Franklin Covey Co (FC) 2018 Q3 法說會逐字稿

Welcome to the Q3 2018 Franklin Covey Earnings Conference Call.

My name is Sheryl, and I will be your operator for today's call.

(Operator Instructions) Please note that this conference is being recorded.

I will now turn the call over to your host, Derek Hatch.

Sir, you may begin.

Thank you, Sheryl.

On behalf of Franklin Covey Co., I would like to welcome you to our third quarter conference call to discuss our earnings this afternoon.

Before we get started, I'd 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 and 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, which are filed with the Securities and Exchange Commission.

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 that the company's actual future performance will meet management's expectations.

These forward-looking statements are based upon 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'd like to turn the presentation over to Mr. Bob Whitman, our Chairman and Chief Executive Officer.

Thanks, Derek.

Good afternoon, everyone.

Hope you're all well.

We're happy to have a chance to talk to with you today.

We're really pleased with the results for the third quarter.

Over the last 3 years, as you know, we've consistently focused on 4 key objectives.

These objectives outlined in Slide 3 are first, to achieve strong overall revenue growth and accelerating growth in the enterprise division; second, to achieve aggressive growth in our subscription and subscription-related business; third, to expand our gross margins; and finally, to continue to significantly increase the lifetime value of our customers and build clients for life.

We're really pleased that in the third quarter and really through the 3 quarters year-to-date we've made significant progress on each of these 4 objectives.

I'm just going to hit a bullet point on each.

First, as you can see on Slide 4, first, revenue growth was strong.

Revenue grew 15.3% in the third quarter, and year-to-date it's also grown 15.3%, so it's been consistent all year long.

In addition to achieving strong overall revenue growth, one of our most important objectives has been to achieve robust growth in the Enterprise Division, our largest growth engine.

Really pleased that revenue in the Enterprise Division grew 17.6% in the quarter and again 17.5% year-to-date and that invoiced sales amounts grew -- in the Enterprise Division grew 9.3% in the third quarter and have grown 8.9% year-to-date.

So we're delighted to return to high single-digit growth on the amount of invoiced sales in the Enterprise Division.

Second, our subscription and related revenue growth was very strong.

Our overall subscription and related revenue grew 43% in the third quarter and 47% year-to-date.

And subscription and related revenue in the Enterprise Division grew an even more significant 66% in the third quarter and 78% year-to-date.

Third, our gross margin percentage continued to expand, reflecting the high margins associated with our subscription offerings.

Our gross margin percent increased 670 basis points in the third quarter to 69.2% compared with 62.5% in last year's third quarter.

And our gross margin dollars or gross profit increased 28% to $34.9 million.

The same patterns have been going on year-to-date, where our gross margin percentage has increased by 520 basis points year-to-date to 69.4%, and our gross margin dollars or gross profit has grown 24.6% to $100.5 million.

Finally, the key factors which are driving significant increases in our customer lifetime value were all very strong in the third quarter and have been strong year-to-date.

Our total number of paying subscribers increased 37% in the third quarter to 540,000.

Our annual revenue retention continued at greater than 90% for the third quarter and year-to-date.

Our sale of All Access Pass add-on services increased 50% year-over-year through the third quarter.

And a new factor we're tracking, approximately 20% of our All Access passholders are now multiyear passholders compared to only approximately 2% just a year ago, and we expect this percentage to continue to increase.

Our customers are really receiving tremendous benefit from the All Access Pass and related services.

One recent example, we're currently working with one of the largest tire manufacturers and retailers in the United States.

2 years ago, this client initially purchased an All Access Pass for 500 leaders in order to implement a single organizational initiative.

This client achieved great success in year 1 and at renewal time expanded their pass from 500 leaders to 1,500 leaders.

They also purchased an additional 100 Franklin Covey-delivered training days to help them implement their initiatives, and they recently renewed their All Access Pass for an additional 3 years.

Today, the Franklin Covey implementation specialist working with that client is helping them drive progress across 4 large separate organization-wide initiatives.

So it's an exciting time for that client, an exciting time for implementation specialists and for us as you see the kind of value the clients are receiving.

We expect continued progress on these same 4 factors in the fourth quarter: revenue growth, an accelerated growth in the Enterprise Division, the subscription and related revenue growth, increase in our gross margins and continued very high customer retention add-on sales, et cetera.

As a consequence, we expect a very strong fourth quarter and strong full fiscal year results.

I'm going to now ask Steve Young to review our overall performance for the third quarter and year-to-date and then ask Paul Walker and Sean Covey to review performance highlights for the Enterprise and Education Divisions, specifically.

Steve?

Hey, thank you, Bob.

Please -- good afternoon, everyone.

Happy to be able to share some numbers and add a little color to the numbers Bob talked about.

We did have a strong third quarter.

As Bob mentioned, our revenue grew 15.3% both in the quarter and year-to-date, and our total subscription and subscription-related revenue grew 43% in the third quarter and 47% year-to-date.

Subscription and subscription-related revenue in the Enterprise Division grew at even more rapid rate at 66% in the third quarter and 78% year-to-date.

Deferred revenue billed on the balance sheet at the end of the third quarter was $34.5 million, a year-over-year increase of 46% or $10.9 million.

Deferred revenue billed and unbilled at the end of the third quarter was $49.6 million, a year-over-year increase of $23.5 million or 90% compared to the $26.1 million in total deferred revenue balances, again, billed and unbilled that we had at the end of last year's third quarter.

Gross margin.

Our gross margin increased 670 basis points to $69.2 million in the third quarter, and our gross margin dollars increased $7.6 million or 27.7% to $34.9 million.

Third, our adjusted EBITDA was $0.6 million higher than last year and also slightly higher than our guidance even after making significant growth investments that we have talked about.

Finally, our total number of paid subscribers grew 37% year-over-year in the third quarter and grew 45% in the Enterprise Division.

I'll now provide just some additional detail on these key metrics that we just talked about.

Slide 6 shows the 15.3% growth in revenue in the quarter to $50.5 million, which is a growth of $6.7 million compared with the $43.8 million of revenue we reported in the third quarter of last year.

Our revenue has grown $19.2 million, the same 15.3%, to $144.9 million compared with $125.7 million of revenue we generated through the third quarter last year.

Our total subscription and subscription-related revenue across both the Enterprise and Education Divisions grew 43% in the third quarter and 47% year-to-date.

Subscription and subscription-related revenues in our Enterprise Division grew at an even faster 66% in the third quarter and 78% year-to-date, of course, driven by All Access Pass and Pass-related sales.

Our total subscription and subscription-related revenue plus the change in deferred revenue billed and unbilled increased to $115.2 million, an increase of $30.5 million or 36% over the last 4 quarters.

As shown in Slide 7, over the latest 12 months All Access passholders purchased $16.3 million of add-on services, growth of $5.4 million or 50% compared to the $10.9 million in add-on services purchased by passholders in the same 12-month period last year.

As shown in Slide 8, our number of paying subscribers across both our Enterprise and Education Divisions increased to approximately 540,000 in the third quarter, an increase of 140,000 or 37% from the approximately 400,000 subscribers we had at the end of last year's third quarter.

In the Enterprise Division, as shown in Slide 9, the approximately 377,000-person subscriber base at the end of the third quarter was up 120,000 subscribers or 45% compared with the 260,000 paying subscribers that we had at the end of last year.

In the Education Division, as shown in Slide 10, we had approximately 161,000 paying subscribers at the end of this year's third quarter, growth of approximately 25,000 subscribers or 20% compared with approximately 135,000 paying subscribers that we had at the end of the third quarter last year.

This significant growth in subscription and related revenue was partially offset by expected declines in our now much smaller legacy facilitator and delivery channels.

So now deferred revenue.

As shown on Slide 11, our total deferred revenue balances billed and unbilled increased to $49.6 million at the end of third quarter, a growth of $23.5 million or 90% year-over-year from $26.1 million in last year's third quarter.

Deferred revenue billed on the balance sheet at the end of the third quarter increased to $34.5 million, year-over-year growth of $10.9 million or 46% compared with the balance of $23.6 million the end of last year's third quarter.

This growth came even with invoiced amounts in the Education Division being $2.5 million lower than the original plan, impacted by the maturation of a generous multiyear funding agreement from a major donor, over the past several years has added to the hundreds of new self-funded schools we add each year.

Now deferred revenue unbilled.

Unbilled deferred revenue, representing business that is contracted but unbilled and off the balance sheet, ended the third quarter at $15.1 million, up more than sixfold compared to the $2.5 million in unbilled deferred revenue balance that we had at the end of the third quarter last year.

Now our adjusted EBITDA.

We had expected and given guidance that our third quarter adjusted EBITDA would be as much as $500,000 higher than what we reported in last year's third quarter.

We are pleased that our actual third quarter adjusted EBITDA was $600,000 higher than last year and slightly better than our expectation and guidance.

This increase in adjusted EBITDA in the third quarter was a result of several factors.

Our year-over-year reported revenue growth of $6.7 million or the 15.3% that we mentioned several times here to $50.5 million.

Our gross margin percentage increased 670 basis points in the third quarter to 69.2%, as shown on Slide 12.

Combined with our strong revenue growth, this resulted in our gross margin dollars increasing $7.6 million or 28% to $34.9 million compared to the $27.3 million in last year's third quarter.

This $7.6 million increase in gross margin was benefited from the nonrepeat of a $1.8 million charge related to exiting the publishing business in Japan last year.

Excluding that benefit, gross margin dollars still increased $5.8 million, more than covering our nearly $5.2 million in planned increase to growth investments related in the $600.6 million increase in adjusted EBITDA in the quarter.

Year-to-date through the third quarter, our revenue has grown $19.2 million or 15.3% to $144.9 million.

Our gross margin has increased 519 basis points to $69.4 million from $64.2 million year-to-date.

And our gross margin dollars have increased $19.9 million or 24.6% to $100.5 million, and our year-to-date adjusted EBITDA has increased by $3.7 million.

So good quarter.

Paul?

All right.

Thanks, Steve.

Hello, everyone.

Happy to have the opportunity to just share a little bit about the Enterprise Division's third quarter and give a little bit of an update on where we are then year-to-date.

In the Enterprise Division, third quarter revenue was up -- came in at $39.9 million, representing growth of $6 million or 17.6% compared with revenue of $33.9 million in last year's third quarter.

The Enterprise Division's gross margin increased a significant 949 basis points to 73.2%, up from 63.7% in last year's third quarter.

This combination of higher revenues and the higher gross margin percentage increased the Enterprise Division's gross margin dollars by $7.6 million in the third quarter.

As noted by Steve previously, this $7.6 million increase in gross margin benefited from the nonrepeat of a $1.8 million charge last year related to exiting the publishing business in Japan.

This growth in gross margin dollars more than offset the $3.9 million of additional All Access Pass-related growth investments that we made in the Enterprise Division in the third quarter, resulting in reported EBITDA of $4.3 million, an amount $1.9 million or 79% higher than in last year's third quarter.

Year-to-date, just an update there here, through the third quarter, the Enterprise Division's revenue has grown $16.9 million or 17.5% to $113.7 million compared with $96.8 million year-to-date through this point last year.

Our gross margin has increased 698 basis points to 73.4%, up from 66.4% last year.

This combination of significantly higher revenue and a significantly higher gross margin percentage has driven a significant increase in the Enterprise Division's EBITDA to $11.7 million year-to-date through the third quarter this year, a growth of $6.7 million or 133% compared with the $5 million in adjusted EBITDA generated in the first 3 quarters last year.

As Bob mentioned earlier, this growth is really being driven by the high acceptance and our clients embracing the All Access Pass.

He shared a brief example of how this is playing out.

I'll just share another brief one here.

We're working with a large global consumer packaged goods company right now, and we began working with them a little over a year ago, and they bought an initial All Access Pass for 100 leaders.

And our client partner and implementation specialists began working with them, and with the client, they identified a population of 2,000 leaders that needed to be developed more broadly.

And this is where you see the depth and the breadth and the richness of the All Access Pass come together.

Because we've got our content in 16 languages now, we've got Jhana, we've got Robert Gregory Coaching Services, the digitized content that we have in addition to the traditional blockbuster-branded, instructor-led courses, we've worked with this client now to develop 21 unique impact journeys.

And those impact journeys are being deployed in multiple countries across 2,000 leaders today.

And recently, the client just signed for another 2 years.

An impact journey, just quickly on that.

This is really at the crux of what we're now able to help clients with that we weren't able to do before All Access Pass.

Traditionally, a client would engage us, and we might deliver a training program, and that program might have a pre or postassessment, but it was primarily built around a 1- or a 2- or a 3-day experience.

When we assembled the All Access Pass, and I've mentioned earlier, we added the pieces like Jhana and the ability to push content, and we digitized all of this content, and we translated the languages, and we created coaching services.

Now that same participant goes through an expanded journey that might be anywhere from a few weeks to a few months.

And in the process of that, that more immersive experience, we can really help the client change the behavior, or build the capability is a better way to say it, of that leader to drive the outcomes the organization wants.

And so in this one example, the client has actually designed with us 21 of those journeys to meet the various needs for their -- these 2,000 leaders.

We've got literally hundreds of experienced -- of customers like this who we're really pleased to be serving now.

And the All Access Pass has become an indispensable part of what they're doing, and obviously, it's changed the basis for our relationship with them.

As Bob noted, we're really pleased by the Enterprise Division's 17.6% reported revenue growth in the third quarter and also that the Enterprise Division achieved growth of 9.3% in invoiced sales amounts, which is shown in Slide 18.

We expect the Enterprise Division to also have a strong fourth quarter, adding to its performance gains for this year.

And now I'll turn it over to Sean.

All right.

Thanks, Paul.

Hi, everybody.

This is Sean, and I'm excited to give you a quick update on education and how we're doing there.

So on Slide 13.

The Education Division reported revenue of $9.2 million in the third quarter, reflects year-over-year growth of $0.6 million or 7.4%.

The Education Division's adjusted EBITDA in the third quarter was a negative $0.7 million, which was less than last year's third quarter EBITDA of $0.3 million.

And this reflects the staffing and marketing investments that the Education Division makes during the first, second and third quarters so that we can generate contracts and deliver on the fourth quarter, with the hundreds of new schools whose revenue is primarily recognized in the fourth quarter.

And as a reminder, in the fourth quarter this is the quarter in which the Education Division generates about half of our annual revenue.

And virtually all of our annual EBITDA comes from the fourth quarter.

Year-to-date through the third quarter, revenue for Education has grown by $2.2 million or 9% to $27.4 million.

So I'm excited to share some other good developments in Education.

I'm pleased to share that The Leader in Me, which is our primary model that we're selling, it's our whole-school improvement model, is now in over 4,000 schools and in over 50 countries.

And we're very excited to see it expanding around the globe through a partnership network similar to what we've created on the corporate side.

For example, we now have over 300 Leader in Me schools in Brazil through our partner there.

Just recently, in the last couple of months, we entered China through several new partners, each owning pieces of China, and we feel like this is going to bring on hundreds of new schools in the coming years in China.

During the third quarter also, we signed up a new partner in Pakistan; and with that, we got just recently 300 new Leader in Me schools starting up in Pakistan.

So we're very pleased to see this global expansion and feel like that's one of the best opportunities we have for education.

We're also excited about The Leader in Me expanding into the high school market.

Until this year, The Leader in Me has primarily been available only for the elementary market and a little bit into the middle school market but not much.

But based on high demand from districts who are doing a lot of Leader in Me with elementary schools and who want it in the upper levels, we've opened it up to high schools this year.

And we're pleased that over 100 high schools will be joining The Leader in Me community this summer, and we expect high schools to be a major source of growth for us in the coming years because with high school will come more expertise with middle schools, so basically doubles the size of our market opportunity from just the primary grades to the secondary market.

I'm also thrilled to announce that this past week The Leader in Me was endorsed by an organization named CASEL, C-A-S-E-L, which stands for the Collaborative for Academic, Social, and Emotional Learning.

And CASEL is the leading authority in the K-12 market for everything related to academic and social and emotional learning.

And their endorsement is based on us meeting several standards, including the quality and breadth of our curriculum and, then most importantly, sufficient and valid empirical peer-reviewed research.

Their endorsement basically states that we're a highly recommended provider in the K-12 market and that we have evidence to back it up.

We now have over 30 independent university studies that validate the positive impact of Leader in Me upon such measures as improved attendance, fewer behavioral problems in students, increased teacher and student engagement, increased academic achievement; and the development of vital skills in students, such as responsibility and goal setting, resilience, problem-solving, public speaking and communication.

As we look to the fourth quarter, our contracting pace for new schools is strong.

And for the year, we plan to bring on about over 500 new schools in the U.S. and Canada.

We also expect more than 90% of our current 2,400 Leader in Me schools in the U.S. and Canada to renew their subscriptions, which is consistent with past years.

We've always been around 90% or a little higher.

As a consequence, we expect to achieve growth in both revenue and EBITDA in the Education Division in the fourth quarter.

So I'll turn it back to you, Bob.

Thanks so much, Steve and Paul and Sean.

I mean as you can hear, there are a lot of exciting things going on in the company.

The flywheel continues to turn, and quarter-by-quarter, we just see the momentum continuing to build based on -- driven by the impact we're having with customers, the ability to retain those customers, expand their relationships with us and expand our sales force and reach around the world.

So finally, I just need to talk about -- make a note about our business model inflection point.

We've now reached an inflection point where under any of a wide variety of revenue growth scenarios we expect to achieve strong revenue growth, increasing gross margins and a significantly increasing and accelerating flow-through of revenue to increases in adjusted EBITDA and cash flow.

Underpinning this inflection is the powerful interplay among the 4 key factors that are outlined in Slide 14.

They are, first, the positive and widening gap between the growth in our subscription-related revenue and the decline or the winding out of our legacy facilitator and on-site business.

As you can -- illustratively in Figure A, you can see that 14 -- during the initial transition to All Access Pass in 2017, the significant and rapid growth of our subscription and related revenue was largely offset by declines in revenue -- in the revenue from our legacy facilitator and on-site delivery channels, even though only -- less than half of the initial sales were made to those clients.

Nevertheless, it interrupted that channel.

However, in fiscal 2018, '19 and beyond, there's a positive gap growing between the growth of our subscription and related business and the decline in our increasingly smaller legacy facilitator and on-site business.

That positive spread is expected to continue to grow as the legacy business gets smaller and smaller and as we continue to achieve accelerated growth in the subscription side.

So that's one driver of the inflection.

The second is the positive relationship between the growth of revenue and the lack of growth of our costs as the relative flatness of our cost increases in the future.

In fiscal '19 and beyond, our incremental investments in new content, portals, localization, et cetera, will continue but be relatively small incrementally compared to fiscal '18's elevated levels.

In addition, our central and central support costs are expected to remain essentially flat.

As a result, as indicated in Figure B in Slide 14, in fiscal '19 and beyond a significantly higher portion of our increases in revenue and gross margin are expected to flow through the increases in adjusted EBITDA and cash flow.

Just to give you an example.

In fiscal '18, we expect revenue to grow approximately $27 million, with the contribution to EBITDA, which isn't immediately obvious, of about 40% of that incremental growth or an extra $11 million of EBITDA contribution being generated from those sales.

In fiscal '18, however, because of the very significant increases in investments for implementation specialists, localization of content into 15 languages, the new portal, the ERP system and other investments we've made that won't have that same increment next year, of that $11 million increase in EBITDA contribution about, say, $3.7 million or so will flow through to increase in EBITDA at least at the -- around the middle of our guidance range.

In fiscal '19, however, if we were to achieve similar growth of $27 million -- incremental growth of $27 million, a very large portion of the approximately $11 million or 40% incremental contribution from those sales would be expected to flow through to increases in adjusted EBITDA and cash flow.

So that's a second important inflection point.

The third factor is the relationship between the growth in revenue and the growth in adjusted EBITDA.

And that's just driven incrementally by the high margins that we have and the highly variable selling costs, as was just indicated, that as revenue grows, aside from there not being central fixed costs, there's very high flow-through because you've got primarily a commissioned sales force with high gross margins.

And that will drive it.

And then finally, the relationship between the growth in adjusted EBITDA and the growth in pretax cash flow.

As illustrated in Figure D, in fiscal '19 and beyond cash flow is expected to grow even more rapidly than reported revenue.

This is due to the fact that the accounting for subscription sales spreads the recognition of the subscription revenue over the term of the contract even though almost all of our subscription revenue is billed upfront at -- from the time it's contracted.

The accounting recognition of deferred revenue, therefore, significantly lags the collection of the cash.

And as a result, cash flow growth is expected to be even more rapid than reported revenue going forward, particularly with the reduced investments.

So the interplay of all these key factors is expected to grow significant growth as we move forward also in the fourth quarter.

So just in conclusion, starting where -- ending where we started, summarizing the points already made in Slide 3, we've achieved strong revenue growth and even -- and the accelerated revenue growth in the Enterprise Division, and we expect that to continue.

We also expect strong revenue growth in the Education Division in the fourth quarter.

Second, our subscription and related momentum continues to be very strong both in the Enterprise and Education Divisions.

Third, our gross margins continue to expand, and we expect that will continue as mix shift towards subscription continues.

And fourth, each of those factors is driving a significantly increased customer lifetime value, which is forming a base for growth.

When we're retaining more than 90% of our previous revenue and adding on services, it creates a tremendous base for accelerated growth, which, as we just pointed, we expect there'll be a lot more flow-through of that incremental growth as we move forward, and we're really on the cusp of that both in the fourth quarter and beyond.

So with that, I'll just turn over the time to Steve to discuss our guidance, and then we'll open it for questions.

Okay.

Thanks, Bob.

So our year-to-date adjusted EBITDA, as we mentioned, is $3.7 million higher than last year.

So we know the math and are pleased that if our fourth quarter adjusted EBITDA result were the same as last year's $10.9 million, then adjusted EBITDA would total $11.4 million for the year, within our guidance range of $10 million to $15 million.

We do expect Q4 adjusted EBITDA to be as much as last year, with increases in sales and gross margin at least covering our increased growth investments.

Therefore, we affirm our original guidance of $10 million to $15 million.

And as you can see, if we hit the same as last year, it would be $11.4 million.

Let me also mention, for -- many of you, I think, would be interested in some of the schedules in the appendix.

We put additional information there that we believe would be helpful to those of you who are analyzing the company and building models and those kind of things.

So we would encourage you to look at the schedules there, where we intend to give you the information that you need to complete your analysis.

So thank you.

Thanks, Steve.

We'll now ask the operator to open this up for questions.

(Operator Instructions) And our first question comes from Jeff Martin from Roth Capital Partners.

Bob, could you give us an update on direct offices both domestically and internationally?

Yes.

Paul, do you have that?

Yes.

So the direct offices make up the vast majority of the Enterprise Division update that we gave.

But they're doing well.

They had good third quarter.

In fact, we're now...

The growth of the direct offices was a little higher than the reported -- because the license fees were relatively flat in the quarter, so the growth rate would have been a couple of hundred basis points higher in the Enterprise Division but for the license fees, so all the rest of it relates to the direct offices keep pulling it.

Yes.

And just another note or 2 that we commented on in the past.

So All Access Pass is going well.

It's being sold in the U.S. and Canada, of course, U.K, Australia.

It's now -- now that we've finished the translation, it's up and running in Japan, and we're starting to sell there.

And we're kind of on the cusp of doing so in China, expect to do that in the first part of next fiscal year is when we'll start selling in China.

I don't know, Jeff, if that's helpful or if you had some any specific questions but happy to help.

I guess, that just leaves Australia then, right?

Sorry.

Yes.

So the U.K, Australia, the U.S. and Canada are all selling All Access Pass, doing well with that.

We're pleased with the revenue retention that we're seeing, and Bob mentioned the services that are being sold.

It's kind of uniformed across all those offices in terms of the performance-related All Access Pass.

Okay.

And then Bob, last quarter, you mentioned the decline in the legacy on-site and related would be about $7 million to $8 million this year.

Just looking for an update if that's tracking to that number or anything [material at all]...

Yes.

That's still tracking, Jeff.

Our guess is by the end of the year it will have exerted about a $7 million drag on growth.

That'll be smaller again next year and the following year.

So the break is coming off year by year as that business gets smaller.

And it'll be a smaller drag this year and a smaller drag again next year.

Okay.

And then you also mentioned, I think, 3 new content programs last quarter.

Could you speak generally to the new -- the content strategy and then specifically to some of those newer programs in terms of how they're functioning?

Just speaking to the strategy -- yes, thanks, Jeff.

Just speaking to the strategy, long ago we made -- 17 years ago, we made the commitment to not only build -- try to develop capabilities in people but to connect those capabilities to specific outcomes and -- like sales performance or customer loyalty or execution of a major initiative.

And today, over 1/3 of all of our revenues relate to a circumstance where a client actually is engaging us to help drive home a specific outcome.

So our content strategy is across 3 things.

One, we'll continue to be strong in building individual capabilities, particularly personal and interpersonal capabilities there.

The second, we want to build particularly strong capabilities around 2 groups of leaders; 1 group is the first level leader, the first -- which is really the connection between a company's strategy and its customers.

And that's an increasingly -- it's always been important, but it's increasingly important as layers have been taken away above those managers and they are now doing jobs that require -- they're managing teams virtually and et cetera.

So that's a big effort for us.

We added Jhana there.

We have a new course focused on that one called the 6 Critical Practices for Leading a Team.

We have a new book coming out in that same area, Everyone Deserves a Great Manager.

We've put additional resources there.

Another level is for the senior-level manager who is responsible not only for leading a team but leading a team of teams, leading multiple teams and so leading leaders of teams.

We have a new offering there called The 4 Essential Roles of Leaders.

We also have an integrated solution that combines trust and execution for those people.

We're taking the Jhana capability that exists, Jhana was primarily focused for the first-level managers, and adding that capability with weekly seats for senior-level managers in education, ultimately also for individuals to be effective.

So everybody will be getting their -- ultimately getting their Jhana weekly but for a specific job to be done.

And we're then trying to just -- and then we're also focusing on that connection between capability and outcomes.

We already have execution.

We're tying it very tightly to offerings like customer loyalty, manufacturing, sales performance, things like that, and a strong, broader offering on accountability throughout an organization.

So that's our map.

Is that helpful?

It is.

It is.

And then last question before I hop off here.

Your growth strategy longer term, how do you envision it in terms of sources of growth, in terms of new content versus adding salespeople versus growing with existing passholders?

How do you envision that over the intermediate and longer term?

Leaving out the decline of the legacy business, so you just look at the pure growth vehicles.

Just retain -- if we can just retain revenue at more than 90% of the previous customers and add on 30% to 40% of add-on sales, we already are in growth land each year just from retention and add-on sales.

The driving of new pass sales though -- and so that's important.

Driving new pass sales and growth beyond that involves the growth of the sales force in 2 components.

The first is the ramp-up of people we already have.

We have $40 million of revenue potential.

If we didn't hire another salesperson, just ramping those people up that we already have who are in their first or second or third year of the 5-year ramp, just continuing to ramp those will add -- should add $40 million of revenue over the next couple of years.

And then we'd never stopped on the issue of growing sales force; although if you look at our number, you'd say we had in the last year because we haven't grown the net sales force very much.

That really masked what's been happening.

3 years ago we'd hired about 25 salespeople just to handle all of our events and sell facilitator sales.

When we moved to All Access Pass, we decided -- that group of people just wasn't geared to do the kind of strategic selling.

And so while we've grown -- we've hired and retained a bunch of new people, we also lost that group of 25 by choice and by design, but we've continued that strategy.

And so I think as you go forward, the addition of new salespeople each year and the ramp-up of new salespeople, the growth of our licensee, that's kind of the distribution growth, the retention of new customers -- of existing customers and add-on sales could continue without a lot of new content.

But we want to build the strategic viability and importance of what we're doing by adding a few key pieces of content each year that strengthens our major strategic [modes].

Our next question comes from Marco Rodriguez from Stonegate Capital.

So real quick question here.

Shifting over to The Leader in Me or the Education Division.

And maybe if you can talk a little bit about the segment expenses on a year-over-year also on a year-to-date basis.

Some fairly significant growth rates.

And I know you talked to the fact that you've been adding and making some investments there.

Was there any other sort of one-off type expenses or very large expenses that are not repeatable?

Or are those types of kind of run rate numbers now?

Sean?

You're talking about basic SG&A expenses and the increases?

Yes.

Those are -- we do this every year, where we make a lot of client-partner investments, marketing investments, other infrastructure investments that help us get ready for the fourth quarter, which is when we bring on all the new schools and do most of the training during the summer months.

So those are expenses that we think will pay off in the fourth quarter and will pay off in coming years as well.

So those aren't onetime expenses.

These are infrastructure.

These are bodies.

These are people.

They're not just onetime things that will go away.

So we have that infrastructure in place.

We think it's going to -- it was necessary to bring on 500-plus new schools in the fourth quarter as well as all the retention of the 2,500 schools that we have right now.

Marco, the one investment though that was made this year that won't be -- won't incrementally increase is the one in research that really backed up in order to get CASEL certification and so forth.

We made the determination that it was such an important thing in education to have peer-reviewed research and to put -- to make sure that we had a fertile field for doing that research.

And so we upped our investment by almost $800,000 this last year.

We're not -- that level won't go down a lot next year.

And we think we can retain that, but it won't be -- you won't have an incremental gain.

That was a big jump this year for us that won't be a -- it won't incrementally repeat each year, whereas the other ones will.

Got you.

Okay.

And you mentioned on the -- in your prepared remarks on the Education side that The Leader in Me, you're starting to kind of move that into the high school market and thereby kind of like it's doubling the market opportunity for you guys.

If you can talk a little bit about how that sort of started and how you started to make your way into the high school market.

And then if you can maybe talk a little bit about what might need to be changed in terms of delivery of the content because I'm assuming that it's a little bit different to communicate with a team versus a -- I'm not sure (inaudible).

Yes, sure.

Yes.

So yes, it is.

We actually started in the high school market years ago when we were much smaller.

We've got some experience with working with them.

But The Leader in Me started in elementary.

We've gotten really good at it.

We understand that market really well.

And what happens is you're selling to districts ultimately.

And these districts will bring on -- if I have 20 schools, and they'll bring on 2 elementary Leader in Me schools, they have great success with it.

They like it.

They go into the middle school and then to the high schools.

And they start saying well, hey, we really like this.

We like what we've done.

We'd like to continue this.

And so there's been a lot of pressure through the years.

And for 5 years in a row, we've said no, not this year.

We've gotten -- we've got so much growth opportunity with elementary let's just stick with it.

But finally, there's been so much pressure from districts to develop a middle school and a high school solution that we decided that now was the time.

So we've spent the last 2 years developing the high school solution.

It's -- we've spent the money on it already, and we're launching it right now.

We made a lot of adjustments.

There's some things that work in Leader in Me in elementary that didn't work in high school.

We -- because we had maybe 20 schools beta testing for the last 4 years, we kind of figured out what's working and what's not.

We've made some adjustments.

We have -- it's more classroom based.

There's -- we have some really good curriculum around college and career success and readiness around leadership skills, goes a lot deeper than we do in the elementary level.

And it really prepares them for college and the workforce.

So we think that there's a lot of money in high schools.

There's a lot of opportunity.

95% of our business is K-6 right now.

If you add 7 to 12, we really think the market opportunity doubles.

So this is our first year into it.

We think we'll get 100 schools, which is about double about what we were expecting.

Next year, we think we can get 250, and we could see that growing really fast over the next 5 to 7 years.

Got it.

And do you have the capacity on the sales side -- sales head side to deliver that?

Or do you have to add additional people for that sort of growth expectation?

I think the sales side will be similar to what it's been.

We'll just keep adding 8 to 10 new salespeople a year.

We're not going to divide the sales group between high school and -- or primary and secondary because they're selling to districts, right?

And they want to keep that relationship.

So we think that we'll have -- we'll continue to have our same salespeople selling both ways.

This year we had a few of them that really cracked the code on it.

And they've got a lot of -- they basically kind of did the same amount of new schools on the elementary side and added a lot of high schools on top of that.

We'll watch it closely.

If there comes a time when we need to divide the 2, we will.

But we don't think it's the way to go at this point.

But yes, we think we have the capacity to deliver good growth next year in both markets with our current strategy around salespeople.

Understood.

And shifting gears here.

Bob, maybe if you can just talk a little bit more here on the shift in the business model.

Obviously, it's taken a little bit of time; but the numbers are starting to show the grand scheme, if you will.

But during this time, we've had some changes in terms of the way you were structuring that business model and how sales are going to be made to the end customer.

Do you feel as if now you're kind of settled on the formula as far as how to deliver everything content-wise and sales-wise?

Or are there other sort of initiatives maybe that you might be thinking about in the back of your mind that might improve things or accelerate things down the road?

Thanks, Marco.

I'm going to let Paul respond first.

Just a couple of comments, Marco.

Good question.

I think the short answer is yes.

I think that things are -- we have a strategy we believe in.

We think things have settled out, to use your word there.

For example, the first couple of years, trying to figure out what was the right support model for these All Access passholding clients relative to implementation specialists.

And we toyed around with a hybrid model using some of our delivery consultants who deliver by day and kind of were supporting clients by night almost.

And we've now centered and have for this past a little over a year now been using a full-time team for that.

It's working really well.

And so that's just one example of probably a dozen whereas we encounter new things we have to figure out how to solve for those.

But today, primarily, we have a sales force that's very talented, increasing in their skill and capability to go position a subscription-type sale that's a renewable asset, that once they've sold that they're in there working with the client to look for expansion opportunities.

They -- we now know how to work through the renewal cycle and the procurement cycle.

These things were new to us when we first started this, having to have a contract for everything versus just a simple order for a facilitator purchase.

And so I do think for us the key will be keeping the revenue retention high, which we're doing, continuing to focus on some of these new service opportunities like coaching.

We're just scratching the surface with what we can do with the Robert Gregory coaching content.

It's growing rapidly, but just scratching the surface there.

And so it'll be adding client partners and then going deeper within the accounts we have and driving new logo sales, I think.

Yes.

Marco, just one other comment.

This probably isn't obvious, but we don't have any salespeople who aren't running the play.

And this is a real -- this is a great credit to our leadership.

We have 17 managing directors who lead the sale -- the direct sales forces.

And they're really -- it's not like we've got part of the sales force still selling the old way and part new.

I mean, everybody is selling the new thing.

That transition, they're across the bridge on that.

And so it seems like now -- it's not like we -- we ask ourselves every day how we can do something better.

It's not like we think we have everything figured out, but we do have something -- just delivering consistent increases in new pass sales, retention, add-on sales, and our [carrier] meetings are always -- spin on the things we're not doing well.

That's -- it's not structural anymore.

We're across the bridge on -- organizationally.

Now it's just performance.

So...

Our next question comes from Kevin Liu from B. Riley.

First, just wanted to clarify something I thought I heard on the call.

Did you guys to say the invoiced amount in education missed by $2.5 million relative to plan?

And if so, could you kind of elaborate on some of those causes?

We did, yes.

We're saying through the third quarter we were $2.5 million behind plan in the education group.

I'll let Sean speak to that.

I mean, he thinks he's going to make up a portion of that, if not all, in the fourth quarter.

But you can just address that, Sean.

Sure, yes.

Well, we've had a couple of things.

One is we've had a large multiyear funding agreement from a major donor that's helped sponsor new schools.

It's a corporation that really believes in what we're doing.

And that was a 6-year agreement, and that basically has come to an end.

And that's hurting us.

We thought that we perhaps could get that renewed.

They're probably going to wait a year or 2 before they start up again.

So that was kind of unexpected, and that's brought us down some.

Also, just as a reminder, over -- about 50% of our revenue and over 60% of our contracted revenue happens in the fourth quarter.

So, so much depends upon -- of the year depends upon how we do in the fourth quarter.

We feel pretty good about our growth prospects in the fourth, so...

Does that address that, Kevin?

We can speak more, but I think that's basically -- yes, we just wanted to make it clear that we were down a little bit versus our plan, even the [ramp-on] plan generally overall.

And our gross margins are so much higher that EBITDA-wise we're well ahead there in terms of gross revenue.

Education has been off versus plan a little bit year-to-date primarily because of the reasons spoken of.

Yes.

No, that's helpful context.

And then the other question I had was just around the facilitator sales.

Could you just remind me how much it's down year-to-date?

And as you look to Q4, I would imagine that's always been kind of the more pronounced period for facilitator sales.

How should we think about those sales trend kind of shifting over to AAP subscription invoicing?

Well, it's in our plan.

Last year, we were down to about $14 million in facilitator sales in the U.S. offices.

We expected that would be down about 45% this year, just a combination of people transitioning and just -- some of that business is always episodic and not repeating each year.

We're down a little less than that.

My guess is that we'll end up the year at somewhere around $9 million of facilitator sales.

So we're not counting all on a huge -- a big fourth quarter in facilitator.

We normally had a promotion.

It'll be smaller this year.

Just the sale -- it's almost a distraction from the sales force.

We're focused on that.

But we do have a team of implement -- inside sales partners that are working on this.

Paul, I don't know if you want to add...

No, we expect it'll be down in the fourth quarter like we expected it to be down throughout the year, and so...

It might be a little bit better than that.

Might be a little better, yes.

Maybe asking the question a little bit differently.

Because Q4 used to be so big for facilitator sales, do you guys have any sort of enhanced promotions or anything to that effect to help drive, kind of conversely, a bigger benefit to your AAP invoicing activity?

Yes.

We've got -- we do a number of little things to that point, initiatives that we have going on internally that we use at our clients to drive, for example, expansion revenue within our current passholders.

And so the one I spoken -- the client I spoke about earlier in my example expanded from a 100-person pass to a 2,000-person pass, so they added 1,900 users.

Not everybody adds 1,900 users.

But we're constantly in there working with clients to try to expand what they're doing.

That certainly gives us a benefit inside a given quarter.

The heavy focus on selling new logos, that benefits us in the quarter.

And then in the fourth quarter, there are a lot of passes to renew from prior year's selling activity as well.

As you know, Kevin, these activities no longer affect the quarter very much.

So we have the expenses associated with another quarter, and the revenue gets put on the -- adds to our deferred balances.

So very little of that effort will actually affect the quarter other than on the expense side, but it does drive longer-term contracts, et cetera, that'll benefit next year.

Our next question comes from Trevor Romeo from William Blair.

Yes, it's Trevor in for Tim today.

Yes, so I guess, if I understood the comment in the prepared remarks correctly, it sounded like adjusted EBITDA in the fourth quarter would be kind of similar to the level in the fourth quarter last year.

I would have expected it to be maybe up a bit given the strong revenue growth that you guys have been seeing lately.

So could you maybe just talk about what's driving that?

Is it really only just a result of the investments you're making?

Or is there anything else going on there?

The only other thing that's going on there that would be cost related is that our pattern of recognizing annual bonuses and commissions is skewed significantly toward the fourth quarter because that's when we make all of our profit.

And since the annual bonuses are driven primarily by profit or the change in profit, we have a fairly significant increase in compensation in the fourth quarter just related to commissions and bonuses.

And then we've talked a lot about the investments that we've made in growth for -- the investments we've made in the year.

A portion of those investments will be made in the fourth quarter.

And so we expect it will be a good fourth quarter.

And when you look at the numbers in the fourth quarter, it's a very profitable and good fourth quarter.

So our comment is partially reflecting the fact that last year's fourth quarter was so good, and we expect an equally good fourth quarter this year.

And the pattern will most likely be revenue being good, our gross margin being up and our SG&A being up because of the investments we're making and what we just talked about, again still resulting in a great quarter that's probably consistent with last year, maybe a little bit more.

And Trevor, just -- following up also on Kevin's question about the fourth quarter.

Obviously, the amount of business that we contract or invoiced during the fourth quarter, just a much smaller percentage of it actually shows up in the quarter, even though you have all the expenses.

And so as a consequence, the huge lumpiness that we always had in the fourth quarter will become less and less so as we add more of this deferred revenue.

Okay.

Got it.

Understood.

And then just what kind of operating cash flow do you expect to generate this year?

And I guess, just generally, with the subscription model gaining some more traction, what sort of, I guess, cash flow conversion ratio do you see for the business going forward?

Yes.

And Steve, if you want to -- historically, let's just say cash flow relative to adjusted EBITDA, of course -- and if you add back the balance of the increase in deferred revenue toward our cash flow, historically our cash flow has really tracked at very high -- very close to our adjusted EBITDA because you add to it the amortization of capitalized development cost that's already deducted for purposes of gross margin and then subtract the depreciation -- or the CapEx and such to get to our cash flow.

And so it's usually pretax been maybe $3 million or $4 million less than our adjusted EBITDA or adjusted EBITDA plus the change in deferred.

And so the contribution this year will actually be similar to that.

It's just that we may -- in a very similar way.

So our -- the cash we're generating will be very strong this year.

And our investments this year, with the incremental investment in implementation specialists, the $3.5 million for the localization of content in 16 languages, $4 million of portal cost, $5 million investment in the ERP system, et cetera, we invested those in things that won't be -- we won't have to invest in again next year, at least won't have to increase next year, and on a cash basis won't actually be investing in a lot of those next year.

But -- so the cash generation will be high, about $4 million less than the sum of adjusted EBITDA plus the change in deferred.

And our investments were also high this year.

Yes, high.

So investment will go down.

One point -- one other point, Bob, it seems like that -- part of the reason the incremental increase in cash is so high compared to the incremental increase in adjusted EBITDA is because our balance sheet consumes less than 20%.

About 15% of that incremental adjusted EBITDA is consumed on the balance sheet by increase in receivables.

So it makes a very high flow-through of cash available for the capital investments that Bob talked about.

And our final question comes from Patrick Retzer from Retzer Capital.

So you just got done talking about cash and cash flow.

About a year ago, you made a couple of significant acquisitions.

Since then, understandably, you've been pretty quiet on the stock buyback front, even though historically you've been very aggressive there.

Can you comment on the outlook for buying stock back here in the foreseeable future?

Sure.

Yes, I think your analysis is exactly right.

In this past year and a little bit before, we made a couple of acquisitions, we invested in the new portal, a localization of the content, a new ERP system.

So our capital spending was planned, and it was significantly higher than it has been in other years.

And at the same time, we're having the transition to the All Access Pass such that we're making the growth in investments there.

So as Bob talked about, the incremental flow-through to cash of the incremental increase in adjusted EBITDA will generate -- and our decreased amount that we allocate to capital spending will mean that we'll have excess cash again in the near future.

And what we have normally done is if there's no acquisition or something like that is to buy back shares.

So we still have the same -- we're still the same people with the same overall capital strategies and intent to buy back shares with excess cash.

At this time, we show no further questions in queue.

Right.

Well, then we'll just conclude by again thanking each of you for joining the call today.

Maybe moreover, thank you so much for your -- the tremendous focus you've had over this transition over the last couple of years, being willing to invest the time and the analysis, which wasn't easy, and really learning the business, understanding what drives it.

We're grateful that we're now showing the -- all those factors are heading the right direction.

Hopefully, it makes it a little easier to follow us.

But we really appreciate everyone sticking in there through this transition, and we look forward now to hopefully rewarding everybody again.

So thanks very much.

And thank you, ladies and gentlemen.

This concludes today's conference call.

Thank you for your participation.

You may now disconnect.