Earnings Call Transcript - FC Q2 2020

Operator, Operator

Welcome to the Q2 2020 Franklin Covey Earnings Conference Call. My name is Adrianne and I will be your operator for today’s call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Please note this conference is being recorded. I will now turn the call over to Derek Hatch. Derek Hatch, you may begin.

Derek Hatch, Executive

Thank you. On behalf of Franklin Covey, we would like to welcome you to our conference call to discuss our second quarter fiscal 2020 financial results and hope that you are all staying safe and are well at this time. Before we begin, we would like to remind everybody that this presentation contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based upon management’s current expectations and are subject to various risks and uncertainties, including but not limited to the ability of the company to stabilize and grow revenues; the acceptance of and renewal rates for the All Access Pass; the ability of the company to hire productive sales professionals; general economic conditions; competition in the company’s targeted marketplace; market acceptance of new products or services and marketing strategies; changes in the company’s market share; changes in the size of the overall market for the company’s products; changes in the training and spending policies of the company’s clients; and other factors identified and discussed in the company’s most recent Annual Report on Form 10-K and other periodic reports filed with the Securities and Exchange Commission, including the forthcoming 10-Q for the second quarter of fiscal 2020, which is expected to be filed next week. Many of these conditions are beyond our control or influence, any one of which may cause future results to differ materially from the company’s current expectations and there can be no assurance the company’s actual future performance will meet management’s expectations. These forward-looking statements are based on management’s current expectations and we undertake no obligation to update or revise these forward-looking statements to reflect events or circumstances after the date of today’s presentation except as required by law. With that out of the way, we would like to turn the time over to Mr. Bob Whitman, our Chairman and Chief Executive Officer.

Bob Whitman, CEO

Thanks, Derek. Good afternoon, everyone. We appreciate you joining us today. In these challenging times, we have been doing a lot lately to help our clients and even non-clients respond to the new changes and challenges they face. For example, as you can see on Slide 3, nearly a month ago, we created a special set of digital materials for our All Access Pass holder organizations entitled, Leading Through Uncertainty, that provides leaders in organizations with a guide for utilizing various All Access Pass resources to help them lead through change or to build the skills of proactivity and resiliency throughout the organization, lead in a remote environment, etc. These resources are providing clients with the ability to engage their workforces, provide team building and development opportunities for remote workers, and utilize digital assets and training, as well as the option of having even higher engagement by having Franklin Covey training consultants facilitate sessions live online, a capability in which we have invested for more than a decade. Similarly, in the education division, as you can see on Slide 4, we curated a special collection of family educational resources and provided them to all of our education clients. In addition, given that so many families are now in a homeschooling situation, we have provided these resources to All Access Pass holders, organizations, and made them free of charge to the general public on our website leaderinme.org. These robust resources include hundreds of videos, articles, and tools for families to use with their children at home, including animated videos, coloring pages, in-home activities, award-winning videos made by students, and our Leader in Me weekly newsletter, which features relevant tools and articles for schools and families in these challenging times. Our employees, many of whom have always worked remotely, are now all working remotely. We are pleased to report that with only a few exceptions, they and their families are safe and healthy. I can’t adequately express how much we appreciate the extraordinary lengths to which our employees are going to serve our clients now more than ever. In this uncertain environment, there are four things we would like you to take away from today’s discussion. You can see on Slide 5, first, our results for the second quarter were very strong and even better than we expected. As a result, we entered the third quarter with real strength operationally and financially and with significant liquidity. Our results for the second quarter, as you can see, reflected the compounding power of the same key factors that have driven our accelerated results over the past quarters and years. Second, we are grateful that we also entered this period strong strategically, with solutions in the business model that are really valued by our clients. While the coming months will undoubtedly contain a lot of uncertainty and challenges, this strength on all three fronts allows us to provide services to our clients that they value. We have consistently invested in content, technology-based delivery, portals, micro-learning, language availability in 21 languages, and a wide variety of delivery modalities in our subscription business model. As a result, we are in a unique position to serve our clients in whatever circumstance they face today. Whenever this period ends, we expect to come out of it having increased our strategic importance to our clients. Third, we expect the same three factors that have driven our accelerated growth in adjusted EBITDA and cash flow over the past many quarters to continue doing so as we come out of this downturn. We expect—we don’t know when exactly that will be, but we expect these three factors, namely our strong subscription offerings, high lifetime customer value and retention, and the high flow-through of incremental EBITDA and cash flow driven by our business model will continue to drive high rates of growth in adjusted EBITDA and cash flow once we get past this period. Finally, we are grateful to be in a position to provide our clients with the kinds of solutions, modalities, and assistance they need during these times. As a result, we expect to exit this period with an even deeper, more enduring relationship with our clients. I would like to briefly address each of these as they are all relevant to the current situation. As noted in Slide 6, our results for the second quarter were indeed very strong; we ended the third quarter with strength operationally and financially and with significant liquidity. Our strong second quarter performance reflected the strength of the same key factors that have driven our accelerated results over the past quarters, namely strong high-single-digit revenue growth, accelerated growth in subscription sales, increasing gross margins, and declining operating SG&A as a percentage of sales. This has resulted in a high flow-through of incremental revenue to increases in adjusted EBITDA and cash flow. From reading our earnings release and as shown on Slide 7, we had very strong second quarter results on all four of those key metrics despite the fact that our operations in China and Japan were closed or restricted for a portion of the quarter. As you can see, revenue grew by $3.4 million, or 6.7% in the second quarter, $8.2 million, or 7.8% year-to-date, and $14 million, or 6.4% for the latest 12 months not shown on this. Adjusted EBITDA increased by $3.1 million, a percentage increase of 321% in the second quarter, and increased by $4.9 million or 118% year-to-date and $9.4 million or 58.6% for the latest 12 months. The flow-through continued to be high. Incremental revenue to incremental adjusted EBITDA, 91% flowed through for the second quarter, 60% year-to-date, and 67% for the latest 12 months, so that trend has continued. Our cash flow from operating activities continued to be strong for the second quarter, increasing again by 30% or $4 million to $17.4 million. Additionally, as powerful as these reported metrics were, excluding China and Japan which I noted were closed most of the quarter, the company’s performance was even stronger. Excluding those operations, China and Japan revenue grew by $4.9 million, or 11.2% in the second quarter, $9 million, or 9.9% year-to-date, and $14.7 million or 7.6% for the latest 12 months. Adjusted EBITDA grew by $4 million in the second quarter. Looking at a high-level overview of industry trends, we feel very good about our revenue growth for the quarter. Overall, we showed resiliency in the face of challenges in Asia, and we are really happy to enter this new period with that kind of strength. Moving on to Slide 10, we want to talk about the current environment. We are pleased that not only did we enter the third quarter with strong momentum but also with a strong financial position. What is really important is that we entered the period strong strategically in terms of relationships with customers and the value they place in our solutions. For more than a decade, we have invested in creating digital courses and content, content that can be delivered live online, blended impact journeys. Five years ago, we added micro-learning to our solutions, and much of our innovation budget in recent years has focused on on-demand and blended delivery offerings. As a result, while we expect to retain our clients during this time, we also anticipate that we will increase our value to them as they try new methods of delivering content that they might not have otherwise considered. We believe we will exit this period with deeper and stronger client engagements and relationships. The current situation is obviously difficult; all of you are experiencing it and hopefully managing through it. We are all navigating significant uncertainty together. It is natural for both individuals and organizations to focus energy and bandwidth on adapting to immediate circumstances. During these times, normal business and decision-making processes often change. The past few weeks have seen exactly this. For the first time, organizations must also adapt to having the majority of their employees working remotely. Now, I would like to address areas of greater and lesser uncertainty for Franklin Covey. I will first start with the areas in which we are very confident—areas which historically have been predictable and which we expect to continue to be predictable include the following. First, our deferred revenue, as shown in Slide 11. We had $47.9 million of billed deferred revenue on the books at the end of the second quarter. Substantially all of this highly profitable revenue will be recognized over the next four quarters. Second, our unbilled deferred revenue, as you can also see in Slide 11, is primarily related to multi-year All Access Pass contracts. We also had $34.8 million of unbilled deferred revenue in the second quarter. The vast majority of this unbilled deferred revenue will be invoiced over the next six quarters. We do not see a risk to that. Third, our All Access Pass subscription renewals have historically had a very high annual revenue retention rate, exceeding 90% in each of the last nine quarters. Most of our clients intend to renew their passes for us. The All Access Pass add-on services revenue totals about $33 million annually, spread throughout the year. These services have also repeated yearly at a high rate of over 90%. Finally, Leader in Me memberships for over 2,700 Leader in Me schools in the U.S. and Canada historically see renewal rates between 87% and 91% annually. Now concerning areas of uncertainty, the greater uncertainty we face over this period relates to three factors: first, potential impacts due to delayed decision-making caused by current circumstances could affect the timing of renewals and new sales, especially in the education division. Annual membership renewal for most Leader in Me schools and the addition of new schools usually occurs between May and August. Second, the fact that people are working from home might create shifts in scheduled training engagement that organizations typically carry out on-site. This means that training sessions now need to occur live online or need to be rescheduled. Many of these have already been either rescheduled live online, or we are in the process of in-person rescheduling. And finally, the ramp-up time required for our recently reopened offices in China and Japan also adds some uncertainty. These factors are not expected to be long-lasting, but they do create revenue gaps which make it difficult to provide accurate quarterly guidance or an update to our annual guidance at this time. Nothing would please us more than to share our guidance, but due to the current environment, we cannot provide accurate figures today. In 60 to 90 days when we report our third quarter performance, we should be in a much better position to share more guidance on future expectations. Moving forward, I would like to ask Paul Walker to discuss what we are seeing with our clients in both divisions during this environment.

Paul Walker, Executive

Thanks, Bob and good afternoon to everyone on the call. It’s good to be with you today. Despite the current uncertainty, we are pleased that in the enterprise division, many organizations have begun to regain their bearings and move forward. For these organizations, our focus is now shifting to critical priorities, such as sharpening their organization’s focus and execution, building the capabilities of their sales forces, and establishing or increasing the trust of their stakeholders. Our strategic relevance and importance to our customers are demonstrated and reinforced every day. In our discussions with a significant portion of our Pass holders over the past 30 days, they have continued to express how important and impactful our solutions are to them, particularly in this current business environment. Just to give you a glimpse into what we are seeing, while a few are requesting changes, for example, to their pass holder populations upon renewal or flexibility in the timing of payments, almost all have reaffirmed their commitment to the All Access Pass. Notably, due to the relevance of our solutions, new clients are also purchasing All Access Passes, even in March during the middle of the current storm. To help address the needs of organizations, we are grateful to be in a position to serve both existing and new customers. If I may, I’d like to provide a little color on what we are seeing in both the enterprise and education divisions. You can see on Slide 13 some examples. Earlier this week, a new client expressed a desire to strengthen their culture of trust and inclusion and made a multi-year purchase of a two-year term All Access Pass for approximately 4,000 people, which is a significant size for us. Another one of our largest execution clients sought us out last week to communicate their commitment to the 4 Disciplines of Execution and extend their ongoing subscription with us. An airline is currently facing substantial uncertainty, but they are finding that their multiyear pass with us is providing them with significant capacity to utilize the All Access Pass while cutting back on investments made with other providers. We are transitioning live on-site training to virtual and online offerings in this context. Meanwhile, a large group of employees at another organization is being considered for an expansion of their already significant pass due to the remote working situation we are currently navigating. Finally, our sales performance practice lead is receiving calls from senior sales leaders seeking assistance in stabilizing revenue with existing customers and exploring ways to grow sales. I want to reiterate that our All Access Pass revenue, which consists of both new and renewal sales, exceeded March of last year in the U.S. and Canada. Despite the challenges, our education division is also adapting. Given this unprecedented disruption, including school closures and schools scrambling to deliver lunches, etc., our education division has done incredible work providing clients and non-clients with free access to Leader in Me student and family resources. They are maintaining strong relationships with both new and existing schools to support and expand their commitment to service. In March, 248 Leader in Me schools renewed their subscriptions, and 38 new schools established contracts to implement Leader in Me for their students and faculty. A sizable district recently engaged us to train 8,400 high school students in leadership skills, with training delivered via the Zoom platform. Another major district is currently finalizing conversations to onboard their 20 schools for Leader in Me this summer. In summary, we entered this period not only strong financially but also with best-in-class offerings that our clients value. We expect to exit this period with increased strategic importance to our clients and to have been a vital partner throughout this time.

Bob Whitman, CEO

Thanks very much, Paul. We'll just quickly cover a couple of other points before we open the floor for questions. Metaphorically, for those who have been mountain climbers, it feels like you make great progress up the mountain, then there is a massive snowstorm or an avalanche. Your strength is not diminished, nor is your capability as a climber, but you are in deep snow, and your progress slows. The fact that you can still progress through deep snow is a testament to your strength rather than an indictment of your lack of strength. Over the last few weeks, we have felt much the same way; we are in deep snow right now, but we are moving forward. Our clients are moving forward, and we expect that, as noted in Slide 15, the same three factors that have helped move us up the mountain rapidly in recent years will also allow us to power through the deep snow and accelerate as we return to more stable footing. While timing and trajectory are uncertain, the three ideas—the power of our subscription model, the high lifetime customer value, and a business model that generates high flow-through—will remain powerful assets. On Slide 16, you can see the growth of our subscription business model, which is a significant revenue driver. Our total subscription revenue in the second quarter grew 24% and has grown 21% year-to-date. All Access Pass revenue has grown even more quickly—by 28% this quarter. Meanwhile, over 34% of our All Access Passes are now multi-year agreements, up from 27% last year. This structural strength is essential. All Access Pass sales have grown from $47 million two years ago to $91 million for the latest 12 months of 2020. Additionally, we expect that the percentage of All Access Pass and related sales among total enterprise division sales will increase to around 75% over the next three years. The growth in subscription sales has led to substantial increases in deferred revenue, totaling $82.7 million, up from $18 million two years ago. As highlighted on Slide 18, our high lifetime customer value—with an over 90% annual revenue retention—continues to create a virtuous cycle. The retention rate remains strong despite the current environment. In conclusion, we are grateful to provide our clients with the solutions they need during these challenging times. As a result, we anticipate that this period will deepen, strengthen, and create enduring relationships with our clients. For our employees, who are very mission-oriented, the value of what they do is at the forefront—never have they been more engaged. To our shareholders, we appreciate the trust and confidence you have extended to us. We remain committed to ensuring that trust is well-placed. With that, we will now open the floor for questions.

Operator, Operator

Thank you. Our first question comes from Alex Paris of Barrington Research. Your line is open.

Chris Howe, Analyst

Good afternoon, everyone. This is Chris Howe sitting in for Alex. I hope everyone is safe and healthy.

Bob Whitman, CEO

Hi, Chris. Thank you. We hope you are as well.

Chris Howe, Analyst

I guess just starting off with these two questions that I had top of mind. Can you provide some more color on the typical sales cycle for All Access Pass and for education? And how does that sales cycle currently look? My follow-up question is in relation to contracts of different lengths, whether they would be multiyear or other contracts. Do these contracts renew automatically?

Bob Whitman, CEO

That’s okay, great. Paul and Sean, do you want to address those questions? Paul, do you want to start?

Paul Walker, Executive

Sure, I will start. Hey, Chris. I will start with the sales cycle and how contracts work in the enterprise division for All Access Pass. The sales cycle can vary, but on average, it takes about 100 to 120 days. As for the outlook, we don’t know exactly how that will change in the coming months, but we were happy to see All Access Pass sales remain strong in March. Renewal sales involve a whole process to ensure that the pass renews on time, and for multi-year contracts, those discussions do not necessitate a renewal until the end of the agreed-upon period. I think that helps clarify the renewal process.

Bob Whitman, CEO

That’s great. I think it is helpful.

Chris Howe, Analyst

Yes. And as we look at these multi-year contracts, do they renew automatically? And how should I think of the portion of multi-year contracts up for renewal this calendar year?

Paul Walker, Executive

Clients sign new contracts when the term is over. We want to ensure that client engagement gives them every reason to renew. In the calendar year, I would estimate about one-third of our contracts are up for renewal. The exact portion may vary as we have contracts that can extend past one or two years.

Sean Frontz, Executive

To provide perspective on the education side, the sales cycle tends to be long and typically begins in the fall. Most schools make decisions starting in January and finalize before the summer season. We have had many conversations with schools recently and indications are positive regarding renewals.

Chris Howe, Analyst

I appreciate all the color, and that’s all I have for now. I will hop back into the queue. Thanks, everyone.

Bob Whitman, CEO

Thanks, Chris.

Andrew Nicholas, Analyst

Hi, good afternoon. I realized the current environment makes any sort of outlook for the remainder of the year difficult. So I totally understand the hesitancy to provide updated guidance and it makes sense to me. I am just wondering about the historical context of 2009 as a proxy for cyclical behavior. If you could talk about differences in business between then and now and how you would expect relative resilience versus 2009?

Bob Whitman, CEO

That's a great question. Back in 2009, we saw a decline of about 8.5%, almost all of it occurring in the first four months. People delayed their decisions and saw very little drop-off afterward. Now we have All Access Passes and multiyear contracts that offer better resilience—it’s a different environment. Even during the financial crisis, it took a couple of months for companies to resume spending. We anticipated that similar processes will unfold this time, however, we do feel more solid now than back then. Great question. As we approach these next quarters, we will see how demand patterns emerge as clients settle into their new realities. I feel good about our ability to retain clients and even grow alongside them.

Andrew Nicholas, Analyst

Thank you. Just one more—on the cost structure. Can you give us a high-level view of how much of your cost base today is fixed versus variable? What opportunities do you have to pull back on spending if the economy remains challenged for a longer period?

Bob Whitman, CEO

Our cost structure is designed to flex quite significantly. Our sales force is primarily commission-based, and a significant portion of manager compensation relies on performance. Most of our costs are personnel-related, and we've continually sought to improve efficiency. We have ongoing initiatives aimed at reducing costs and have been successful in achieving declines in SG&A relative to revenue over the last eight to nine quarters. Our structure gives us flexibility to adapt to changing market conditions.

Marco Rodriguez, Analyst

I was wondering about the impact you saw in Asia, China, and Japan, particularly in terms of revenue cadence as lockdowns were implemented. How is that impact currently seen?

Bob Whitman, CEO

Paul, would you like to address that?

Paul Walker, Executive

Sure, Marco. China was dramatically impacted as it entered lockdown during Chinese New Year. Revenue dramatically fell there for the majority of our second quarter. However, we're pleased to see clients engage again quickly, and while operations are reopening, training program requests are currently virtual. Meanwhile, Japan is coming back more gradually. Our revenues did not fall off as sharply there, as conversations with clients have continued to drive our business.

Bob Whitman, CEO

I would note also that the pattern is expected to be a bit different this time around, as we have only recently begun selling the All Access Pass in China.

Marco Rodriguez, Analyst

Understood. And shifting gears, can you discuss the importance of your client partners actually being on a plane and meeting clients for new logos or renewals?

Paul Walker, Executive

Our client partners are geographically close to their assigned clients. They regularly engage via videoconference, and we expect to maintain engagement and productivity through remote methods. Clients are available and open to discussions, even during this time of uncertainty. Decision-making processes may slow down due to internal approvals not being done in person, but we are capable of continuing to sell effectively.

Marco Rodriguez, Analyst

Got it. Lastly, have your hiring targets for client partners changed under current circumstances?

Paul Walker, Executive

We are still committed to hiring and have already added 255 client partners. We plan to shift the next few hiring classes by a couple of months as we feel it will be more beneficial to new client partners’ success when the environment is more stable.

Samir Patel, Analyst

Thank you for taking my questions. Paul, could you repeat if bookings for both renewals and new sales were actually up in March?

Paul Walker, Executive

Yes, they were. In March, our All Access Pass revenue, new and renewals, increased in the U.S. and Canada compared to last year.

Samir Patel, Analyst

Could you describe what renewal and client conversations look like with those clients potentially facing lots of challenges?

Paul Walker, Executive

Yes. Clients are navigating the spectrum of conditions—some are looking to expand under all circumstances, while others might need to delay payments or request flexible terms to meet liquidity challenges. We take each discussion seriously, aiming to be a supportive partner. Despite these discussions, we have not seen widespread cancellations, and many clients are moving forward with their services.

Zach Cummins, Analyst

Hi, good afternoon. Regarding education, can you talk about renewal navigation for that cycle in light of current challenges? Is there any chance to extend renewal windows past the traditional timeframe?

Sean Frontz, Executive

Most of our renewals start in March and accelerate through the summer season. We are calling and checking-in with schools actively. We've seen a good number of schools say, 'Let's revisit in a couple of weeks.' Several urban districts are ahead of their rural counterparts in readiness. Leader in Me has a long-term model, so I feel good about our retention rates.

Zach Cummins, Analyst

Can you break down how many services can be offered online versus onsite? How are you adapting to provide both?

Sean Frontz, Executive

We can effectively deliver all our services live online or on-demand. Many schools prefer a hybrid approach, or they want to reserve onsite training for situations longer down the road. We are fully equipped to assist them in both avenues.

Bob Whitman, CEO

If we can effectively manage the delivery of both methods based on client needs, we expect good uptake through our adapted models.

Zach Cummins, Analyst

Will having a higher portion of recurring revenue lead to better margins moving forward?

Steve Young, CFO

Yes, if recurring revenue increases, margins will follow suit on the whole. This will always depend on how we manage fixed costs, but overall gross margins should improve as the subscription model becomes a larger portion of the total mix.

Jeff Martin, Analyst

Can you shed light on the transition of onsite to online delivery?

Paul Walker, Executive

All of our onsite programs can be delivered live online. Our net promoter scores remain high in this format. We are working to build each client's comfort with new delivery methods while rebooking postponed programs into the future. Most recent discussions show a high engagement with those clients now willing to consider live online options.

Bob Whitman, CEO

I think we can continue moving forward, and we will adapt to clients during this time.

Operator, Operator

Thank you, ladies and gentlemen. This concludes today’s conference call. Thank you for participating. You may now disconnect.