From the Chief Financial Officer
The School’s economic model proved its strength in fiscal 2015. Harvard Business Publishing (HBP) and Executive Education contended with a unique set of short-term revenue challenges, and Harvard Business School (HBS) as a whole continued to experience pressures on fixed costs. Nonetheless, total revenue exceeded our forecast, cash flow increased from fiscal 2014, and HBS ended the year with a larger unrestricted reserves balance than initially anticipated.
Looking ahead, our outlook for fiscal 2016 is buoyed by the School’s strong results this past year, but tempered by a fact that informs our financial planning. The School has been consistently successful in fueling innovation in teaching and knowledge creation and in enhancing the residential learning experience. This, in turn, has enlarged the scale and scope of activity at HBS, expanding the operational footprint and increasing fixed costs, making it more challenging to generate a healthy operating surplus each year.
Our revenue/cost challenge comes in two flavors. First, activities that enrich the HBS student experience typically lead to incremental expenses that do not have an associated revenue stream. For instance, FIELD is now core to MBA education at HBS, and field-method learning adds about $10 million of incremental annual expenses—only a small portion of which is recovered by MBA tuition and fees. In addition, the School is committed to consistently increasing student financial assistance from year to year, independent of income received from endowed fellowship funds.
Second, the School continually makes strategic investments with an eye toward fulfilling the HBS mission over the long term. For example, HBP spends today to build the technology platforms necessary to deliver competitive products in the future. The School is investing in HBX—the digital learning initiative—to develop that emerging educational platform. In Executive Education, ensuring that HBS continues to deliver a transformational experience requires not just outstanding faculty, but also steady investments in facilities and information technology (I.T.).
Although the objective for investments such as these is to generate revenue and operating income, this cycle can take years to complete. As a result, our financial plan for the second half of the decade anticipates greater pressure on the School’s operating margins as the fixed costs associated with its strategic initiatives continue to increase.
One of our financial planning goals is for HBS to serve as a living model of a well-run organization—consistent with the skills, tools, and frameworks taught across the School’s educational programs each year. Achieving this goal starts with transparency. To that end, the School’s fiscal 2015 financial results are reported in detail in the Supplemental Financial Information section.
The balance of this letter is aimed at reporting on the School’s financial performance in the context of the dynamics outlined above. I will start by reviewing the fiscal 2015 operational and financial highlights as they pertain to the HBS economic model. The letter will continue with some thoughts on our strategic financial challenges. It will conclude with our financial forecast for 2016, as well as our longer-term outlook.
Fiscal 2015 in Review
Turning first to HBP, we anticipated that fiscal 2015 would be a year of slower top-line growth. This forecast reflected a new approach to revenue recognition for Harvard ManageMentor, the Corporate Learning Group’s flagship product, because of its shift from packaged software to a subscription service model. Despite this accounting transition, HBP’s revenues grew more than 4 percent in fiscal 2015, exceeding our forecast for the sixth consecutive year. HBP outperformed our expectations for expense management as well, and the group’s margin contribution was higher than initially planned.
Executive Education faced residence and dining capacity constraints in fiscal 2015. The group successfully managed these challenges and delivered stronger-than-anticipated 5 percent revenue growth, year-over-year. This also was a successful year for Executive Education from a cost perspective. Overall operating expenses were down substantially from fiscal 2014, resulting in strong sales growth leverage. As a result, the group’s margin contribution was up substantially year-over-year, also exceeding our forecast.
In addition to earned income from its competitive business units, the School’s economic model relies on two philanthropic revenue streams: distribution from the endowment and current use gifts. The endowment distribution and current use gifts represented 18 percent and 9 percent, respectively, of the School’s total revenue in fiscal 2015. The School’s distribution of income from the endowment in fiscal 2015, as well as the endowment’s investment performance, is discussed in detail in the Supplemental Financial Information section.
It was a solid year for giving as part of The Harvard Business School Campaign. Reflecting strong support across the HBS community, the Campaign raised more than $850 million in new gifts and pledges by the fiscal year-end. About 50 percent of this giving consisted of unrestricted and restricted current use gifts intended to support near-term priorities. The balance was intended to sustain the School’s core operations over the long term by creating new endowment accounts, and to support major capital projects.
Together with endowment gifts and gifts for capital projects, current use giving is vital to the School’s economic model. Driven by the HBS community’s generosity, recent restricted and unrestricted current use giving to HBS has been nothing short of extraordinary—growing from a total of $26 million five years ago to $63 million in fiscal 2015.
Fellowship Spending
IN MILLIONS | FY 15 | FY 14 | FY 13 | FY 12 | FY 11 |
---|---|---|---|---|---|
MBA | $ 33 | 31 | 29 | 27 | 26 |
Total (includes Doctoral Programs & Executive Education) | $ 44 | 43 | 40 | 37 | 36 |
Investment in Research
IN MILLIONS | ||||
FY 15 | FY 14 | FY 13 | FY 12 | FY 11 |
---|---|---|---|---|
$ 123 | 117 | 110 | 109 | 97 |
Unrestricted current use giving is particularly crucial because it functions as a flexible source of seed money to launch the kinds of visionary efforts, such as FIELD and the i-lab in prior years and HBX more recently, which have long driven innovation in teaching and learning at the School. Fiscal 2015 was a strong year for unrestricted current use giving to HBS. Including Campaign giving as well as reunion and annual giving, revenue from unrestricted current use gifts in fiscal 2015 grew by $8 million, or 29 percent, from the prior year to a record $36 million.
Income from gifts also provides crucial support for development of the HBS campus. Approximately $160 million of fiscal 2015 giving to the School was earmarked for capital projects. The School’s investments in building renewal and maintenance, infrastructure and I.T. upgrades, and construction of new facilities are based on a comprehensive master plan for preserving and enhancing the campus over the long term.
In fiscal 2015 and for the prior three years, this master plan has focused on expanding Executive Education space in the northeast section of the campus. These new and newly renovated buildings were designed to increase and enhance the quality of the living, dining, and educational capacity available on campus in a highly competitive arena.
Fiscal 2015 also marked the first of several years of investment in Klarman Hall, a new facility adjacent to the Spangler Center. Scheduled for opening in fiscal 2018, Klarman Hall has been designed to leverage the School’s convening power by accommodating the hundreds of diverse events hosted by HBS each year.
In addition, the School continued to invest in energy efficiency measures to meet the University’s ambitious greenhouse gas emissions goals. Demonstrating the impact of these measures to date, the School’s fiscal 2015 energy consumption and greenhouse gas emissions were the lowest ever recorded, despite extremely cold weather this past winter.
Restricted current use giving is also important to the economic viability of HBS. Revenue from this source is now included in the School’s Income Statement, where it is reported as declining to $27 million in fiscal 2015, from $37 million a year earlier. Reporting restricted current use giving as a separate line item is the most notable outcome of our move to full Generally Accepted Accounting Principles (GAAP) reporting during the year, along with the first-ever inclusion of depreciation expense, which was approximately flat year-over-year at $34 million.
The University has asked all the Harvard schools to report their results on a GAAP basis in pursuit of greater comparability across the schools. In addition to results for fiscal 2015, this year’s HBS Statement of Activity and Cash Flows reports results for fiscal years 2013 and 2014 that have been restated in accordance with GAAP.
Our prior accounting approach provided a useful lens through which to view the School’s operations and assess its financial condition. Compared with GAAP reporting, it placed greater emphasis on changes in cash generated by the business. Our prior approach, however, did not mirror the University’s practice of including depreciation as a line item on its income statement. Depreciation can be considered a proxy for the ongoing campus investment necessary to prevent the deferred maintenance problem experienced by a great many universities. We believe that including depreciation in the School’s financial results will add healthy discipline to our future financial planning.
This discipline served the School well in fiscal 2015. Given the anticipated constraints on revenue, continued strategic investment, and growing expenses, our financial forecast assumed that internally generated cash flow would be modest at best. The School’s actual financial results were stronger than we expected, primarily driven by healthy contribution margins from HBP and Executive Education, as well as growth in income from alumni giving to the School.
The resulting incremental cash flow from operations enabled HBS to continue to fund its core educational programs, drive innovation in teaching and research, and invest in strategic opportunities, while still concluding fiscal 2015 with a stronger-than-expected balance of unrestricted reserves. These reserves are crucial in providing the School with sufficient liquidity to execute on its mission and sustain the campus through economic cycles over the long term.
Strategic Financial Challenges
Looking ahead to fiscal 2016 and future years, our key financial objective is to support the higher fixed costs we anticipate related to the MBA curriculum and HBX, ongoing investments in I.T. and campus renewal and maintenance, and continued innovation. We will be operating in as lean a manner as possible—asking the organization to make tradeoffs when necessary and instilling greater discipline in the School’s budgeting processes. For example, in fiscal 2015 we strengthened the School’s I.T. expense governance, capping spending in certain areas and prioritizing projects based on their alignment with strategic goals.
Although these efforts will sound familiar to anyone running a for-profit business, certain nuances make expense management somewhat different at HBS and in higher education, generally. The concept of productivity, for instance, does not strictly apply to an enterprise like HBS that strives to provide faculty members with robust support for their research. In a similar vein, the School’s space and occupancy expenses are not considered “overhead,” but rather costs that are inherent in creating a physical environment that enhances the residential learning experience.
In addition, the HBS learning model is inherently more expensive than programs that rely largely on lectures, and MBA education remains at the top of the School’s investment priority list. For example, complementing the case method with field-method teaching in the elective curriculum will require significant new resources. Future MBA curriculum innovation beyond FIELD likely will lead to additional costs. Rather than being borne by students, funding for these new MBA program expenses will have to come primarily from gifts to the School.
Readers of this report will note that, for the first time, our fiscal 2015 income statement includes HBX, along with Executive Education and HBP, as one of the School’s revenue- generating groups. HBX is modeled on the School’s core principle of participant-centered MBA education. But unlike the MBA program, HBX is envisioned by the School as an initiative that will evolve into a self-sustaining and surplus-generating activity. This will take some time, however. HBX generated $5 million in revenue on expenses of $16 million in fiscal 2015, resulting in an operating deficit of $11 million. Looking ahead to fiscal 2016, we are anticipating higher expenses as well as increased revenue, meaning that HBX is not expected to contribute positive operating margin in the near term.
Publishing Revenue
IN MILLIONS | ||||
FY 15 | FY 14 | FY 13 | FY 12 | FY 11 |
---|---|---|---|---|
$ 203 | 194 | 180 | 165 | 152 |
Executive Education Revenue
IN MILLIONS | ||||
FY 15 | FY 14 | FY 13 | FY 12 | FY 11 |
---|---|---|---|---|
$ 168 | 163 | 146 | 142 | 132 |
I.T. Investment
IN MILLIONS | ||||
FY 15 | FY 14 | FY 13 | FY 12 | FY 11 |
---|---|---|---|---|
$ 80 | 79 | 68 | 54 | 50 |
The HBS I.T. infrastructure is becoming increasingly fundamental to every aspect of the School’s work and activities. New technology applications, for example, were instrumental in the rollout of FIELD in the MBA program. Computer-based modeling and simulation are used extensively in both MBA and Executive Education. The School must invest, as well, in the back-of-house platforms that support teaching and learning—programs that facilitate everything from admissions to housing to course delivery.
As a result, the School’s I.T. investments, including both operating and capital expenses, have grown at a compound annual rate of nearly 15 percent over the past five years—from $40 million in fiscal 2010 to $80 million in fiscal 2015. I.T. spending represented 10.8 percent of the School’s total operating expenses in fiscal 2015, compared with 8.2 percent on a smaller expense base five years earlier. Consequently, I.T. is front and center as we work to exert more control over the School’s total expense growth rate going forward.
The School also faces incremental permanent expenses related to campus expansion. HBS plans to invest more than $400 million in the campus during the next five years. This investment will enhance the School’s physical infrastructure in line with its evolving educational and strategic objectives. Expansion of the campus footprint will also give rise to increased costs related to space and occupancy, depreciation, and facilities renewal and maintenance.
Fiscal 2016 Outlook
Looking at the School’s recent financial results in light of these dynamics, HBS has been remarkably successful in maintaining a balance of unrestricted reserves for investing in innovation while accommodating campus expansion, and providing for long-term financial security and flexibility. Our challenge is to extend this record of success into fiscal 2016 and future years.
This will involve adjusting spending as necessary in light of trends in the global economy. It will also require further growth in unrestricted current use giving, as well as endowment giving for timeless activities such as professorships, fellowships, FIELD, and cross-disciplinary global research.
With that as background, let me provide a brief look at our near-term financial expectations. For planning purposes, we have assumed that global economic conditions— and therefore academic and higher education market trends—will generally mirror those experienced in fiscal 2015. This assumption underlies our forecast of total year-over-year revenue growth of 4 percent in fiscal 2016.
The School’s revenue from MBA tuition and fees is projected to increase at about the same rate. This will be partially offset by a 9 percent increase in financial aid, primarily earmarked for MBA fellowships. At HBP, revenue for fiscal 2016 is forecasted to grow in the range of 2 to 3 percent, as the impacts of the revenue recognition accounting transition begin to diminish. Executive Education revenue is expected to increase 1 percent from fiscal 2015, reflecting the capacity constraints mentioned previously.
The University has advised the School that its fiscal 2016 endowment payout will grow 6 percent from fiscal 2015. With this anticipated payout, as well as income from new gifts to the endowment, we expect the School’s total endowment distribution revenue for fiscal 2016 to increase nearly 9 percent from fiscal 2015. Anticipating continued strong Campaign results, we are forecasting approximately the same level of total current use giving as in fiscal 2015.
Capital Investment
IN MILLIONS | ||||
FY 15 | FY 14 | FY 13 | FY 12 | FY 11 |
---|---|---|---|---|
$ 81 | 92 | 80 | 51 | 34 |
Building Debt Outstanding
IN MILLIONS | ||||
FY 15 | FY 14 | FY 13 | FY 12 | FY 11 |
---|---|---|---|---|
$ 78 | 85 | 91 | 99 | 103 |
Moving down the Income Statement, we remain committed to rigorous expense control in fiscal 2016 for the reasons outlined above. The School’s revenues have grown at a compound annual rate of 8 percent over the past five years, while expenses have risen 8.7 percent. As a result, operating margin declined from 9.6 percent in fiscal 2010 to 6.6 percent this past year. We have made it a priority to reverse this trend over the long term. Although our fiscal 2016 financial plan assumes a 9 percent increase in total operating expenses, we are working diligently to bring in a lower actual number.
Nearly 50 percent of the School’s expense base relates to compensation for faculty and administrative staff. Reflecting salary increases and benefits costs, the School’s fiscal 2016 financial plan assumes a 7 percent increase year-over-year in total compensation expense. Collectively, the School’s other line item expenses are expected to increase 11 percent from fiscal 2015, in large part driven by growth-focused investments in Executive Education, HBP, and HBX.
The School’s total capital budget for fiscal 2016 is $96 million—up more than 18 percent from the $81 million invested in fiscal 2015. In addition to ongoing Ruth Mulan Chu Chao Center and Klarman Hall construction, this budget reflects a second consecutive year of significantly increased capital investment in smaller renewal, upgrade, and energy efficiency projects across the campus. These projects are designed to prevent deferred maintenance and to preserve the value of the campus for future generations.
Over the past several years, the School has made good progress on its strategic objectives while continuing to generate a healthy operating surplus. Our highest priority is to extend this record in fiscal 2016. We are keeping a watchful eye on the economic trends, and our financial plan and reserves balance provide the flexibility necessary to adjust to changing conditions while continuing to invest in mission-driven innovation and campus development.
We remain committed to thoughtful stewardship of the School’s resources in the year ahead.
– Richard Melnick, MBA 1992 Chief Financial Officer 01 OCT 2015