remeasurement of U.S. net deferred tax liabilities associated with indefinite-lived intangible assets to reflect the change in U.S. corporate tax rate from 35% to 21%, and

 

   

A $40.4 million benefit related to the release of valuation allowance due to the Company’s ability to utilize indefinite-lived deferred tax liabilities as a source of future taxable income in its assessment of realization of deferred tax assets. This is a result of the U.S. tax law change that would extend net operating losses generated in taxable years beginning after December 31, 2017 to an unlimited carryforward period subject to an 80% utilization against future taxable earnings.

The 2017 income tax benefit was partially offset by movement in the deferred tax liability associated with tax amortization on indefinite-lived intangibles, and state and foreign taxes. The 2016 income tax benefit was primarily related to a change from indefinite-lived intangibles to definite-lived, partially offset by movement in the deferred tax liability associated with tax amortization on indefinite-lived intangibles, and state and foreign taxes. For both periods, the income tax benefit was impacted by certain discrete tax items including the accrual of potential interest and penalties on uncertain tax positions. Including the effects of these discrete items, the effective tax rate was 29.9% and 14.4% for the years ended December 31, 2017 and 2016.

Adjusted EBITDA From Continuing Operations

To supplement our financial statements presented in accordance with GAAP, we have presented Adjusted EBITDA from continuing operations, which is not prepared in accordance with GAAP. This information should be considered as supplemental in nature and should not be considered in isolation or as a substitute for the related financial information prepared in accordance with GAAP. Management believes that the presentation of Adjusted EBITDA provides useful information to investors regarding our results of operations because it assists both investors and management in analyzing and benchmarking the performance and value of our business. Adjusted EBITDA provides an indicator of general economic performance that is not affected by debt restructurings, fluctuations in interest rates or effective tax rates, non-cash charges, or levels of depreciation or

 

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amortization along with costs such as severance, separation and facility closure costs, acquisition/disposition-related activity costs, restructuring costs and integration costs. Accordingly, our management believes that this measurement is useful for comparing general operating performance from period to period. In addition, targets in Adjusted EBITDA (further adjusted to include changes in deferred revenue) are used as performance measures to determine certain compensation of management, and Adjusted EBITDA is used as the base for calculations relating to incurrence covenants in our debt agreements. Other companies may define Adjusted EBITDA differently and, as a result, our measure of Adjusted EBITDA may not be directly comparable to Adjusted EBITDA of other companies. Although we use Adjusted EBITDA as a financial measure to assess the performance of our business, the use of Adjusted EBITDA is limited because it does not include certain material costs, such as interest and taxes, necessary to operate our business. Adjusted EBITDA should be considered in addition to, and not as a substitute for, net loss/income in accordance with GAAP as a measure of performance. Adjusted EBITDA is not intended to be a measure of liquidity or free cash flow for discretionary use. You are cautioned not to place undue reliance on Adjusted EBITDA.

Below is a reconciliation of Adjusted EBITDA from continuing operations to our net loss from continuing operations for the years ended December 31, 2018, 2017 and 2016:

 

     Years Ended December 31,  
     2018     2017     2016  

Net loss from continuing operations

   $ (137,457   $ (120,337   $ (306,145

Interest expense

     45,680       42,805       39,181  

Interest income

     (2,550     (1,338     (518

Provision (benefit) for income taxes

     5,597       (51,419     (51,556

Depreciation expense

     75,116       71,049       74,467  

Amortization expense—film asset

     6,057       —       —  

Amortization expense

     170,903       195,394       209,592  

Non-cash charges—stock-compensation

     13,248       10,728       10,491  

Non-cash charges—(gain) loss on derivative instruments

     1,374       (1,366     614  

Non-cash charges—asset impairment charges

     —       3,980       130,205  

Purchase accounting adjustments

     —       —       5,116  

Fees, expenses or charges for equity offerings, debt or acquisitions/dispositions

     2,883       1,464       1,123  

2017 Restructuring Plan

     4,657       37,775       —  

Restructuring/Integration

     —       —       14,364  

Severance, separation costs and facility closures

     6,821       177       15,371  

Legal (reimbursement) settlement

     —       (3,633     10,000  

Gain on sale of assets

     (201     —       —  
  

 

 

   

 

 

   

 

 

 

Adjusted EBITDA from continuing operations

   $ 192,128     $ 185,279     $ 152,305  
  

 

 

   

 

 

   

 

 

 

 

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Segment Operating Results

Results of Operations—Comparing Years Ended December 31, 2018, 2017 and 2016

Education

 

    Years Ended December 31,     2018 vs. 2017     2017 vs. 2016  
    Dollar
change
    Percent
change
    Dollar
change
    Percent
change
 
    2018     2017     2016  

Net sales

  $ 1,122,689     $ 1,146,453     $ 1,126,363     $ (23,764     (2.1 )%    $ 20,090       1.8

Costs and expenses:

             

Cost of sales, excluding publishing rights and pre-publication amortization

    451,195       472,925       466,593       (21,730     (4.6 )%      6,332       1.4

Publishing rights amortization

    28,059       38,721       52,660       (10,662     (27.5 )%      (13,939     (26.5 )% 

Pre-publication amortization

    108,953       119,540       121,459       (10,587     (8.9 )%      (1,919     (1.6 )% 
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cost of sales

    588,207       631,186       640,712       (42,979     (6.8 )%      (9,526     (1.5 )% 

Selling and administrative

    518,014       498,334       522,806       19,680       3.9     (24,472     (4.7 )% 

Other intangible asset amortization

    20,989       23,436       22,875       (2,447     (10.4 )%      561       2.5

Impairment charge for pre-publication costs and intangible assets

    —       3,980       130,205       (3,980     NM       (126,225     NM  

Gain on sale of assets

    (201     —       —       (201     NM       —       NM  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating loss from continuing operations

  $ (4,320   $ (10,483   $ (190,235   $ 6,163       58.8   $ 179,752       94.5
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss from continuing operations

  $ (4,320   $ (10,483   $ (190,235   $ 6,163       58.8   $ 179,752       94.5
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Adjustments from net income (loss) from continuing operations to Education segment Adjusted EBITDA

             

Depreciation expense

  $ 57,124     $ 48,747     $ 52,552     $ 8,377       17.2   $ (3,805     (7.2 )% 

Amortization expense

    158,001       181,697       196,994       (23,696     (13.0 )%      (15,297     (7.8 )% 

Non-cash charges—asset impairment charges

    —       3,980       130,205       (3,980     NM       (126,225     (96.9 )% 

Purchase accounting adjustments

    —       —       5,116       —       NM       (5,116     NM  

Gain on sale of assets

    (201     —       —       (201     NM       —       NM  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Education segment Adjusted EBITDA

  $ 210,604     $ 223,941     $ 194,632     $ (13,337     (6.0 )%    $ 29,309       15.1
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Education segment Adjusted EBITDA as a % of net sales

    18.8     19.5     17.3        
 

 

 

   

 

 

   

 

 

         

NM = not meaningful

Our Education segment net sales for the year ended December 31, 2018 decreased $23.8 million, or 2.1%, from $1,146.5 million in 2017 to $1,122.7 million. The net sales decrease was primarily due to lower net sales from Core Solutions, which declined by $57.0 million from $595.0 million in 2017 to $538.0 million. The

 

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primary drivers of the decrease in Core Solutions sales were decreases in sales relating to disciplines reaching the end of their product lifecycle that are scheduled to be replaced in 2019 with newer programs. Net sales within our science discipline, which is a new program, increased year over year offsetting some of the older program declines. Also contributing to the decline in Core Solutions sales was the non-recurrence of the $5.0 million one-time fee we recognized in 2017 in connection with the expiration of a distribution agreement. Partially offsetting the decrease in our Core Solutions sales was an increase in sales from our Extensions businesses, which primarily consist of our Heinemann brand, intervention and supplemental products as well as professional services. Extensions businesses net sales increased $33.0 million from $551.0 million in 2017 to $584.0 million in 2018 primarily driven by higher Heinemann net sales. The primary driver of the increase in our Heinemann net sales was sales of the Fountas & Pinnell Classroom product, which was introduced in the third quarter of 2017 and additional product launches during the third quarter of 2018.

Our Education segment net sales for the year ended December 31, 2017 increased $20.1 million, or 1.8%, from $1,126.4 million in 2016 to $1,146.5 million. The net sales increase was primarily due to greater sales from our Extension businesses, which primarily consist of Heinemann, intervention, supplemental and assessment products as well as professional services. Extension businesses net sales for 2017 increased $28.0 million from $523.0 million in the 2016 to $551.0 million primarily driven by higher Heinemann and supplemental net sales. The primary drivers of the increase in our Heinemann net sales were sales of our Classroom Libraries offering along with the introduction of our Fountas & Pinnell Classroom product. The primary drivers of the increase in our supplemental net sales for the year ended December 31, 2017 were sales of custom book bundles. Also within our Extension businesses, our assessment and intervention net sales declined year over year, offsetting a portion of the above increases. Partially offsetting the increase in our Extension businesses net sales were lower Core Solutions sales, inclusive of international sales, which declined by $8.0 million from $603.0 million in 2016 to $595.0 million in 2017. The primary drivers behind the decrease in our Core Solutions business were lower net sales of open territory programs, Core Solutions math programs across adoption states and lower sales from our international business, primarily due to a large Department of Defense order in the prior year not repeated in 2017. Partially offsetting the decrease in Core Solutions net sales was a $5.0 million one-time fee we recognized in connection with the expiration of a distribution agreement.

Our Education segment cost of sales for the year ended December 31, 2018 decreased $43.0 million, or 6.8%, from $631.2 million in 2017 to $588.2 million. Publishing rights and pre-publication amortization decreased by $21.2 million from 2017 primarily due a decline in pre-publication amortization attributed to the timing of product releases along with our use of accelerated amortization methods for publishing rights amortization. Our cost of sales, excluding publishing rights and pre-publication amortization, decreased $21.7 million from $472.9 million in 2017 to $451.2 million in 2018 of which $9.8 million is attributed to lower sales volume coupled with $11.9 million of improved profitability as our cost of sales, excluding publishing rights and pre-publication amortization, as a percentage of net sales decreased to 40.2% from 41.3%, primarily due to product mix.

Our Education segment cost of sales for the year ended December 31, 2017, decreased $9.5 million, or 1.5%, from $640.7 million in 2016 to $631.2 million. Publishing rights and pre-publication amortization decreased by $15.9 million from 2017 primarily due to our use of accelerated amortization methods for publishing rights amortization. Our cost of sales, excluding publishing rights and pre-publication amortization, increased $6.3 million primarily due to higher sales volume.

Our Education segment selling and administrative expense for the year ended December 31, 2018 increased $19.7 million, or 3.9%, from $498.3 million in 2017 to $518.0 million. The increase was driven by higher depreciation, an increase in professional fees, an increase in variable expenses such as commissions and depository fees and an increase in discretionary spending such as travel and entertainment. Partially offsetting the increases in costs was a reduction in labor related costs, partially offset by benefit and medical expenses as well as planned merit increases, along with a decrease in technology costs due to reduced hosting and maintenance contracts in connection with the actions taken under the 2017 Restructuring Plan.

 

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Our Education segment selling and administrative expense for the year ended December 31, 2017 decreased $24.5 million, or 4.7%, from $522.8 million in 2016 to $498.3 million. The decrease was driven by a reduction in internal and outside labor related costs, a reduction in marketing and advertising costs along with lower travel and entertainment expenses, primarily as a result of actions taken under the 2017 Restructuring Plan. Further, samples, transportation and depository fees were lower in 2017. The decrease was partially offset by higher incentive compensation, and higher commission expense due to greater achievement levels than in 2016 along with higher office lease cost due to the expiration of favorable office leases.

Our Education segment other intangible asset amortization expense for the year ended December 31, 2018 decreased $2.4 million, or 10.4%, from 2017, which was due to certain intangible assets becoming fully amortized in the middle of 2017.

Our Education segment other intangible asset amortization expense for the year ended December 31, 2017 increased $0.6 million from 2016, which was related to the amortization of certain previously unamortized tradenames, due to a change in estimate of their useful lives during the fourth quarter of 2016, partially offset by decline of other existing intangible assets.

Our Education segment impairment charge for pre-publication costs decreased $4.0 million in 2018 from 2017. There was no impairment charge in 2018. In 2017, the impairment charge of $4.0 million was related to a certain program included within pre-publication costs.

Our Education segment impairment charge for pre-publication costs and intangible assets decreased $126.2 million in 2017 from 2016. In 2016, the impairment charge of $130.2 million was for intangible assets, as the Company made the strategic decision to gradually migrate away from specific imprints, primarily Holt McDougal and various supplemental brands, in favor of branding our products under the HMH and Houghton Mifflin Harcourt names. In 2017, the impairment charge of $4.0 million was related to a certain program included within pre-publication costs.

Our Education segment Adjusted EBITDA for the year ended December 31, 2018 decreased $13.3 million, or 6.0%, from $223.9 million in 2017 to $210.6 million. Our Education segment Adjusted EBITDA excludes depreciation, amortization and loss on sale of assets. The decrease is due to the identified factors impacting net sales, cost of sales and selling and administrative expenses after removing those items not included in Education segment Adjusted EBITDA. Education segment Adjusted EBITDA as a percentage of net sales was 18.8% and 19.5% for each of the years ended December 31, 2018 and 2017, respectively.

Our Education segment Adjusted EBITDA for the year ended December 31, 2017, improved $29.3 million, or 15.1%, from $194.6 million in 2016 to $223.9 million in 2017. Our Education segment Adjusted EBITDA excludes depreciation, amortization, asset impairment charges and purchase accounting adjustments. The 2016 purchase accounting adjustments primarily relate to a 2015 acquisition. The increase is due to the identified factors impacting net sales, cost of sales and selling and administrative expenses after removing those items not included in Education segment Adjusted EBITDA. Education segment Adjusted EBITDA as a percentage of net sales was 19.5% and 17.3% for each of the years ended December 31, 2017 and 2016, respectively.

 

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Trade Publishing

 

     Years Ended December 31,     2018 vs. 2017     2017 vs. 2016  
  Dollar
change
    Percent
change
    Dollar
change
    Percent
change
 
   2018     2017     2016  

Net sales

   $ 199,728     $ 180,576     $ 165,615     $ 19,152       10.6   $ 14,961       9.0

Costs and expenses:

              

Cost of sales, excluding publishing rights and pre-publication amortization

     130,272       115,593       111,724       14,679       12.7     3,869       3.5

Publishing rights amortization

     6,654       7,517       8,691       (863     (11.5 )%      (1,174     (13.5 )% 

Pre-publication amortization

     304       368       407       (64     (17.4 )%      (39     (9.6 )% 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cost of sales

     137,230       123,478       120,822       13,752       11.1     2,656       2.2

Selling and administrative

     54,129       53,288       48,227       841       1.6     5,061       10.5

Other intangible asset amortization

     5,944       5,812       3,500       132       2.3     2,312       66.1
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating income (loss)

   $ 2,425     $ (2,002   $ (6,934   $ 4,427       NM     $ 4,932       71.1
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss)

   $ 2,425     $ (2,002   $ (6,934   $ 4,427       NM     $ 4,932       71.1
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Adjustments from net income (loss) to Trade Publishing segment Adjusted EBITDA

              

Depreciation expense

   $ 558     $ 401     $ 591     $ 157       39.2   $ (190     (32.1 )% 

Amortization expense film asset

     6,057       —       —       6,057       NM       —       NM  

Amortization expense

     12,902       13,697       12,598       (795     (5.8 )%      1,099       8.7
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Trade Publishing segment Adjusted EBITDA

   $ 21,942     $ 12,096     $ 6,255     $ 9,846       81.4   $ 5,841       93.4
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Trade Publishing segment Adjusted EBITDA as a % of net sales

     11.0     6.7     3.8        
  

 

 

   

 

 

   

 

 

         

NM = not meaningful

Our Trade Publishing segment net sales for the year ended December 31, 2018 increased $19.2 million, or 10.6%, from $180.6 million in 2017 to $199.7 million. The increase was primarily due to licensing revenue driven by a new agreement pertaining to our classic backlist titles 1984 and Animal Farm. There was also additional licensing revenue associated with the new Netflix original series, Carmen Sandiego. Further, the year benefited from sales of the Little Blue Truck series, Instant Pot Miracle and the Whole 30 series. Additionally, there were strong net sales of the backlist title Beautiful Boy which benefited from the release of the movie. Partially offsetting the aforementioned was a decrease in ebook sales.

Our Trade Publishing segment net sales for the year ended December 31, 2017 increased $15.0 million, or 9.0%, from $165.6 million in 2016 to $180.6 million. The increase in net sales was driven by 2017 sales of the Whole30 series and Tim Ferriss’ Tribe of Mentors and Tools of Titans, stronger ebook sales, such as The Handmaid’s Tale and 1984, and backlist print title sales, such as The Polar Express and The Giver, along with favorable product return experience and higher subrights income.

Our Trade Publishing segment cost of sales for the year ended December 31, 2018 increased $13.8 million, or 11.1%, from $123.5 million in 2017 to $137.2 million. The increase was primarily driven by our cost of sales, excluding publishing rights and pre-publication amortization which increased $14.7 million. Approximately

 

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$12.3 million of the increase was driven by higher sales volume, coupled with an unfavorable change in profitability of $2.4 million as our cost of sales, excluding publishing rights and pre-publication amortization, as a percentage of net sales increased to 65.2% from 64.0%. The increase in rate was due to a product mix partially driven by a decrease in ebook sales. Partially offsetting the aforementioned increases were slightly lower publishing rights amortization due to our use of accelerated amortization methods.

Our Trade Publishing segment cost of sales for the year ended December 31, 2017 increased $2.7 million, or 2.2%, from $120.8 million in 2016 to $123.5 million. Approximately $10.1 million of the increase was driven by higher sales volume, partially offset by $6.2 million of lower costs as our cost of sales, excluding publishing rights and pre-publication amortization, as a percentage of net sales decreased to 64.0% from 67.5%. The decline in rate was due to a product mix partially driven by an increase in ebook sales. Further, the increase in our costs of sales was also slightly offset by $1.2 million of lower amortization expense of publishing rights and pre-publication amortization due to our use of accelerated amortization methods.

Our Trade Publishing segment selling and administrative expense for the year ended December 31, 2018 increased $0.8 million from $53.3 million in 2017, to $54.1 million. The increase was primarily due to higher marketing and advertising costs.

Our Trade Publishing segment selling and administrative expense for the year ended December 31, 2017 increased $5.1 million from $48.2 million in 2016, to $53.3 million. The increase was primarily due to higher transportation costs associated with increased sales volume along with higher costs to support consumer products, partially offset by a reduction of internal and outside labor related costs and lower discretionary costs, all largely due to actions taken under the 2017 Restructuring Plan.

Our Trade Publishing segment other intangible asset amortization expense for the year ended December 31, 2018 slightly increased from 2017.

Our Trade Publishing segment other intangible asset amortization expense for the year ended December 31, 2017 increased $2.3 million from 2016, which was related to amortization of certain previously unamortized tradenames, due to a change in estimate of their useful lives during the fourth quarter of 2016, offset by our use of accelerated amortization methods.

Our Trade Publishing segment Adjusted EBITDA for the year ended December 31, 2018 changed favorably from $12.1 million in 2017 to $21.9 million. Our Trade Publishing segment Adjusted EBITDA excludes depreciation and amortization costs. Our Trade Publishing segment Adjusted EBITDA as a percentage of net sales was 11.0% for the year ended December 31, 2018, which was a favorable change from 6.7% in 2017 due to the identified factors impacting net sales, cost of sales and selling and administrative expenses after removing those items not included in Trade Publishing segment Adjusted EBITDA.

Our Trade Publishing segment Adjusted EBITDA for the year ended December 31, 2017 improved $5.8 million, from $6.3 million in 2016 to $12.1 million in 2017. Our Trade Publishing segment Adjusted EBITDA excludes depreciation and amortization costs. Our Trade Publishing segment Adjusted EBITDA as a percentage of net sales was 6.7% for the year ended December 31, 2017, which was a favorable change from 3.8% in 2016 due to the identified factors impacting net sales, cost of sales and selling and administrative expenses after removing those items not included in Trade Publishing segment Adjusted EBITDA.

 

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Corporate and Other

 

          2018 vs. 2017     2017 vs. 2016  
    Years Ended December 31,     Dollar
change
    Percent
change
    Dollar
change
    Percent
change
 
    2018     2017     2016  

Net sales

  $ —     $ —     $ —     $ —         NM     $ —         NM  

Costs and expenses:

         

Cost of sales, excluding publishing rights and pre-publication amortization

    —       —       —       —         NM       —         NM  

Publishing rights amortization

    —       —       —       —         NM       —         NM  

Pre-publication amortization

    —       —       —       —         NM       —         NM  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cost of sales

    —       —       —       —         NM       —         NM  

Selling and administrative

    77,152       84,704       110,137       (7,552     (8.9 )%      (25,433     (23.1 )% 

Restructuring

    4,657       37,775       —       (33,118     (87.7 )%      37,775       NM  

Severance and other charges

    6,821       177       15,371       6,644       NM       (15,194     (98.8 )% 
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating loss

  $ (88,630   $ (122,656   $ (125,508   $ 34,026       27.7   $ 2,852       2.3
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Retirement benefits non-service income

    1,280       3,486       4,253       (2,206     (63.3 )%      (767     (18.0 )% 

Interest expense

    (45,680     (42,805     (39,181     (2,875     (6.7 )%      (3,624     (9.2 )% 

Interest income

    2,550       1,338       518       1,212       90.6     820       NM  

Change in fair value of derivative instruments

    (1,374     1,366       (614     (2,740     NM       1,980       NM  

Income from transition services agreement

    1,889       —       —       1,889       NM       —      

 

NM

 

 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss before taxes

    (129,965     (159,271     (160,532     29,306       18.4     1,261       0.8

Income tax (benefit) expense

    5,597       (51,419     (51,556     57,016       NM       137       0.3
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

  $ (135,562   $ (107,852   $ (108,976   $ (27,710     (25.7 )%    $ 1,124       1.0
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Adjustments from net loss to Corporate and Other Adjusted EBITDA

             

Interest expense

  $ 45,680     $ 42,805     $ 39,181     $ 2,875       6.7   $ 3,624       9.2

Interest income

    (2,550     (1,338     (518     (1,212     90.6     (820     NM  

Provision (benefit) for income taxes

    5,597       (51,419     (51,556     57,016       NM       137       0.3

Depreciation expense

    17,434       21,901       21,324       (4,467     (20.4 )%      577       2.7

Non-cash charges—loss on derivative instruments

    1,374       (1,366     614       2,740       NM       (1,980     NM  

Non-cash charges—stock-compensation

    13,248       10,728       10,491       2,520       23.5     237       2.3

Fees, expenses or charges for equity offerings, debt or acquisitions/dispositions

    2,883       1,464       1,123       1,419       96.9     341       30.4

2017 Restructuring Plan

    4,657       37,775       —       (33,118     (87.7 )%      37,775       NM  

Restructuring/integration

    —       —       14,364       —         NM       (14,364     NM  

Severance separation costs and facility closures

    6,821       177       15,371       6,644       NM       (15,194     (98.8 )% 

Legal (reimbursement) settlement

    —       (3,633     10,000       3,633       NM       (13,633     NM  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Corporate and Other Adjusted EBITDA

  $ (40,418   $ (50,758   $ (48,582   $ 10,340       20.4   $ (2,176     (4.4 )% 
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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NM= not meaningful

The Corporate and Other category represents certain general overhead costs not fully allocated to the business segments such as legal, accounting, treasury, human resources, technology and executive functions along with restructuring, severance and other non-operating costs.

Our selling and administrative expense for the Corporate and Other category for year the ended December 31, 2018 decreased $7.6 million, or 8.9%, from $84.7 million in 2017 to $77.2 million. The decrease was primarily due to $4.5 million of lower depreciation expense associated with the Company’s technology infrastructure and lower labor costs, rent and technology cost, all attributed to the 2017 Restructuring actions partially offset by higher professional fees and stock compensation charges.

Our selling and administrative expense for the Corporate and Other category for the year ended December 31, 2017 decreased $25.4 million, or 23.1%, from $110.1 million in 2016 to $84.7 million. The decrease was primarily due to legal settlement costs for permissions litigation of $10.0 million in 2016 and a subsequent insurance net reimbursement of $3.6 million which occurred in 2017, and lower travel and entertainment expenses. Further, there were lower restructuring/integration costs as 2016 had costs associated with integration of systems to support the 2015 acquisition. Partially offsetting the decrease were higher annual incentive plan compensation costs in 2017 and costs under our 2017 Restructuring Plan.

Our 2017 Restructuring Plan costs for the year ended December 31, 2018 were $4.7 million of real estate consolidation costs.

Our 2017 Restructuring Plan costs for the year ended December 31, 2017 were $37.8 million, which included severance and termination benefits of $16.2 million, real estate consolidation costs of $5.0 million, implementation costs of $7.5 million and an impairment charge related to a certain long-lived asset included within property, plant, and equipment of $9.1 million.

Severance and other charges for the year ended December 31, 2018 changed unfavorably compared to the prior year by $6.6 million as the majority of such expenses during the 2017 period were in connection with our 2017 Restructuring Plan and were included within the restructuring line item.

Severance and other charges for the year ended December 31, 2017 changed favorably compared to the prior year by $15.2 million as the majority of such expenses during the 2017 period were in connection with our 2017 Restructuring Plan and were included within the restructuring line item.

Retirement benefits non-service income for the year ended December 31, 2018 changed unfavorably by $2.2 million due to the lowering of the expected return on plan assets assumption in the calculation of net periodic benefit cost in 2018.

Retirement benefits non-service income for the year ended December 31, 2017 changed unfavorably by $0.8 million due to the increase in amortization of net loss in the calculation of net periodic benefit cost in 2017.

Interest expense for the year ended December 31, 2018 increased $2.9 million from $42.8 million in 2017 to $45.7 million, primarily due to an increase in interest on the term loan facility of $6.3 million due to an increase in variable interest rates, offset by a reduction of $3.4 million of net settlement payments on our interest rate derivative instruments during 2018.

Our interest expense for the Corporate and Other category for the year ended December 31, 2017 increased $3.6 million, or 9.2%, from $39.2 million in 2016 to $42.8 million, primarily due to $4.1 million of net settlement payments on our interest rate derivative instruments during 2017, partially offset by the lower outstanding balance on our term loan facility.

 

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Interest income for the year ended December 31, 2018 increased $1.2 million from $1.3 million in 2017 to $2.5 million, primarily due to increases in interest rates on our investments and higher investment balances.

Interest income for the year ended December 31, 2017 increased $0.8 million from $0.5 million in 2016 to $1.3 million, primarily due to increases in interest rates on our investments.

Change in fair value of derivative instruments for the year ended December 31, 2018 unfavorably changed by $2.7 million from a gain of $1.4 million in 2017 to a loss of $1.4 million in 2018. The change in fair value of derivative instruments was related to foreign exchange forward contracts executed on the Euro that were unfavorably impacted by the stronger U.S. dollar against the Euro.

Change in fair value of derivative instruments for the year ended December 31, 2017 favorably changed by $2.0 million from a loss of $0.6 million in 2016 to a gain of $1.4 million in 2017. The change in fair value of derivative instruments was related to foreign exchange forward contracts executed on the Euro that were favorably impacted by the weaker U.S. dollar against the Euro.

Income from transition services agreement for the year ended December 31, 2018 was $1.9 million and was related to transition service fees under the transition services agreement with the purchaser of the Riverside Business whereby we provide certain support functions for a period of up to 18 months from the disposition date in the fourth quarter of 2018.

Income tax expense for the year ended December 31, 2018 increased $57.0 million from a benefit of $51.4 million in 2017 to an expense of $5.6 million in 2018. The 2018 income tax expense was primarily related to movement in the deferred tax liability associated with tax amortization on indefinite-lived intangibles, and state and foreign taxes. The 2017 income tax benefit of $51.4 million was primarily related to the effects of the Tax Cuts and Jobs Act. As a result of the effects of new tax legislation, the Company recognized a $31.5 million benefit related to the remeasurement of U.S. deferred tax liabilities associated with indefinite-lived intangible assets to reflect the change in U.S. corporate tax rate from 35% to 21% and a $40.4 million benefit related to the release of valuation allowance due to the Company’s ability to utilize indefinite-lived deferred tax liabilities as a source of future taxable income in the Company’s assessment of its realization of deferred tax assets. This is a result of the U.S. tax law change that would extend net operating losses generated in taxable years beginning after December 31, 2017 to an unlimited carryforward period subject to an 80% utilization against future taxable earnings. The income tax benefit recognized from the effects of U.S. tax reform was partially offset by movement in the deferred tax liability associated with tax amortization on indefinite-lived intangibles, and state and foreign taxes. For both periods, the income tax expense was impacted by certain discrete tax items including the accrual of potential interest and penalties on uncertain tax positions. Including the tax effects of these discrete tax items, the effective tax rate was (4.2)% and 29.9% for the years ended December 31, 2018 and 2017, respectively.

Income tax benefit for the year ended December 31, 2017 decreased $0.2 million from a benefit of $51.6 million in 2016 to a benefit of $51.4 million in 2017. The 2017 income tax benefit was primarily related to the effects of the Tax Cuts and Jobs Act. As a result of the effects of new tax legislation, the Company recognized a $31.5 million benefit related to the remeasurement of U.S. deferred tax liabilities associated with indefinite-lived intangible assets to reflect the change in U.S. corporate tax rate from 35% to 21% and a $40.4 million benefit related to the release of valuation allowance due to the Company’s ability to utilize indefinite-lived deferred tax liabilities as a source of future taxable income in the Company’s assessment of its realization of deferred tax assets. This is a result of the U.S. tax law change that would extend net operating losses generated in taxable years beginning after December 31, 2017 to an unlimited carryforward period subject to an 80% utilization against future taxable earnings. The income tax benefit recognized from the effects of U.S. tax reform was partially offset by movement in the deferred tax liability associated with tax amortization on indefinite-lived intangibles, and state and foreign taxes. The income tax benefit of $51.6 million for the year ended December 31, 2016 was primarily related to a change from indefinite-lived intangibles to definite-lived,

 

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partially offset by movement in the deferred tax liability associated with tax amortization on indefinite-lived intangibles, and state and foreign taxes. For both periods, the income tax benefit was impacted by certain discrete tax items including the accrual of potential interest and penalties on uncertain tax positions. Including the tax effects of these discrete tax items, the effective tax rate was 29.9% and 14.4% for the years ended December 31, 2017 and 2016, respectively.

Adjusted EBITDA for the Corporate and Other category for the year ended December 31, 2018 favorably changed $10.3 million, or 20.4%, from a loss of $50.8 million in 2017 to a loss of $40.4 million. Our Adjusted EBITDA for the Corporate and Other category excludes interest, taxes, depreciation, derivative instruments charges, equity compensation charges, acquisition/disposition-related activity, restructuring costs, integration costs, severance and facility vacant space costs and legal settlement reimbursements. The favorable change in our Adjusted EBITDA for the Corporate and Other category was due to the factors described above after removing those items not included in Adjusted EBITDA for the Corporate and Other category.

Adjusted EBITDA for the Corporate and Other category for the year ended December 31, 2017 changed unfavorably by $2.2 million, or 4.4%, from a loss of $48.6 million in 2016 to a loss of $50.8 million. Our Adjusted EBITDA for the Corporate and Other category excludes interest, taxes, depreciation, derivative instruments charges, equity compensation charges, acquisition-related activity, restructuring costs, integration costs, severance and facility vacant space costs, and legal settlement charges/reimbursements. The unfavorable change in our Adjusted EBITDA for the Corporate and Other category was due to the factors described above after removing those items not included in Adjusted EBITDA for the Corporate and Other category.

Seasonality and Comparability

Our net sales, operating profit or loss and net cash provided by or used in operations are impacted by the inherent seasonality of the academic calendar. Consequently, the performance of our businesses may not be comparable quarter to consecutive quarter and should be considered on the basis of results for the whole year or by comparing results in a quarter with results in the same quarter for the previous year.

Approximately 85% of our net sales for the year ended December 31, 2018 were derived from our Education segment, which is a markedly seasonal business. Schools conduct the majority of their purchases in the second and third quarters of the calendar year in preparation for the beginning of the school year. Thus, over the past three completed fiscal years, approximately 67% of our consolidated net sales were realized in the second and third quarters. Sales of K-12 instructional materials are also cyclical, with some years offering more sales opportunities than others in light of the state adoption calendar. The amount of funding available at the state level for educational materials also has a significant effect on year-to-year net sales. Although the loss of a single customer would not have a material adverse effect on our business, schedules of school adoptions and market acceptance of our products can materially affect year-to-year net sales performance.

 

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The following table is indicative of the seasonality of our business and the related results:

Quarterly Results of Operations

 

(in thousands)   First
Quarter
2017
    Second
Quarter
2017
    Third
Quarter
2017
    Fourth
Quarter
2017
    First
Quarter
2018
    Second
Quarter
2018
    Third
Quarter
2018
    Fourth
Quarter
2018
 

Education segment

  $ 167,152     $ 330,949     $ 465,017     $ 183,335     $ 163,023     $ 321,276     $ 449,636     $ 188,754  

Trade Publishing segment

    36,533       42,444       51,189       50,410       36,736       36,089       66,619       60,284  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net sales

    203,685       373,393       516,206       233,745       199,759       357,365       516,255       249,038  

Costs and expenses:

               

Cost of sales, excluding publishing rights and pre-publication amortization

    100,183       168,485       202,053       117,797       99,733       160,058       201,748       119,928  

Publishing rights amortization

    13,398       10,867       10,987       10,986       10,090       8,148       8,238       8,237  

Pre-publication amortization

    26,402       28,238       32,113       33,155       25,621       26,332       28,094       29,210  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cost of sales

    139,983       207,590       245,153       161,938       135,444       194,538       238,080       157,375  

Selling and administrative

    152,027       161,159       173,690       149,450       145,527       169,323       176,202       158,243  

Other intangible asset amortization

    7,701       7,753       6,873       6,921       6,866       6,676       6,696       6,695  

Impairment charge for intangible assets

    —       —       —       3,980       —       —       —       —  

Restructuring

    3,798       30,515       1,845       1,617       —       —       3,077       1,580  

Severance and other charges

    670       213       272       (978     3,943       2,075       362       441  

Gain on sale of assets

    —       —       —       —       884       (500     —       (585
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating income (loss)

    (100,494     (33,837     88,373       (89,183     (92,905     (14,747     91,838       (74,711
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other income (expense)

               

Retirement benefits non-service income

    872       872       871       871       320       320       320       320  

Interest expense

    (10,453     (10,547     (10,980     (10,825     (10,936     (11,472     (11,627     (11,645

Interest income

    245       115       281       697       506       117       277       1,650  

Change in fair value of derivative instruments

    45       851       377       93       372       (1,097     (249     (400

Income from transition services agreement

    —       —       —       —       —       —       —       1,889  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss from continuing operations before taxes

    (109,785     (42,546     78,922       (98,347     (102,643     (26,879     80,559       (82,897

Income tax expense (benefit)

    14,076       6,120       (9,714     (61,901     3,243       2,210       (3,349     3,493  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss from continuing operations

  $ (123,861   $ (48,666   $ 88,636     $ (36,446   $ (105,886   $ (29,089   $ 83,908     $ (86,390
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Earnings from discontinued operations, net tax

    3,203       1,799       1,870       10,278       4,575       5,817       2,441       —  

Gain on sale of discontinued operations, net of tax

    —       —       —       —       —       —       —       30,469  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss)

  $ (120,658   $ (46,867   $ 90,506     $ (26,168   $ (101,311   $ (23,272   $ 86,349     $ (55,921
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Liquidity and Capital Resources

 

     December 31,  
(in thousands)    2018      2017      2016  

Cash and cash equivalents

   $ 253,365      $ 148,979      $ 226,102  

Short-term investments

     49,833        86,449        80,841  

Current portion of long-term debt

     8,000        8,000        8,000  

Long-term debt, net of discount

     755,649        760,194        764,738  
     Years ended December 31,  
     2018      2017      2016  

Net cash provided by operating activities

   $ 114,915      $ 135,130      $ 143,751  

Net cash used in investing activities

     (6,405      (204,923      (113,946

Net cash (used in) provided by financing activities

     (4,124      (7,330      (37,960

Operating activities

Net cash provided by operating activities was $114.9 million for the year ended December 31, 2018, a $20.2 million decrease from the $135.1 million of net cash provided by operating activities for the year ended December 31, 2017. Net cash provided by operating activities included $10.8 million and $30.4 million of cash flow from discontinued operations in 2018 and 2017, respectively. Net cash provided by operating activities from continuing operations was $104.1 million in 2018 compared to $104.7 million in 2017. The $0.6 million decrease in cash provided by operating activities from continuing operations from 2017 to 2018 was primarily driven by unfavorable net changes in operating assets and liabilities of $13.2 million. The unfavorable net changes in operating assets and liabilities were primarily due to unfavorable changes in inventory of $41.6 million, unfavorable changes in accounts receivable of $23.6 million due to timing of collections and fourth quarter net sales, partially offset by favorable changes in accounts payable of $22.1 million, due to timing of payments, favorable changes in pension and post-retirement benefits of $6.0 million, favorable changes in deferred revenue of $5.8 million, and favorable changes in other assets and liabilities of $14.5 million and $3.6 million, respectively. The decrease in net cash provided by operating activities from continuing operations was partially offset by more profitable operations, net of non-cash items, of $12.6 million.

Net cash provided by operating activities was $135.1 million for the year ended December 31, 2017, a $8.7 million decrease from the $143.8 million of net cash provided by operating activities for the year ended December 31, 2016. Net cash provided by operating activities included $30.4 million and $32.0 million of cash flow from discontinued operations in 2017 and 2016, respectively. Net cash provided by operating activities from continuing operations was $104.7 million in 2017 compared to $111.8 million in 2016. The $7.1 million decrease in cash provided by operating activities from continuing operations from 2016 to 2017 was primarily driven by unfavorable net changes in operating assets and liabilities of $61.0 million, partially offset by more profitable operations, net of non-cash items, of $53.9 million. The unfavorable net changes in operating assets and liabilities were primarily due to unfavorable changes in deferred revenue of $52.7 due to lower billings of Core Solutions products, which typically carry a high deferral rate, unfavorable changes in accounts receivable of $25.3 million due to timing of collections and fourth quarter net sales, and unfavorable changes in pension and post-retirement benefits of $10.6 million, partially offset by favorable changes in accounts payable and royalties of $18.2 million and $11.3 million, respectively, due to timing of payments.

Investing activities

Net cash used in investing activities was $6.4 million for the year ended December 31, 2018, a decrease of $198.5 million from the $204.9 million used in investing activities for the year ended December 31, 2017. Net cash used in investing activities included $6.8 million and $11.0 million of expenditures from discontinued

 

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operations in 2018 and 2017, respectively. Net cash provided by investing activities from continuing operations was $0.4 million in 2018 compared to net cash used in investing activities from continuing operations of $193.9 million in 2017. The decrease in net cash used in investing activities was primarily due to $140.0 million in proceeds from the sale of the Riverside Business and higher net proceeds from short-term investments of $42.5 million compared to 2017 and $9.2 million of lower capital expenditures.

Net cash used in investing activities was $204.9 million for the year ended December 31, 2017, an increase of $91.0 million from the $113.9 million used in investing activities for the year ended December 31, 2016. Net cash used in investing activities included $11.0 million and $7.8 million of expenditures from discontinued operations in 2017 and 2016, respectively. Net cash used in investing activities from continuing operations was $193.9 million in 2017 compared to $106.1 million in 2016. The increase in investing activities was primarily due to lower net proceeds from short-term investments of $122.2 million compared to 2016 along with $12.7 million of higher pre-publication costs in advance of 2018 adoptions. Partially offsetting, capital investing expenditures related to property, plant, and equipment decreased by $48.1 million, which was primarily due to lower spend on leasehold improvements related to various office moves and technology infrastructure.

Financing activities

Net cash used in financing activities was $4.1 million for the year ended December 31, 2018, a decrease of $3.2 million from the $7.3 million of net cash used in financing activities for the year ended December 31, 2017. The decrease in cash used in financing activities was primarily due to net collections and remittances under the transition services agreement.

Net cash used in financing activities was $7.3 million for the year ended December 31, 2017, a decrease of $30.7 million from the $38.0 million of net cash used in financing activities for the year ended December 31, 2016. The decrease in cash used in financing activities was primarily due to there being no share repurchases in 2017 under our share repurchase program for our common stock, compared to $55.0 million of share repurchases in 2016, partially offset by $24.0 million less proceeds related to stock option exercises during 2017 compared to 2016.

Debt

Under both our revolving credit facility and term loan facility, Houghton Mifflin Harcourt Publishers Inc., HMH Publishers LLC and Houghton Mifflin Harcourt Publishing Company are the borrowers (collectively, the “Borrowers”), and Citibank, N.A. acts as both the administrative agent and the collateral agent.

The obligations under the revolving credit facility and the term loan facility are guaranteed by the Company and each of its direct and indirect for-profit domestic subsidiaries (other than the Borrowers) (collectively, the “Guarantors”) and are secured by all capital stock and other equity interests of the Borrowers and the Guarantors and substantially all of the other tangible and intangible assets of the Borrowers and the Guarantors, including, without limitation, receivables, inventory, equipment, contract rights, securities, patents, trademarks, other intellectual property, cash, bank accounts and securities accounts and owned real estate. The revolving credit facility is secured by first priority liens on receivables, inventory, deposit accounts, securities accounts, instruments, chattel paper and other assets related to the foregoing (the “Revolving First Lien Collateral”), and second priority liens on the collateral which secures the term loan facility on a first priority basis. The term loan facility is secured by first priority liens on the capital stock and other equity interests of the Borrower and the Guarantors, equipment, owned real estate, trademarks and other intellectual property, general intangibles that are not Revolving First Lien Collateral and other assets related to the foregoing, and second priority liens on the Revolving First Lien Collateral.

 

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Term Loan Facility

On May 29, 2015, we entered into an amended and restated $800.0 million term loan credit facility (the “term loan facility”). As of December 31, 2018, we had approximately $772.0 million ($763.6 million, net of discount and issuance costs) outstanding under the term loan facility.

The term loan facility has a six-year term and matures on May 29, 2021. The interest rate applicable to borrowings under the facility is based, at our election, on LIBOR plus 3.0% or an alternative base rate plus applicable margins. LIBOR is subject to a floor of 1.0%, with the length of the LIBOR contracts ranging up to six months at the option of the Company. As of December 31, 2018, the interest rate of the term loan facility was 5.5%.

The term loan facility is required to be repaid in quarterly installments of $2.0 million, may be prepaid, in whole or in part, at any time, without premium.

The term loan facility does not require us to comply with financial maintenance covenants. We are currently required to meet certain incurrence based financial covenants as defined under our term loan facility.

The term loan facility is subject to usual and customary conditions, representations, warranties and covenants, including restrictions on additional indebtedness, liens, investments, mergers, acquisitions, asset dispositions, dividends to stockholders, repurchase or redemption of our stock, transactions with affiliates and other matters. The term loan facility is subject to customary events of default. If an event of default occurs and is continuing, the administrative agent may, or at the request of certain required lenders shall, accelerate the obligations outstanding under the term loan facility.

We are subject to an excess cash flow provision under the term loan facility which is predicated upon our leverage ratio and cash flow. We were not required to make a payment under the excess cash flow provision in 2018 and 2017.

Revolving Credit Facility

On July 22, 2015, we entered into an amended and restated revolving credit facility (the “revolving credit facility”) to, among other things, reduce the pricing, extend the maturity, conform certain terms to those of our term loan facility and to provide greater availability and operational flexibility. The revolving credit facility provides borrowing availability in an amount equal to the lesser of $250.0 million and a borrowing base that is computed monthly or weekly as the case may be and comprised of the Borrowers’ and certain Guarantors’ eligible inventory and receivables.

The revolving credit facility includes a letter of credit subfacility of $50.0 million, a swingline subfacility of $20.0 million and the option to expand the facility by up to $100.0 million in the aggregate under certain specified conditions. The amount of any outstanding letters of credit reduces borrowing availability under the revolving credit facility on a dollar-for-dollar basis. As of December 31, 2018, no loans are currently drawn on the revolving credit facility. As of December 31, 2018, we had approximately $24.3 million of outstanding letters of credit and approximately $167.4 million of borrowing availability under the revolving credit facility. As of February 28, 2019, there were no amounts drawn on the revolving credit facility.

The revolving credit facility has a five year term and matures on July 22, 2020. The interest rate applicable to borrowings under the facility is based, at our election, on LIBOR plus 1.75% or an alternative base rate plus 0.75%; such applicable margins may increase up to 2.25% and 1.25%, respectively, based on average daily availability. The revolving credit facility may be prepaid, in whole or in part, at any time, without premium.

The revolving credit facility requires us to maintain a minimum fixed charge coverage ratio of 1.0 to 1.0 on a trailing four-quarter basis for periods in which excess availability under the facility is less than the greater of

 

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$25.0 million and 12.5% of the lesser of the total commitment and the borrowing base then in effect, or less than $20.0 million if certain conditions are met. The minimum fixed charge coverage ratio was not applicable under the facility as of December 31, 2018, due to our level of borrowing availability.

The revolving credit facility is subject to usual and customary conditions, representations, warranties and covenants, including restrictions on additional indebtedness, liens, investments, mergers, acquisitions, asset dispositions, dividends to stockholders, repurchase or redemption of our stock, transactions with affiliates and other matters. The revolving credit facility is subject to customary events of default. If an event of default occurs and is continuing, the administrative agent may, or at the request of certain required lenders shall, accelerate the obligations outstanding under the revolving credit facility.

General

We had $253.4 million of cash and cash equivalents and $49.8 million of short-term investments at December 31, 2018. We had $149.0 million of cash and cash equivalents and $86.4 million of short-term investments at December 31, 2017.

Our business is impacted by the inherent seasonality of the academic calendar, which typically results in a cash flow usage in the first half of the year and a cash flow generation in the second half of the year. We expect our net cash provided by operations combined with our cash and cash equivalents and borrowing availability under our revolving credit facility to provide sufficient liquidity to fund our current obligations, capital spending, debt service requirements and working capital requirements over at least the next twelve months.

The ability of the Company to fund planned operations is based on assumptions, which involve significant judgment and estimates of future revenues, capital spend and other operating costs.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates, assumptions and judgments by management that affect the reported amounts of assets, liabilities, net sales, expenses and related disclosure of contingent assets and liabilities in the amounts reported in the financial statements and accompanying notes. On an on-going basis, we evaluate our estimates and assumptions, including, but not limited to, book returns, deferred revenue and related standalone selling price estimates, allowance for bad debts, recoverability of advances to authors, valuation of inventory, financial instruments valuation, income taxes. pensions and other postretirement benefits obligations, contingencies, litigation, depreciation and amortization periods, and the recoverability of long-term assets such as property, plant and equipment, capitalized pre-publication costs, other identified intangibles, and goodwill. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from those estimates. For a complete description of our significant accounting policies, see Note 2 to the consolidated financial statements. The following policies and account descriptions include those identified as critical to our business operations and the understanding of our results of operations.

Revenue Recognition

Revenue is recognized when a customer obtains control of promised goods or services, in an amount that reflects the consideration which we expect to receive in exchange for those goods or services. To determine revenue recognition for arrangements that we determine are within the scope of the new revenue recognition accounting standard, we perform the following five steps: (i) identify the contract with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) we satisfy a

 

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performance obligation. We only apply the five-step model to contracts when it is probable that we will collect the consideration we are entitled to in exchange for the goods or services we transfer to the customer. At contract inception, we assess the goods or services promised within each contract and determine those that are performance obligations and assess whether each promised good or service is distinct. We then recognize as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied.

Revenue is measured as the amount of consideration we expect to receive in exchange for transferring products or services to a customer. To the extent the transaction price includes variable consideration, which generally reflects estimated future product returns, we estimate the amount of variable consideration that should be included in the transaction price utilizing the expected value method to which we expect to be entitled. Variable consideration is included in the transaction price if, in our judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. Estimates of variable consideration and the determination of whether to include estimated amounts in the transaction price are based largely on all information (historical, current and forecasted) that is reasonably available. Sales, value add, and other taxes collected on behalf of third parties are excluded from revenue.

We estimate the collectability of contracts upon execution. For contracts with rights of return, the transaction price is adjusted to reflect the estimated returns for the arrangement on these sales and is made at the time of sale based on historical experience by product line or customer. The transaction prices allocated are adjusted to reflect expected returns and are based on historical return rates and sales patterns. Shipping and handling fees charged to customers are included in net sales.

When determining the transaction price of a contract, an adjustment is made if payment from a customer occurs either significantly before or significantly after performance, resulting in a significant financing component. We do not assess whether a significant financing component exists if the period between when we perform our obligations under the contract and when the customer pays is one year or less. Significant financing components’ income is included in interest income.

Contracts are often modified to account for changes in contract specifications and requirements. Contract modifications exist when the modification either creates new, or changes the existing, enforceable rights and obligations. Generally, contract modifications are for products or services that are not distinct from the existing contract due to the inability to use, consume or sell the products or services on their own to generate economic benefits and are accounted for as if they were part of that existing contract. The effect of such a contract modification on the transaction price and measure of progress for the performance obligation to which it relates is recognized as an adjustment to revenue (either as an increase in or a reduction of revenue) on a cumulative catch-up basis.

Physical product revenue is generally recognized when the customer obtains control of our product, which occurs at a point in time, and may be upon shipment or upon delivery based on the contractual shipping terms of a contract. Revenues from static digital content commence upon delivery to the customer of the digital entitlement that is required to access and download the content and is typically recognized at a point in time. Revenues from subscription software licenses, related hosting services and product support are recognized evenly over the license term as we believe this best represents the pattern of transfer to the customer. The perpetual software licenses provide the customer with a functional license to our products and their related revenues are recognized when the customer receives entitlement to the software. For the technical services provided to customers in connection with the software license, including hosting services related to perpetual licenses, we recognize revenue upon delivery of the services. As the invoices are based on each day of service, this is directly linked to the transfer of benefit to the customer.

If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. We enter into certain contracts that have multiple performance obligations, one or more

 

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of which may be delivered subsequent to the delivery of other performance obligations. These performance obligations may include print and digital media, professional development services, training, software licenses, access to hosted content, and various services related to the software including but not limited to hosting, maintenance and support, and implementation. We allocate the transaction price based on the estimated relative standalone selling prices of the promised products or services underlying each performance obligation. We determine standalone selling prices based on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through past transactions, we estimate the standalone selling price taking into account available information such as market conditions and internally approved standard pricing discounts related to the performance obligations. Generally, our performance obligations include print and digital textbooks and instructional materials, trade books, reference materials, formative assessment materials and multimedia instructional programs; licenses to book rights and content; access to hosted content; and services including professional development, consulting and training. Our contracts may also contain software performance obligations including perpetual and subscription based licenses and software maintenance and support services.

Accounts Receivable

Accounts receivable include amounts billed and currently due from customers and are recorded net of allowances for doubtful accounts and reserves for returns. In the normal course of business, we extend credit to customers that satisfy predefined criteria. Allowances for doubtful accounts are established through the evaluation of accounts receivable aging and prior collection experience to estimate the ultimate collectability of these receivables.

Contract Assets

Contract assets include unbilled amounts where revenue is recognized over time as the services are delivered to the customer based on the extent of progress towards completion and revenue recognized exceeds the amount billed to the customer, and right of payment is not subject to the passage of time. Amounts may not exceed their net realizable value. Contract assets are included in prepaid expenses and other assets on our consolidated balance sheets.

Deferred Commissions

Our incremental direct costs of obtaining a contract, which consist of sales commissions, are deferred and amortized over the period of contract performance. Applying the practical expedient, we recognize sales commission expense when incurred if the amortization period of the assets that we otherwise would have recognized is one year or less. At December 31, 2018 and January 1, 2018, we had $22.6 million and $24.0 million of deferred commissions, respectively. We had $10.5 million of amortization expense related to deferred commissions during the year ended December 31, 2018. These costs are included in selling and administrative expenses.

Deferred Revenue

Our contract liabilities consist of advance payments and billings in excess of revenue recognized and are classified as deferred revenue on our consolidated balance sheets. Our contract assets and liabilities are accounted for and presented on a net basis as either a contract asset or contract liability at the end of each reporting period. We classify deferred revenue as current or noncurrent based on the timing of when we expect to recognize revenue. In order to determine revenue recognized in the period from contract liabilities, we first allocate revenue to the individual contract liability balance outstanding at the beginning of the period until the revenue exceeds that balance. If additional advances are received on those contracts in subsequent periods, we assume all revenue recognized in the reporting period first applies to the beginning contract liability as opposed to a portion applying to the new advances for the period.

 

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Refer to Note 2 to the consolidated financial statements for a detailed description of the impact of the adoption of the new revenue recognition standard on our consolidated balance sheets and statements of operations.

Allowance for Doubtful Accounts and Reserves for Book Returns

Accounts receivable are recorded net of allowances for doubtful accounts and reserves for book returns. In the normal course of business, we extend credit to customers that satisfy predefined criteria. We estimate the collectability of our receivables. Allowances for doubtful accounts are established through the evaluation of accounts receivable aging, prior collection experience and specific facts and circumstances. Reserves for book returns are based on historical return rates and sales patterns. We determine the required reserves by segregating our returns into the applicable product or sales channel pools. Returns in the K-12 market have been historically low. We have experienced higher returns with respect to sales to resellers, international sales and Trade Publishing sales, which all result in a greater degree of risk and subjectivity when establishing the appropriate level of reserves for this customer base. At the time we determine that a receivable balance, or any portion thereof, is deemed to be permanently uncollectible, the balance is written off. The allowance for doubtful accounts and reserve for returns are reported as reductions of the accounts receivable balance and amounted to $2.2 million and $18.6 million, and $2.5 million and $20.6 million as of December 31, 2018 and 2017, respectively.

Inventories

Inventories are substantially stated at the lower of weighted average cost or net realizable value. The level of obsolete and excess inventory is estimated on a program or title-level basis by comparing the number of units in stock with the expected future demand. The expected future demand of a program or title is determined by the copyright year, the previous years’ sales history, the subsequent year’s sales forecast, known forward-looking trends including our development cycle to replace the title or program and competing titles or programs. A change in sales trends could affect the estimated reserve. The inventory obsolescence reserve is reported as a reduction of the inventories balance and amounted to $46.5 million and $47.4 million as of December 31, 2018 and 2017, respectively.

Pre-publication Costs

Pre-publication costs are capitalized and are primarily amortized from the year of sale over five years using the sum-of-the-years-digits method, which is an accelerated method for calculating an asset’s amortization. Under this method, the amortization expense recorded for a pre-publication cost asset is approximately 33% (year 1), 27% (year 2), 20% (year 3), 13% (year 4) and 7% (year 5). We utilize this policy for all pre-publication costs, except with respect to our Trade Publishing young readers and general interest books, for which we expense such costs as incurred. Additionally, pre-publication costs recorded in connection with the acquisition of the EdTech business are amortized over 7 years on a projected sales pattern. The amortization methods and periods chosen best reflects the pattern of expected sales generated from individual titles or programs. On a quarterly basis, we evaluate the remaining lives and recoverability of capitalized pre-publication costs, which are often dependent upon program acceptance by state adoption authorities.

Amortization expense related to pre-publication costs for the years ended December 31, 2018, 2017 and 2016 were $109.3 million, $119.9 million and $121.9 million, respectively.

For the year ended December 31, 2017, the Company recorded an impairment charge of $4.0 million related to assets that had no future value. For the years ended December 31, 2018 and 2016, no pre-publication costs were deemed to be impaired.

 

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Goodwill and Indefinite-Lived Intangible Assets

Goodwill and indefinite-lived intangible assets (certain tradenames) are not amortized, but are reviewed at least annually for impairment or earlier, if an indication of impairment exists. Goodwill is allocated entirely to our Education reporting unit. Determining the fair value of a reporting unit is judgmental in nature and involves the use of significant estimates and assumptions. These estimates and assumptions may include net sales growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions, the determination of appropriate market comparables as well as the fair value of individual assets and liabilities.

We have the option of first assessing qualitative factors to determine whether it is necessary to perform the current two-step impairment test for goodwill or we can perform the two-step impairment test without performing the qualitative assessment. In performing the qualitative (Step 0) assessment, we consider certain events and circumstances specific to the reporting unit and to the entity as a whole, such as macroeconomic conditions, industry and market considerations, overall financial performance and cost factors when evaluating whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount.

Recoverability of goodwill can also be evaluated using a two-step process. In the first step, the fair value of a reporting unit is compared to its carrying value. If the fair value of a reporting unit exceeds the carrying value of the net assets assigned to a reporting unit, goodwill is considered not impaired and no further testing is required. If the carrying value of the net assets assigned to a reporting unit exceeds the fair value of a reporting unit, the second step of the impairment test is performed in order to determine the implied fair value of a reporting unit’s goodwill. Determining the implied fair value of goodwill requires valuation of a reporting unit’s tangible and intangible assets and liabilities in a manner similar to the allocation of purchase price in a business combination. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, goodwill is deemed impaired and is written down to the extent of the difference. We estimate total fair value of the Education reporting unit by using various valuation techniques including an evaluation of our market capitalization and peer company multiples. With regard to indefinite-lived intangible assets, which includes the Houghton Mifflin Harcourt tradename at December 31, 2018 and 2017, the recoverability is evaluated using a one-step process whereby we determine the fair value by asset and then compare it to its carrying value to determine if the asset is impaired. We estimate the fair value based by preparing a relief-from-royalty discounted cash flow analysis using forwarding looking revenue projections. The significant assumptions used in discounted cash flow analysis include: future net sales, a long-term growth rate, a royalty rate and a discount rate used to present value future cash flows and the terminal value of the Education reporting unit. The discount rate is based on the weighted-average cost of capital method at the date of the evaluation.

We completed our annual goodwill impairment tests as of October 1, 2018 and 2017. The fair value of the Education reporting unit substantially exceeded its carrying value as of the evaluation dates and there was no goodwill impairment for the years ended December 31, 2018, 2017 and 2016. We will continue to monitor and evaluate the carrying value of goodwill. If market and economic conditions or business performance deteriorate, this could increase the likelihood of us recording an impairment charge.

We completed our annual indefinite-lived asset impairment tests as of October 1, 2018 and 2017. No indefinite-lived intangible assets were deemed to be impaired for the years ended December 31, 2018 and 2017.We recorded a non-cash impairment charge of $130.2 million for the year ended December 31, 2016. The impairment charge related to four specific tradenames within the Education segment in 2016 and primarily resulted from the strategic decision to market our products under the Houghton Mifflin Harcourt and HMH name rather than legacy imprints and certain declining sales projections.

Royalty Advances

Royalty advances to authors are capitalized and represent amounts paid in advance of the sale of an author’s product and are recovered as earned. As advances are recorded, a partial reserve may be recorded immediately

 

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based primarily upon historical sales experience to estimate the likelihood of recovery. Additionally, advances are evaluated periodically to determine if they are expected to be recovered on a title-by-title basis, with consideration given to the other titles in the author’s portfolio also earning against the outstanding advance. Any portion of a royalty advance that is not expected to be recovered is fully reserved. The reserve for royalty advances is reported as a reduction of the royalty advances to authors balance and amounted to $117.8 million and $103.6 million as of December 31, 2018 and 2017, respectively.

Stock-Based Compensation

The fair value of each restricted stock and restricted stock unit was estimated at the date of the grant based upon the target value of the award and the current market price. The fair value of each market-based restricted stock unit was estimated at the date of grant using the Monte Carlo simulation, which requires management’s use of highly subjective estimates and assumptions. The fair value of each stock option grant was estimated on the date of grant using the Black-Scholes option pricing model, which also requires management’s use of highly subjective estimates and assumptions. The use of different estimates and assumptions in the option pricing model could have a material impact on the estimated fair value of option grants and the related expense. We estimate our expected volatility based on the historical volatility of our publicly traded peer companies (including our own) and expect to continue to do so until such time as we have adequate historical data regarding the volatility of our traded stock price. The expected life assumption is based on the simplified method for estimating the expected term for awards. This option has been elected as we do not have sufficient stock option exercise experience to support a reasonable estimate of the expected term. The risk-free interest rate is the yield currently available on U.S. Treasury zero-coupon issues with a remaining term approximating the expected term of the option. The expected dividend yield is based on actual dividends paid or to be paid. We recognize stock-based compensation expense over the awards requisite service period on a straight-line basis for time-based stock options, restricted stock and restricted stock units and on a graded basis for restricted stock and restricted stock units that are contingent on the achievement of performance conditions. We recognize compensation expense for only the portion of stock-based awards that are expected to vest. Accordingly, we have estimated expected forfeitures of stock-based awards based on our historical forfeiture rates and used these rates in developing a future forfeiture rate. If our actual forfeiture rate varies from our historical rates and estimates, additional adjustments to compensation expense may be required in future periods.

Income Taxes

We had accounted for the tax effects of The Tax Cuts and Jobs Act, enacted on December 22, 2017, on a provisional basis and have subsequently finalized our accounting analysis based on guidance, interpretations available at December 31, 2018. Adjustments made in the fourth quarter of 2018 upon finalization of our accounting analysis were not material to our financial statements. See Note 8 to the consolidated financial statements for further detail.

Impact of Inflation and Changing Prices

We believe that inflation has not had a material impact on our results of operations during the years ended December 31, 2018, 2017 and 2016. We cannot be sure that future inflation will not have an adverse impact on our operating results and financial condition in future periods. Our ability to adjust selling prices has always been limited by competitive factors and long-term contractual arrangements which either prohibit price increases or limit the amount by which prices may be increased. Further, a weak domestic economy at a time of low inflation could cause lower tax receipts at the state and local level, and the funding and buying patterns for textbooks and other educational materials could be adversely affected.

Covenant Compliance

As of December 31, 2018, we were in compliance with all of our debt covenants.

 

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We are currently required to meet certain incurrence based financial covenants as defined under our term loan facility and revolving credit facility. We have incurrence based financial covenants primarily pertaining to a maximum leverage ratio, fixed charge coverage ratio, and liquidity. A breach of any of these covenants, ratios, tests or restrictions, as applicable, for which a waiver is not obtained could result in an event of default, in which case our lenders could elect to declare all amounts outstanding to be immediately due and payable and result in a cross-default under other arrangements containing such provisions. A default would permit lenders to accelerate the maturity for the debt under these agreements and to foreclose upon any collateral securing the debt owed to these lenders and to terminate any commitments of these lenders to lend to us. If the lenders accelerate the payment of the indebtedness, our assets may not be sufficient to repay in full the indebtedness and any other indebtedness that would become due as a result of any acceleration. Further, in such an event, the lenders would not be required to make further loans to us, and assuming similar facilities were not established and we are unable to obtain replacement financing, it would materially affect our liquidity and results of operations.

Contractual Obligations

The following table provides information with respect to our estimated commitments and obligations as of December 31, 2018 (in thousands):

 

Contractual Obligations

   Total      Less than
1 year
     1-3 years      3-5 years      More than
5 years
 

Term loan facility due May 29, 2021 (1)

   $ 772,000      $ 8,000      $ 764,000      $ —      $ —  

Interest payable on term loan facility due May 29, 2021 (2)

     103,220        39,155        64,065        —        —  

Operating leases (3)

     308,922        32,694        53,007        52,018        171,203  

Purchase obligations (4)

     100,158        44,373        52,623        3,162        —  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total cash contractual obligations

   $ 1,284,300      $ 124,222      $ 933,695      $ 55,180      $ 171,203  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)

The term loan facility amortizes at a rate of 1.0% per annum of the original $800.0 million amount.

(2)

As of December 31, 2018, the interest rate was 5.5%.

(3)

Represents minimum lease payments under non-cancelable operating leases.

(4)

Purchase obligations are agreements to purchase goods or services that are enforceable and legally binding. These goods and services consist primarily of author advances, subcontractor expenses, information technology licenses, and outsourcing arrangements.

In addition to the payments described above, we have employee benefit obligations that require future payments. For example, we expect to make $1.6 million of contributions in 2019 relating to our pension and postretirement benefit plans. We expect to periodically draw and repay borrowings under the revolving credit facility. We believe that we will be able to meet our cash interest obligations on our outstanding debt when they are due and payable.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements.

 

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Item 7A. Quantitative and Qualitative Disclosures About Market Risk

We are exposed to market risk from foreign currency exchange rates and interest rates, which could affect operating results, financial position and cash flows. We manage exposure to these market risks through our regular operating and financing activities and, when appropriate, through the use of derivative financial instruments. These derivative financial instruments are utilized to hedge economic exposures as well as reduce our earnings and cash flow volatility resulting from shifts in market rates. As permitted, we may designate certain of these derivative contracts for hedge accounting treatment in accordance with authoritative guidance regarding accounting for derivative instruments and hedging activities. However, certain of these instruments may not qualify for, or we may choose not to elect, hedge accounting treatment and, accordingly, the results of our operations may be exposed to some level of volatility. Volatility in our results of operations will vary with the type and amount of derivative hedges outstanding, as well as fluctuations in the currency and interest rate market during the period. Periodically, we may enter into derivative contracts, including interest rate swap agreements and interest rate caps and collars to manage interest rate exposures, and foreign currency spot, forward, swap and option contracts to manage foreign currency exposures. The fair market values of all of these derivative contracts change with fluctuations in interest rates and/or currency rates and are designed so that any changes in their values are offset by changes in the values of the underlying exposures. Derivative financial instruments are held solely as risk management tools and not for trading or speculative purposes.

By their nature, all derivative instruments involve, to varying degrees, elements of market and credit risk not recognized in our financial statements. The market risk associated with these instruments resulting from currency exchange and interest rate movements is expected to offset the market risk of the underlying transactions, assets and liabilities being hedged. Our policy is to deal with counterparties having a single A or better credit rating at the time of the execution. We manage our exposure to counterparty risk of derivative instruments by entering into contracts with a diversified group of major financial institutions and by actively monitoring outstanding positions.

We continue to review liquidity sufficiency by performing various stress test scenarios, such as cash flow forecasting, which considers hypothetical interest rate movements. Furthermore, we continue to closely monitor current events and the financial institutions that support our credit facility, including monitoring their credit ratings and outlooks, credit default swap levels, capital raising and merger activity.

As of December 31, 2018, we had $772.0 million ($763.6 million, net of discount and issuance costs) of aggregate principal amount indebtedness outstanding under our term loan facility that bears interest at a variable rate. An increase or decrease of 1% in the interest rate will change our interest expense by approximately $7.7 million on an annual basis. We also have up to $250.0 million of borrowing availability, subject to borrowing base availability, under our revolving credit facility, and borrowings under the revolving credit facility bear interest at a variable rate. As of December 31, 2018, there were no amounts outstanding on the revolving credit facility. Assuming that the revolving credit facility is fully drawn, an increase or decrease of 1% in the interest rate will change our interest expense associated with the revolving credit facility by $2.5 million on an annual basis.

Our interest rate risk relates primarily to U.S. dollar borrowings partially offset by U.S. dollar cash investments. We have historically used interest rate derivative instruments to manage our earnings and cash flow exposure to changes in interest rates. On August 17, 2015, we entered into interest rate derivative contracts with various financial institutions having an aggregate notional amount of $400.0 million to convert floating rate debt into fixed rate debt, which we designated as cash flow hedges, and for which we had $400.0 million outstanding as of December 31, 2018. These contracts were effective beginning September 30, 2016 and mature on July 22, 2020.

We conduct various digital development activities in Ireland, and as such, our cash flows and costs are subject to fluctuations from changes in foreign currency exchange rates. We manage our exposures to this market risk through the use of short-term foreign exchange forward and option contracts, when deemed appropriate, which were not significant as of December 31, 2018 and December 31, 2017. We do not enter into derivative transactions or use other financial instruments for trading or speculative purposes.

 

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Item 8. Financial Statements and Supplementary Data

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of

Houghton Mifflin Harcourt Company:

Opinions on the Financial Statements and Internal Control over Financial Reporting

We have audited the accompanying consolidated balance sheets of Houghton Mifflin Harcourt Company and its subsidiaries (the “Company”) as of December 31, 2018 and December 31, 2017, and the related consolidated statements of operations, comprehensive loss, cash flows, and stockholders’ equity for each of the three years in the period ended December 31, 2018, including the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and December 31, 2017, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control—Integrated Framework (2013) issued by the COSO.

Change in Accounting Principle

As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for revenues from contracts with customers in 2018.

Basis for Opinions

The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.

Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and

 

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testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

Definition and Limitations of Internal Control over Financial Reporting

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/ PricewaterhouseCoopers LLP

Boston, Massachusetts

February 28, 2019

We have served as the Company’s auditor since 2003.

 

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Houghton Mifflin Harcourt Company

Consolidated Balance Sheets

 

 

     December 31,  
(in thousands of dollars, except share information)    2018     2017  

Assets

    

Current assets

    

Cash and cash equivalents

   $ 253,365     $ 148,979  

Short-term investments

     49,833       86,449  

Accounts receivable, net of allowances for bad debts and book returns of $20.7 million and $23.1 million, respectively

     203,574       192,569  

Inventories

     184,209       150,694  

Prepaid expenses and other assets

     15,297       29,919  

Assets of discontinued operations

     —       123,761  
  

 

 

   

 

 

 

Total current assets

     706,278       732,371  

Property, plant, and equipment, net

     125,925       148,659  

Pre-publication costs, net

     323,641       313,997  

Royalty advances to authors, net

     47,993       46,469  

Goodwill

     716,073       716,073  

Other intangible assets, net

     520,892       582,538  

Deferred income taxes

     3,259       3,593  

Deferred commissions

     22,635       —  

Other assets

     28,428       19,891  
  

 

 

   

 

 

 

Total assets

   $ 2,495,124     $ 2,563,591  
  

 

 

   

 

 

 

Liabilities and Stockholders’ Equity

    

Current liabilities

    

Current portion of long-term debt

   $ 8,000     $ 8,000  

Accounts payable

     76,313       60,810  

Royalties payable

     66,893       66,798  

Salaries, wages, and commissions payable

     50,225       52,838  

Deferred revenue

     251,944       265,074  

Interest payable

     136       322  

Severance and other charges

     6,020       6,926  

Accrued postretirement benefits

     1,512       1,618  

Other liabilities

     26,649       19,657  

Liabilities of discontinued operations

     —       24,706  
  

 

 

   

 

 

 

Total current liabilities

     487,692       506,749  

Long-term debt, net of discount and issuance costs

     755,649       760,194  

Long-term deferred revenue

     395,500       418,734  

Accrued pension benefits

     29,320       24,133  

Accrued postretirement benefits

     14,300       20,285  

Deferred income taxes

     27,075       22,269  

Other liabilities

     17,118       16,034  
  

 

 

   

 

 

 

Total liabilities

     1,726,654       1,768,398  
  

 

 

   

 

 

 

Commitments and contingencies (Note 12)

    

Stockholders’ equity

    

Preferred stock, $0.01 par value: 20,000,000 shares authorized; no shares issued and outstanding at December 31, 2018 and 2017

     —       —  

Common stock, $0.01 par value: 380,000,000 shares authorized; 148,164,854 and 147,911,466 shares issued at December 31, 2018 and 2017, respectively; 123,587,820 and 123,334,432 shares outstanding at December 31, 2018 and 2017, respectively

     1,481       1,479  

Treasury stock, 24,577,034 shares as of December 31, 2018 and 2017, respectively, at cost

     (518,030     (518,030

Capital in excess of par value

     4,893,174       4,879,793  

Accumulated deficit

     (3,562,971     (3,521,527

Accumulated other comprehensive loss

     (45,184     (46,522
  

 

 

   

 

 

 

Total stockholders’ equity

     768,470       795,193  
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 2,495,124     $ 2,563,591  
  

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Houghton Mifflin Harcourt Company

Consolidated Statements of Operations

 

 

(in thousands of dollars, except share and per share data)    Years Ended December 31,  
   2018     2017     2016  

Net sales

   $ 1,322,417     $ 1,327,029     $ 1,291,978  

Costs and expenses

      

Cost of sales, excluding publishing rights and pre-publication amortization

     581,467       588,518       578,317  

Publishing rights amortization

     34,713       46,238       61,351  

Pre-publication amortization

     109,257       119,908       121,866  
  

 

 

   

 

 

   

 

 

 

Cost of sales

     725,437       754,664       761,534  

Selling and administrative

     649,295       636,326       681,170  

Other intangible asset amortization

     26,933       29,248       26,375  

Impairment charge for pre-publication costs and intangible assets

     —       3,980       130,205  

Restructuring

     4,657       37,775       —  

Severance and other charges

     6,821       177       15,371  

Gain on sale of assets

     (201     —       —  
  

 

 

   

 

 

   

 

 

 

Operating loss

     (90,525     (135,141     (322,677
  

 

 

   

 

 

   

 

 

 

Other income (expense)

      

Retirement benefits non-service income

     1,280       3,486       4,253  

Interest expense

     (45,680     (42,805     (39,181

Interest income

     2,550       1,338       518  

Change in fair value of derivative instruments

     (1,374     1,366       (614

Income from transition services agreement

     1,889       —       —  
  

 

 

   

 

 

   

 

 

 

Loss from continuing operations before taxes

     (131,860     (171,756     (357,701

Income tax expense (benefit) for continuing operations

     5,597       (51,419     (51,556
  

 

 

   

 

 

   

 

 

 

Loss from continuing operations

     (137,457     (120,337     (306,145
  

 

 

   

 

 

   

 

 

 

Earnings from discontinued operations, net of tax

     12,833       17,150       21,587  

Gain on sale of discontinued operations, net of tax

     30,469       —       —  
  

 

 

   

 

 

   

 

 

 

Income from discontinued operations, net of tax

     43,302       17,150       21,587  
  

 

 

   

 

 

   

 

 

 

Net loss

   $ (94,155   $ (103,187   $ (284,558
  

 

 

   

 

 

   

 

 

 

Net loss per share attributable to common stockholders

      

Basic and diluted:

      

Continuing operations

   $ (1.11   $ (0.98   $ (2.50

Discontinued operations

     0.35       0.14       0.18  
  

 

 

   

 

 

   

 

 

 

Net loss

   $ (0.76   $ (0.84   $ (2.32
  

 

 

   

 

 

   

 

 

 

Weighted average shares outstanding

      

Basic

     123,444,943       122,949,064       122,418,474  
  

 

 

   

 

 

   

 

 

 

Diluted

     123,444,943       122,949,064       122,418,474  
  

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Houghton Mifflin Harcourt Company

Consolidated Statements of Comprehensive Loss

 

 

     Years Ended December 31,  
(in thousands of dollars)    2018     2017     2016  

Net loss

   $ (94,155   $ (103,187   $ (284,558

Other comprehensive income (loss), net of taxes:

      

Foreign currency translation adjustments, net of tax

     (156     109       (1,220

Net change in pension and benefit plan liabilities, net of tax

     (2,056     1,734       (9,937

Unrealized gain (loss) on short-term investments, net of tax

     9       (18     57  

Net change in unrealized gain (loss) on derivative financial instruments, net of tax

     3,541       4,948       (2,467
  

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss), net of taxes

     1,338       6,773       (13,567
  

 

 

   

 

 

   

 

 

 

Comprehensive loss

   $ (92,817   $ (96,414   $ (298,125
  

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Houghton Mifflin Harcourt Company

Consolidated Statements of Cash Flows

 

 

     Years Ended December 31,  
(in thousands of dollars)    2018     2017     2016  

Cash flows from operating activities

      

Net loss

   $ (94,155   $ (103,187   $ (284,558

Adjustments to reconcile net loss to net cash provided by operating activities

      

Earnings from discontinued operations, net of tax

     (12,833     (17,150     (21,587

Gain on sale of discontinued operations, net of tax

     (30,469     —       —  

Gain on sale of assets

     (201     —       —  

Depreciation and amortization expense

     250,466       266,443       284,059  

Amortization of debt discount and deferred financing costs

     4,181       4,181       4,181  

Deferred income taxes

     5,140       (49,247     (53,182

Stock-based compensation expense

     13,248       10,728       10,491  

Impairment charge for pre-publication costs and intangible assets

     —       3,980       130,205  

Restructuring charges related to property, plant, and equipment

     —       9,841       —  

Change in fair value of derivative instruments

     1,374       (1,366     614  

Changes in operating assets and liabilities

      

Accounts receivable

     (11,005     12,564       37,897  

Inventories

     (33,515     8,122       8,465  

Other assets

     3,908       (10,548     6,673  

Accounts payable and accrued expenses

     16,144       (5,937     (24,155

Royalties payable and author advances, net

     (1,650     (1,449     (12,738

Deferred revenue

     (7,692     (13,500     39,249  

Interest payable

     (186     129       87  

Severance and other charges

     (2,823     221       4,315  

Accrued pension and postretirement benefits

     (904     (6,932     3,675  

Other liabilities

     5,056       (2,145     (21,906
  

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities—continuing operations

     104,084       104,748       111,785  

Net cash provided by operating activities—discontinued operations

     10,831       30,382       31,966  
  

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

     114,915       135,130       143,751  
  

 

 

   

 

 

   

 

 

 

Cash flows from investing activities

      

Proceeds from sales and maturities of short-term investments

     86,539       80,690       197,724  

Purchases of short-term investments

     (49,553     (86,211     (81,086

Additions to pre-publication costs

     (123,403     (131,282     (118,603

Additions to property, plant, and equipment

     (53,741     (55,092     (103,152

Proceeds from sale of business

     140,000       —       —  

Acquisition of intangible asset

     —       (2,000     —  

Investment in preferred stock

     (500     —       (1,000

Proceeds from sale of assets

     1,085       —       —  
  

 

 

   

 

 

   

 

 

 

Net cash provided by (used in) investing activities—continuing operations

     427       (193,895     (106,117

Net cash used in investing activities—discontinued operations

     (6,832     (11,028     (7,829
  

 

 

   

 

 

   

 

 

 

Net cash used in investing activities

     (6,405     (204,923     (113,946
  

 

 

   

 

 

   

 

 

 

Cash flows from financing activities

      

Borrowings under revolving credit facility

     50,000       —       —  

Payments of revolving credit facility

     (50,000     —       —  

Payments of long-term debt

     (8,000     (8,000     (8,000

Repurchases of common stock

     —       —       (55,017

Tax withholding payments related to net share settlements of restricted stock units and awards

     (1,190     (1,450     (1,672

Proceeds from stock option exercises

     —       512       24,532  

Issuance of common stock under employee stock purchase plan

     1,263       1,608       2,197  

Net collections (remittances) under transition service agreement

     3,803       —       —  
  

 

 

   

 

 

   

 

 

 

Net cash used in financing activities—continuing operations

     (4,124     (7,330     (37,960
  

 

 

   

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     104,386       (77,123     (8,155

Cash and cash equivalent at the beginning of the period

     148,979       226,102       234,257  
  

 

 

   

 

 

   

 

 

 

Cash and cash equivalent at the end of the period

   $ 253,365     $ 148,979     $ 226,102  
  

 

 

   

 

 

   

 

 

 

Supplemental disclosure of cash flow information

      

Interest paid

   $ 41,758     $ 38,295     $ 34,884  

Income taxes paid

     430       715       5,104  

Non-cash investing activities

      

Pre-publication costs included in accounts payable and accruals

   $ 13,974     $ 16,681     $ 14,397  

Property, plant, and equipment included in accounts payable and accruals

     1,908       11,403       5,707  

Property, plant, and equipment acquired under capital leases

     480       —       —  

The accompanying notes are an integral part of these consolidated financial statements.

 

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Houghton Mifflin Harcourt Company

Consolidated Statements of Stockholders’ Equity

 

 

(in thousands of dollars, except share
information)
  Common Stock     Treasury Stock     Capital
in excess
of Par
Value
    Accumulated
Deficit
    Accumulated
Other
Comprehensive
Loss
    Total  
  Shares
Issued
    Par Value  

Balance at December 31, 2015

    145,613,978     $ 1,456     $ (463,013   $ 4,833,388     $ (3,133,782   $ (39,728   $ 1,198,321  

Net loss

    —       —         —         —         (284,558     —         (284,558

Other comprehensive loss, net of tax

    —         —         —         —         —         (13,567     (13,567

Issuance of common stock for employee purchase plan

    140,579       1       —         2,777       —         —         2,778  

Issuance of common stock for vesting of restricted stock units

    102,151       1       —         (1     —         —         —    

Issuance of common stock for exercise of stock options

    1,879,924       19       —         23,714       —         —         23,733  

Stock withheld to cover tax withholdings requirements upon vesting of restricted stock units

    —         —         —         (1,672     —         —         (1,672

Restricted stock forfeitures and cancellations

    (179,828     (2     —         2       —         —         —    

Repurchases of common stock

    —         —         (55,017     —         —         —         (55,017

Stock-based compensation expense

    —         —         —         10,022       —         —         10,022  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2016

    147,556,804       1,475       (518,030     4,868,230       (3,418,340     (53,295     880,040  

Net loss

    —         —         —         —         (103,187     —         (103,187

Other comprehensive income, net of tax

    —         —         —         —         —         6,773       6,773  

Issuance of common stock for employee purchase plan

    176,749       2       —         2,130       —         —         2,132  

Issuance of common stock for vesting of restricted stock units

    175,555       2       —         (2     —         —         —    

Issuance of common stock for exercise of stock options

    39,200       —         —         512       —         —         512  

Stock withheld to cover tax withholdings requirements upon vesting of restricted stock units

    —         —         —         (1,450     —         —         (1,450

Restricted stock forfeitures and cancellations

    (36,842     —         —         —         —         —         —    

Stock-based compensation expense

    —         —         —         10,373       —         —         10,373  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2017

    147,911,466       1,479       (518,030     4,879,793       (3,521,527     (46,522     795,193  

Net loss

    —         —         —         —         (94,155     —         (94,155

Other comprehensive income, net of tax

    —         —         —         —         —         1,338       1,338  

Effects of adoption of new revenue accounting standard

    —         —         —         —         52,711       —         52,711  

Issuance of common stock for employee purchase plan

    175,428       2       —         1,611       —         —         1,613  

Issuance of common stock for vesting of restricted stock units

    346,255       3       —         (3     —         —         —    

Stock withheld to cover tax withholdings requirements upon vesting of restricted stock units

    —         —         —         (1,190     —         —         (1,190

Restricted stock forfeitures and cancellations

    (268,295     (3     —         3       —         —         —    

Stock-based compensation expense

    —         —         —         12,960       —         —         12,960  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2018

    148,164,854     $ 1,481     $ (518,030   $ 4,893,174     $ (3,562,971   $ (45,184   $ 768,470  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Houghton Mifflin Harcourt Company

Notes to Consolidated Financial Statements

 

(in thousands of dollars, except share and per share information)

 

1.

Basis of Presentation

Houghton Mifflin Harcourt Company (“HMH,” “Houghton Mifflin Harcourt,” “we,” “us,” “our,” or the “Company”) is a global learning company, committed to delivering integrated solutions that engage learners, empower educators and improve student outcomes. As a leading provider of Kindergarten through 12th grade (“K-12”) core curriculum, supplemental and intervention solutions and professional learning services, HMH partners with educators and school districts to uncover solutions that unlock students’ potential and extend teachers’ capabilities. HMH serves more than 50 million students and 3 million educators in 150 countries, while its award-winning children’s books, novels, non-fiction, and reference titles are enjoyed by readers throughout the world.

The K-12 market is our primary market, and in the United States, we are a leading provider of educational content by market share. Some of our core educational offerings include HMH Science Dimensions, Collections, GO Math!, Read 180 Universal, and Journeys. We believe our long-standing reputation and trusted brand enable us to capitalize on trends in the education market through our existing and developing channels.

Furthermore, for nearly two centuries, we have published renowned and awarded children’s, fiction, nonfiction, culinary and reference titles enjoyed by readers throughout the world. Our distinguished author list includes ten Nobel Prize winners, forty-eight Pulitzer Prize winners, and fifteen National Book Award winners. We are home to popular characters and titles such as Curious George, Carmen Sandiego, The Lord of the Rings, The Whole30, The Best American Series, the Peterson Field Guides, CliffsNotes, and The Polar Express, and published distinguished authors such as Philip Roth, Temple Grandin, Tim O’Brien, Amos Oz, Kwame Alexander, Lois Lowry, and Chris Van Allsburg.

We sell our products and services across multiple media and distribution channels. Leveraging our portfolio of content, including some of our best-known children’s brands and titles, such as Carmen Sandiego and Curious George, we have created interactive digital content, mobile applications and educational games that can be used by families at home or on the go.

Our digital products portfolio, combined with our content development or distribution agreements with recognized technology leaders such as Apple, Google, Intel and Microsoft, enable us to bring our next-generation educational solutions and content to learners across virtually all platforms and devices. Additionally, we believe our technology and development capabilities allow us to enhance content engagement and effectiveness with embedded assessment, interactivity and personalized adaptable content as well as increased accessibility.

The consolidated financial statements of HMH include the accounts of all of our wholly-owned subsidiaries as of December 31, 2018 and 2017 and for the periods ended December 31, 2018, 2017 and 2016.

The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Our accompanying consolidated financial statements include the results of operations of the Company and our wholly-owned subsidiaries. All material intercompany accounts and transactions are eliminated in consolidation.

We expect our net cash provided by operations combined with our cash and cash equivalents and borrowing availability under our revolving credit facility to provide sufficient liquidity to fund our current obligations, capital spending, debt service requirements and working capital requirements over at least the next twelve months.

The ability of the Company to fund planned operations is based on assumptions which involve significant judgment and estimates of future revenues, capital spend and other operating costs.

 

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Houghton Mifflin Harcourt Company

Notes to Consolidated Financial Statements

 

(in thousands of dollars, except share and per share information)

 

 

Seasonality and Comparability

Our net sales, operating profit or loss and net cash provided by or used in operations are impacted by the inherent seasonality of the academic calendar, which results in a cash flow usage in the first half of the year and a cash flow generation in the second half of the year. Consequently, the performance of our businesses may not be comparable quarter to consecutive quarter and should be considered on the basis of results for the whole year or by comparing results in a quarter with results in the same quarter for the previous year.

Approximately 85% of our net sales for the year ended December 31, 2018 were derived from our Education segment, which is a markedly seasonal business. Schools conduct the majority of their purchases in the second and third quarters of the calendar year in preparation for the beginning of the school year. Thus, for the years ended December 31, 2018, 2017 and 2016, approximately 67% of our consolidated net sales were realized in the second and third quarters. Sales of K-12 instructional materials and customized testing products are also cyclical with some years offering more sales opportunities than others in light of the state adoption calendar. The amount of funding available at the state level for educational materials also has a significant effect on year-to-year net sales. Although the loss of a single customer would not have a material adverse effect on our business, schedules of school adoptions and market acceptance of our products can materially affect year-to-year net sales performance.

 

2.

Significant Accounting Policies

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the use of estimates, assumptions and judgments by management that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosure of contingent assets and liabilities in the amounts reported in the financial statements and accompanying notes. On an ongoing basis, we evaluate our estimates and assumptions including, but not limited to, book returns, deferred revenue and related standalone selling price estimates, allowance for bad debts, recoverability of advances to authors, valuation of inventory, financial instruments valuation, income taxes, pensions and other postretirement benefits obligations, contingencies, litigation, depreciation and amortization periods, and the recoverability of long-term assets such as property, plant, and equipment, capitalized pre-publication costs, other identified intangibles and goodwill. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from those estimates.

Adoption of New Revenue Recognition Accounting Standard

On January 1, 2018, we adopted the new revenue standard utilizing the modified retrospective method. As a result, we changed our accounting policy for revenue recognition as detailed below. We recognized the cumulative effect of initially applying the new revenue standard as an adjustment to the opening balance of accumulated deficit. Using the modified retrospective approach, we applied the standard only to contracts that were not completed at the date of initial application. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods as we believe it is still comparable.

There was a significant impact relating to the requirement to capitalize incremental costs to acquire new contracts, which consist of sales commissions. During previous periods, these costs were expensed as incurred. Further, there is an impact to our accounting for software license revenue. Under the previous

 

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Notes to Consolidated Financial Statements

 

(in thousands of dollars, except share and per share information)

 

guidance, when vendor specific objective evidence (“VSOE”) was not established for undelivered maintenance services, software licenses were recognized ratably over the life of the service period due to the separation criteria of the software license and related maintenance services not being met. The requirement for establishing VSOE does not exist under the new standard, thus software licenses are no longer recognized over the maintenance term, but rather as the software licenses are delivered as fair value can be established to allow for separate recognition.

The cumulative effect of the changes made to our consolidated balance sheets at January 1, 2018 were as follows:

 

    December 31, 2017     Adjustments
due to
Adoption
    January 1, 2018  

Assets

     

Accounts receivable, net

  $ 192,569     $ (1,092   $ 191,477  

Contract assets (1)

    —       1,092       1,092  

Deferred commissions

    —       24,040       24,040  

Liabilities

     

Deferred revenue (current and long-term)

  $ 683,808     $ (28,671   $ 655,137  

Stockholders’ equity

     

Accumulated deficit (2)

  $ (3,521,527   $ 52,711     $ (3,468,816

 

(1)

Contract assets are included in prepaid expenses and other assets on our consolidated balance sheets.

(2)

The adoption resulted in the write off of a portion of a deferred tax asset for deferred revenue. However, due to our valuation allowance position, there is no net tax effect on accumulated deficit as the valuation allowance will also be reversed commensurate to the reduction in the deferred tax asset.

Impact of New Revenue Recognition Accounting Standard on Financial Statement Line Items

In accordance with the new revenue standard requirements, the disclosure of the impact of adoption on our consolidated balance sheets, statements of operations and cash flows were as follows:

 

     December 31, 2018  
     As Reported      Balances Without
Adoption
     Effect of Change
Higher / (Lower)
 

Assets

        

Accounts receivable, net

   $ 203,574      $ 203,648      $ (74

Contract assets

     74        —        74  

Deferred commissions

     22,635        —        22,635  

Liabilities

        

Deferred revenue (current and long-term)

   $ 647,444      $ 693,678      $ (46,234

Stockholders’ equity

        

Accumulated deficit

   $ (3,562,971    $ (3,625,345    $ (62,374

 

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Notes to Consolidated Financial Statements

 

(in thousands of dollars, except share and per share information)

 

     Year Ended December 31, 2018  
     As Reported      Balances Without
Adoption
     Effect of Change
Higher / (Lower)
 

Net sales

   $ 1,322,417      $ 1,304,854      $ 17,563  

Selling and administrative

     649,295        647,891        1,404  

Operating loss

     (90,525      (106,684      16,159  

Loss from continuing operations

     (131,860      (148,019      16,159  

Income from discontinued operations, net of tax

     43,302        43,302        —  

Net loss

     (94,155      (110,314      16,159  

The adoption resulted in offsetting shifts in cash flows through net loss within cash flows from operating activities for deferred commissions, which are included within other assets, and deferred revenue consistent with the effects on our consolidated statements of operations as noted in the table above. The adoption had no impact on our overall cash flows from operating, investing or financing activities.

 

     Year Ended December 31, 2018  
     As Reported      Balances Without
Adoption
     Effect of Change
Higher / (Lower)
 

Cash flows from operating activities

        

Net loss

   $ (94,155    $ (110,314    $ 16,159  

Adjustments to reconcile net loss to net cash provided by operating activities

        

Other assets

     3,908        2,504        1,404  

Deferred revenue

     (7,692      9,871        (17,563

Net cash provided by operating activities—continuing operations

     104,084        104,084        —  

Net cash provided by operating activities—discontinued operations

     10,831        10,831        —  

Net cash provided by operating activities

     114,915        114,915        —  

Revenue Recognition

Revenue is recognized when a customer obtains control of promised goods or services, in an amount that reflects the consideration which we expect to receive in exchange for those goods or services. To determine revenue recognition for arrangements that we determine are within the scope of the new revenue recognition accounting standard, we perform the following five steps: (i) identify the contract with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) we satisfy a performance obligation. We only apply the five-step model to contracts when it is probable that we will collect the consideration we are entitled to in exchange for the goods or services we transfer to the customer. At contract inception, we assess the goods or services promised within each contract and determine those that are performance obligations and assess whether each promised good or service is distinct. We then recognize as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) the performance obligation is satisfied.

Revenue is measured as the amount of consideration we expect to receive in exchange for transferring products or services to a customer. To the extent the transaction price includes variable consideration, which generally reflects estimated future product returns, we estimate the amount of variable consideration that

 

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Notes to Consolidated Financial Statements

 

(in thousands of dollars, except share and per share information)

 

should be included in the transaction price utilizing the expected value method to which we expect to be entitled. Variable consideration is included in the transaction price if, in our judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur. Estimates of variable consideration and the determination of whether to include estimated amounts in the transaction price are based largely on all information (historical, current and forecasted) that is reasonably available. Sales, value add, and other taxes collected on behalf of third parties are excluded from revenue.

We estimate the collectability of contracts upon execution. For contracts with rights of return, the transaction price is adjusted to reflect the estimated returns for the arrangement on these sales and is made at the time of sale based on historical experience by product line or customer. The transaction prices allocated are adjusted to reflect expected returns and are based on historical return rates and sales patterns. Shipping and handling fees charged to customers are included in net sales.

When determining the transaction price of a contract, an adjustment is made if payment from a customer occurs either significantly before or significantly after performance, resulting in a significant financing component. We do not assess whether a significant financing component exists if the period between when we perform our obligations under the contract and when the customer pays is one year or less. Significant financing components’ income is included in interest income.

Contracts are often modified to account for changes in contract specifications and requirements. Contract modifications exist when the modification either creates new, or changes the existing, enforceable rights and obligations. Generally, contract modifications are for products or services that are not distinct from the existing contract due to the inability to use, consume or sell the products or services on their own to generate economic benefits and are accounted for as if they were part of that existing contract. The effect of such a contract modification on the transaction price and measure of progress for the performance obligation to which it relates is recognized as an adjustment to revenue (either as an increase in or a reduction of revenue) on a cumulative catch-up basis.

Physical product revenue is generally recognized when the customer obtains control of our product, which occurs at a point in time, and may be upon shipment or upon delivery based on the contractual shipping terms of a contract. Revenues from static digital content commence upon delivery to the customer of the digital entitlement that is required to access and download the content and is typically recognized at a point in time. Revenues from subscription software licenses, related hosting services and product support are recognized evenly over the license term as we believe this best represents the pattern of transfer to the customer. The perpetual software licenses provide the customer with a functional license to our products and their related revenues are recognized when the customer receives entitlement to the software. For the technical services provided to customers in connection with the software license, including hosting services related to perpetual licenses, we recognize revenue upon delivery of the services. As the invoices are based on each day of service, this is directly linked to the transfer of benefit to the customer.

If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. We enter into certain contracts that have multiple performance obligations, one or more of which may be delivered subsequent to the delivery of other performance obligations. These performance obligations may include print and digital media, professional development services, training, software licenses, access to hosted content, and various services related to the software including, but not limited to hosting, maintenance and support, and implementation. We allocate the transaction price based on the estimated relative standalone selling prices of the promised products or services underlying each performance obligation. We determine standalone selling prices based on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through past transactions, we estimate the standalone selling price taking into account available information such as

 

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Notes to Consolidated Financial Statements

 

(in thousands of dollars, except share and per share information)

 

market conditions and internally approved standard pricing discounts related to the performance obligations. Generally, our performance obligations include print and digital textbooks and instructional materials, trade books, reference materials, formative assessment materials and multimedia instructional programs; licenses to book rights and content; access to hosted content; and services including professional development, consulting and training. Our contracts may also contain software performance obligations including perpetual and subscription based licenses and software maintenance and support services.

Accounts Receivable

Accounts receivable include amounts billed and currently due from customers and are recorded net of allowances for doubtful accounts and reserves for returns. In the normal course of business, we extend credit to customers that satisfy predefined criteria. Allowances for doubtful accounts are established through the evaluation of accounts receivable aging and prior collection experience to estimate the ultimate collectability of these receivables.

Contract Assets

Contract assets include unbilled amounts where revenue is recognized over time as the services are delivered to the customer based on the extent of progress towards completion and revenue recognized exceeds the amount billed to the customer, and right of payment is not subject to the passage of time. Amounts may not exceed their net realizable value. Contract assets are included in prepaid expenses and other assets on our consolidated balance sheets.

Deferred Commissions

Our incremental direct costs of obtaining a contract, which consist of sales commissions, are deferred and amortized over the period of contract performance. Applying the practical expedient, we recognize sales commission expense when incurred if the amortization period of the assets that we otherwise would have recognized is one year or less. At December 31, 2018 and January 1, 2018, we had $22.6 million and $24.0 million of deferred commissions, respectively. We had $10.5 million of amortization expense related to deferred commissions during the year ended December 31, 2018. These costs are included in selling and administrative expenses.

Deferred Revenue

Our contract liabilities consist of advance payments and billings in excess of revenue recognized and are classified as deferred revenue on our consolidated balance sheets. Our contract assets and liabilities are accounted for and presented on a net basis as either a contract asset or contract liability at the end of each reporting period. We classify deferred revenue as current or noncurrent based on the timing of when we expect to recognize revenue. In order to determine revenue recognized in the period from contract liabilities, we first allocate revenue to the individual contract liability balance outstanding at the beginning of the period until the revenue exceeds that balance. If additional advances are received on those contracts in subsequent periods, we assume all revenue recognized in the reporting period first applies to the beginning contract liability as opposed to a portion applying to the new advances for the period.

Advertising Costs and Sample Expenses

Advertising costs are charged to selling and administrative expenses as incurred. Advertising costs were $12.0 million, $12.4 million and $11.0 million for the years ended December 31, 2018, 2017 and 2016,

 

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Notes to Consolidated Financial Statements

 

(in thousands of dollars, except share and per share information)

 

respectively. Sample expenses are charged to selling and administrative expenses when the samples are shipped.

Cash and Cash Equivalents

Cash and cash equivalents consist primarily of cash in banks and highly liquid investment securities that have maturities of three months or less when purchased. The carrying amount of cash equivalents approximates fair value because of the short-term maturity of these investments.

Short-term Investments

Short-term investments typically consist of marketable securities with maturities between three and twelve months at the balance sheet date. We have classified all of our short-term investments as available-for-sale at December 31, 2018 and 2017. The investments are reported at fair value with any unrealized gains or losses excluded from earnings and reported as a separate component of stockholders’ equity as other comprehensive income (loss).

Accounts Receivable

Accounts receivable are recorded net of allowances for doubtful accounts and reserves for returns. In the normal course of business, we extend credit to customers that satisfy predefined criteria. We estimate the collectability of our receivables. Allowances for doubtful accounts are established through the evaluation of accounts receivable aging and prior collection experience to estimate the ultimate collectability of these receivables. Reserves for returns are based on historical return rates and sales patterns.

Inventories

Inventories are stated at the lower of weighted-average cost or net realizable value. The level of obsolete and excess inventory is estimated on a program or title level-basis by comparing the number of units in stock with past usage and the expected future demand. The expected future demand of a program or title is determined by the copyright year, the previous year’s usage, the subsequent years’ sales forecast, and known forward-looking trends including our development cycle to replace the title or program and competing titles or programs.

Property, Plant, and Equipment

Property, plant, and equipment are stated at cost, or in the case of assets acquired in business combinations, at fair value as of the acquisition date, less accumulated depreciation. Equipment under capital lease is stated at fair value at inception of the lease, less accumulated depreciation. Maintenance and repair costs are charged to expense as incurred, and renewals and improvements that extend the useful life of the assets are capitalized. Costs associated with developing film and episodic series assets are deferred if such amounts are expected to be recovered through future revenues. Film and episodic series costs are amortized on a pro rata basis of revenue earned and total revenue expected to be earned from the film or episodic series. Depreciation on property, plant, and equipment is calculated using the straight-line method over the estimated useful lives of the assets or, in the case of assets acquired in business combinations, over their remaining lives. Equipment held under capital leases and leasehold improvements are amortized using the

 

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Notes to Consolidated Financial Statements

 

(in thousands of dollars, except share and per share information)

 

straight-line method over the shorter of the lease term or estimated useful life of the asset. Estimated useful lives of property, plant, and equipment are as follows:

 

     Estimated
Useful Life
 

Building and building equipment

     10 to 35 years  

Machinery and equipment

     2 to 15 years  

Capitalized software

     3 to 5 years  

Leasehold improvements

     Lesser of useful life or lease term  

Film and media

     Revenue earned  

Capitalized Internal-Use Software and Software Development Costs

Capitalized internal-use and external-use software are included in property, plant and equipment on the consolidated balance sheets.

We capitalize certain costs related to obtaining or developing computer software for internal use including external customer-facing websites. Costs incurred during the application development stage, including external direct costs of materials and services, and payroll and payroll related costs for employees who are directly associated with the internal-use software project, are capitalized and amortized on a straight-line basis over the expected useful life of the related software. The application development stage includes design of chosen path, software configuration and integration, coding, hardware installation and testing. Costs incurred during the preliminary project stage, as well as maintenance, training and upgrades that do not result in additional functionality subsequent to general release are expensed as incurred.

Certain computer software development costs for software that is to be sold or marketed are capitalized in the consolidated balance sheets. Capitalization of computer software development costs begins upon the establishment of technological feasibility. We define the establishment of technological feasibility as a working model. Amortization of capitalized computer software development costs is provided on a product-by-product basis using the straight-line method, beginning upon commercial release of the product, and continuing over the remaining estimated economic life of the product. The carrying amounts of computer software development costs are annually compared to net realizable value and impairment charges are recorded, as appropriate, when amounts expected to be realized are lower.

We review internal-use software and software development costs for impairment. For the years ended December 31, 2018, 2017 and 2016, there was no impairment of software developments costs.

Pre-publication Costs

We capitalize the art, prepress, manuscript and other costs incurred in the creation of the master copy of a book or other media (the “pre-publication costs”). Pre-publication costs are primarily amortized from the year of sale over five years using the sum-of-the-years-digits method, which is an accelerated method for calculating an asset’s amortization. Under this method, the amortization expense recorded for a pre-publication cost asset is approximately 33% (year 1), 27% (year 2), 20% (year 3), 13% (year 4) and 7% (year 5). This policy is used throughout the Company, except for the Trade Publishing young readers and general interest books, which generally expenses such costs as incurred. Additionally, pre-publication costs recorded in connection with the acquisition of the EdTech business are amortized over 7 years on a projected sales pattern. The amortization methods and periods chosen best reflects the pattern of expected sales generated from individual titles or programs. We periodically evaluate the remaining lives and recoverability of capitalized pre-publication costs, which are often dependent upon program acceptance by state adoption authorities.

 

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Notes to Consolidated Financial Statements

 

(in thousands of dollars, except share and per share information)

 

Amortization expense related to pre-publication costs for the years ended December 31, 2018, 2017 and 2016 were $109.3 million, $119.9 million and $121.9 million, respectively.

For the year ended December 31, 2017, an impairment charge for pre-publication costs of $4.0 million was recorded as certain products will no longer be sold in the marketplace. For the years ended December 31, 2018 and 2016, there was no impairment of pre-publication costs.

Goodwill and Indefinite-lived Intangible Assets

Goodwill is the excess of the purchase price paid over the fair value of the net assets of the business acquired. Other intangible assets principally consist of branded trademarks and trade names, acquired publishing rights and customer relationships. Goodwill and indefinite-lived intangible assets (certain tradenames) are not amortized, but are reviewed at least annually for impairment or earlier, if an indication of impairment exists. Goodwill is allocated entirely to our Education reporting unit. Determining the fair value of a reporting unit is judgmental in nature, and involves the use of significant estimates and assumptions. These estimates and assumptions may include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions, the determination of appropriate market comparables as well as the fair value of individual assets and liabilities.

We have the option of first assessing qualitative factors to determine whether it is necessary to perform the current two-step impairment test for goodwill or we can perform the two-step impairment test without performing the qualitative assessment. In performing the qualitative (Step 0) assessment, events and circumstances specific to the reporting unit and to the entity as a whole, such as macroeconomic conditions, industry and market considerations, overall financial performance and cost factors are considered when evaluating whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount.

Recoverability of goodwill can also be evaluated using a two-step process. In the first step, the fair value of a reporting unit is compared to its carrying value. If the fair value of a reporting unit exceeds the carrying value of the net assets assigned to a reporting unit, goodwill is considered not impaired and no further testing is required. If the carrying value of the net assets assigned to a reporting unit exceeds the fair value of a reporting unit, the second step of the impairment test is performed in order to determine the implied fair value of a reporting unit’s goodwill. Determining the implied fair value of goodwill requires valuation of a reporting unit’s tangible and intangible assets and liabilities in a manner similar to the allocation of purchase price in a business combination. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, goodwill is deemed impaired and is written down to the extent of the difference. We estimate total fair value of the Education reporting unit by using various valuation techniques including an evaluation of our market capitalization and peer company multiples. With regard to indefinite-lived intangible assets, which includes the Houghton Mifflin Harcourt tradename at December 31, 2018 and 2017, the recoverability is evaluated using a one-step process whereby we determine the fair value by asset and then compare it to its carrying value to determine if the asset is impaired. We estimate the fair value based by preparing a relief-from-royalty discounted cash flow analysis using forwarding looking revenue projections. The significant assumptions used in discounted cash flow analysis include: future net sales, a long-term growth rate, a royalty rate and a discount rate used to present value future cash flows and the terminal value of the Education reporting unit. The discount rate is based on the weighted-average cost of capital method at the date of the evaluation.

We completed our annual goodwill impairment tests as of October 1, 2018 and 2017. In 2018 and 2017, we used income and market valuation approaches to determine the fair value of the Education reporting unit. The fair value of the Education reporting unit substantially exceeded its carrying value as of the evaluation dates. No goodwill was deemed to be impaired for the years ended December 31, 2018, 2017 and 2016, respectively.

 

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Notes to Consolidated Financial Statements

 

(in thousands of dollars, except share and per share information)

 

We completed our annual indefinite-lived intangible assets impairment tests as of October 1, 2018 and 2017. No indefinite-lived intangible assets were deemed to be impaired for the years ended December 31, 2018 and 2017. We recorded non-cash impairment charges of $130.2 million for the year ended December 31, 2016. The impairment charges related to four specific tradenames within the Education segment in 2016 and primarily resulted from the strategic decision to market our products under the Houghton Mifflin Harcourt and HMH name rather than legacy imprints along with certain declining sales projections.

Publishing Rights

A publishing right is an acquired right that allows us to publish and republish existing and future works as well as create new works based on previously published materials. We determine the fair market value of the publishing rights arising from business combinations by discounting the after-tax cash flows projected to be derived from the publishing rights and titles to their net present value using a rate of return that accounts for the time value of money and the appropriate degree of risk. The useful life of the publishing rights is based on the lives of the various copyrights involved. We calculate amortization using the percentage of the projected operating income before taxes derived from the titles in the current year as a percentage of the total estimated operating income before taxes over the remaining useful life. Acquired publication rights, as well as customer-related intangibles with definitive lives, are primarily amortized on an accelerated basis over periods ranging from 3 to 20 years.

Impairment of Other Long-lived Assets

We review our other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. If the future undiscounted cash flows are less than their book value, impairment exists. The impairment is measured as the difference between the book value and the fair value of the underlying asset. Fair value is normally determined using an undiscounted cash flow model.

Severance