Graham Holdings Company — Q3 2018 Form 10-Q
Reporting period: Three and nine months ended September 30, 2018; financial statements are unaudited. Graham is a diversified education and media company, with additional healthcare, manufacturing and other businesses. Amounts below are in U.S. dollars unless noted.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Revenue | $674.8 million | $657.2 million | $2,006.9 million | $1,916.0 million |
| Operating income | $60.7 million | $27.0 million | $170.6 million | $86.9 million |
| Net income attributable to Graham common stockholders | $125.1 million | $24.8 million | $214.5 million | $87.9 million |
| Diluted earnings per share | $23.28 | $4.42 | $39.54 | $15.64 |
| Operating margin | 9.0% | 4.1% | 8.5% | 4.5% |
Revenue increased 3% in Q3 and 5% year to date. Operating income improved substantially, while reported net income also reflected significant investment gains and a tax benefit. Q3 included a $45.0 million net gain on marketable equity securities and a $17.8 million deferred state tax benefit from releasing valuation allowances. The nine-month securities gain was $28.3 million. Excluding the $17.8 million state tax benefit and $1.8 million stock-compensation tax benefit, management reported a 23.3% effective tax rate for the first nine months; the reported rate was 15.6%.
- Education: Q3 revenue fell 5% to $358.6 million, while operating income rose 61% to $22.3 million. Nine-month revenue declined 3% to $1,104.1 million and operating income increased 46% to $82.5 million.
- Television broadcasting: Q3 revenue rose 28% to $130.0 million and operating income rose to $55.5 million, aided by political advertising and retransmission fees. Nine-month revenue increased 18% to $352.9 million and operating income rose 37% to $137.1 million.
- Healthcare: Q3 revenue declined 12% to $35.5 million; the segment recorded an $8.7 million operating loss, including a $7.9 million impairment of the Celtic trade name. Nine-month operating loss was $9.3 million.
- Other businesses: Q3 revenue rose 9% to $150.7 million and operating income was $4.6 million, versus a $7.0 million loss. SocialCode's results included a $7.5 million credit related to phantom equity plans. Manufacturing operating income weakened in Q3, partly due to lower wood prices affecting Hoover inventory values.
Operating cash flow was $191.9 million for the first nine months, down from $220.9 million. The filing attributes the decline to lower customer cash receipts and increased prepayments. Investing activities used $151.3 million and financing activities used $167.2 million. Cash capital expenditures were $58.9 million; management separately reported $57.8 million of capital expenditures on its stated basis.
Financial position and liquidity
- At September 30, 2018, cash and cash equivalents were $265.2 million, restricted cash was $11.6 million, and marketable equity securities and other investments totaled $517.9 million. Management reported combined cash, restricted cash and investments of $794.7 million.
- Total debt was $479.6 million, compared with $493.3 million at December 31, 2017. The company refinanced $400 million of 7.25% notes due in 2019 with $400 million of 5.75% unsecured notes due in 2026, incurring $11.4 million of extinguishment costs. Its $300 million revolving credit facility matures in May 2023. The company reported compliance with its financial covenants.
- Working capital was $731.7 million, down from $857.2 million at year-end. Management said it expects to meet cash needs over the next 12 months using existing cash and internally generated funds. Approximately $165 million of cash and cash equivalents was held outside the U.S.; the company considers a significant portion of overseas cash not readily available for U.S. operations.
- Net cash decreased by $130.8 million during the first nine months. Cash uses included $110.8 million of Class B share repurchases, $21.6 million of dividends and $16.5 million to purchase a noncontrolling interest. The company had 286,025 shares remaining under its repurchase authorization at September 30.
Material changes and management commentary
- Kaplan transferred the institutional assets and operations of Kaplan University to a Purdue-affiliated nonprofit on March 22, 2018. Kaplan retained a long-term support-services agreement with Purdue University Global. The transfer contributed to lower reported Higher Education revenue; the company recognized service-fee revenue subject to its assessment of collectability and the agreement’s payment waterfall.
- Graham reorganized its education reporting segments following the transaction. It also adopted new revenue-recognition guidance, recording a $7.4 million increase to opening retained earnings, and adopted guidance requiring fair-value changes in marketable equity securities to be recognized in net income. Adoption of the latter guidance moved $194.9 million of after-tax unrealized gains from accumulated other comprehensive income to retained earnings.
- Eight businesses were acquired during the first nine months for $120.9 million in cash and contingent consideration. Management expects 2018 capital expenditures of $95 million to $105 million, including a U.K. academic and residential facility and television spectrum-repacking costs, which are expected to be largely reimbursed by the FCC.
- Management cited stronger television and manufacturing revenue as offsets to weaker education revenue. Education results benefited from improved Kaplan International, test-preparation and Higher Education operating results, while enrollment declines and the Kaplan University transfer weighed on education revenue. No consolidated earnings guidance was provided.
Risks, contingencies and unusual items
- Management said reasonably possible future losses from existing and threatened legal, regulatory and other proceedings could exceed recorded amounts by approximately $45 million. It does not expect currently known proceedings to have a material effect, based on information available.
- Kaplan is appealing U.K. VAT assessments of £15.4 million already paid and recorded as a receivable; an adverse outcome would result in a pre-tax operating expense. Separate proposed U.K. VAT guidance could add an estimated £4.5 million of annual expense to the Pathways business if enacted and if Kaplan cannot preserve an exemption.
- Graham is secondarily liable on transferred leases totaling approximately $16.3 million through 2024 following the sale of its KHE Campuses business. The buyer, Education Corporation of America, entered receivership proceedings in October 2018; Graham could become primarily liable if the buyer’s reorganization fails.
- Education Department program reviews remain open, including a review of Kaplan University. The company does not expect a material impact but cannot predict the reviews’ outcomes. Kaplan retains responsibility for certain liabilities from reviews open when campuses were sold.
- The Purdue University Global agreement makes Kaplan’s support-cost reimbursement and fee dependent on available university cash and contract priorities. Kaplan advanced $20 million toward Purdue Global’s first two annual priority payments and may be required to advance additional amounts if specified revenues are insufficient.
- Q3 and nine-month results include volatile investment gains, a discrete tax benefit, impairment charges and debt-extinguishment costs. Television political advertising benefited from the 2018 election cycle; the filing does not provide an outlook for the persistence of these results.
Important facts for investors to verify
- How much of reported earnings growth is attributable to recurring operating performance versus marketable-securities gains and the valuation-allowance tax benefit.
- Future service-fee collections, cash advances and other payment outcomes under the Purdue University Global agreement.
- The resolution and potential financial effect of the U.K. VAT assessments and proposed guidance, ECA’s lease obligations, and open Education Department reviews.
- Whether television advertising, retransmission revenue and manufacturing margins remain at recent levels, and how education enrollment and healthcare performance develop.
- Cash availability by geography, capital expenditure requirements, and continued compliance with debt covenants.