Description

Investment Thesis: Ability to buy the leading player in a growing, consolidated industry at less than 10x unlevered, after-tax FCF. It can be bought at around the same price it came public at ~4 years ago. The opportunity exists because the business’ free cash flow generation is lumpy from year to year; the accounting obfuscates the cash earnings power of the business; and new management has recently taken over to clean up the operational mess and communication issues of the prior CEO and CFO.

Overview: Houghton Mifflin Harcourt (HMHC) derives a majority of its revenue and profit from its Education segment, which primarily provides education solutions to educational institutions for the pre-K – 12 market, and which is expected to grow at a 2-3% CAGR (~2% from price/mix and 0.6% from population growth) over the foreseeable future. It is one of the leading players with approximately 40% market share. It has a few key competitors including Pearson and McGraw-Hill Education. The business competes primarily on the quality of content as opposed to price.

Why Opportunity Exists: HMHC is an orphan stock. It operates in a niche business with little sell-side coverage by analysts from various sectors who have a difficult time properly valuing the company.

Additionally, the business is cyclical for two main reasons. For one, as it stands today, the industry’s sales are greatly affected by state and local tax receipts predominantly driven by property taxes and therefore home prices. A period like we have had over the past eight years post the great financial crisis has affected the amount schools have available to spend on educational materials. Second, because the average contract length is seven years, this results in certain years being stronger than others depending on when large state contracts such as California, Texas and Florida are up for renewal.

While the analytically correct way to value this business would be to look at average annual free cash flow over a seven-year cycle, most analysts fail to do this and place way too much emphasis on quarterly or annual results for the most recent period. Therefore, there can be easy or difficult comparisons in any given year, which can affect short-term movement in the stock price.

Lastly, as the education solutions business has increasingly transitioned from a pure print business to one with a large digital component, what used to be straight forward accounting in the print-only era now has “messy” accounting as it relates to its digital sales. Digital sales are deferred and amortized over the contract life, which on average is seven years. While all expenses are recognized upfront, sales are not. This likely understates economic earnings because a majority of the cash for print and digital materials schools pay is received upfront by HMHC. As a result, in the most recent years the company appears to have lost money or make very little, which is in stark contrast to its robust free cash flow generating ability. As a result, it may be many years before HMHC gets to a steady state print/digital mix that keeps deferred revenue from increasing meaningfully. As a result, HMHC is unlikely to screen cheaply on a reported earnings basis until at least the end of the decade (assuming the stock price were to remain around current levels). 

How Business Works:

• The business is seasonal with ~40% of the company’s revenue coming in Q3

• Most of the contracts and adoptions are on a 7-year cycle 

• The company has approximately 3,000 employees, of which 650 are sales reps

• Approximately 60% of costs are typically fixed

• Approximately 87% of funding for public education comes from state and local budgets

• There are generally two distinct purchase categories for K-12 materials in the U.S.; adoption states and open territories. 

• Adoption states:  the state government screens educational materials for eligibility to receive state funds and limits the market to certain approved textbooks. The state also determines the timing of purchases for each subject matter. Materials are usually refreshed on a 7-year cycle. The states provide funding to the local school districts.

• Only 20 of the 50 states are adoption states, but they account for approximately half of K-12 enrollment and half of materials purchases. The three largest states in terms of students are California, Texas and Florida, with 29% of total enrollment, which are all adoption states. Texas recently went to an 8-year adoption cycle.
• Open territory states: the content and timing of purchase decisions is left to the local level even though a portion of the budget is usually provided by the state. Materials are usually refreshed on a 5-10 year cycle with an average of 7 years.

Company History: Houghton Mifflin (“Houghton” or “HMHC”) was publicly traded from 1967 to 2001, but was bought by Vivendi in 2001 for $2.1 billion, including assumed debt. Vivendi, facing increasing financial and legal pressure, sold Houghton the next year to a group of private equity investors including Thomas H. Lee Partners, Bain Capital and Blackstone for $1.66 billion, or 25% less than they paid for it the year before.

The private equity group turned around and sold Houghton to an Irish educational software firm called Riverdeep Holdings in 2006 for a total enterprise value of $3.4 billion.

An Irish investor named Barry O’Callaghan who owned 40% of the stock ran Riverdeep. In 2007, he had Houghton Mifflin buy Reed Elsevier’s Harcourt Education division for $4.0 billion ($3.7 billion in cash and $300 million in Riverdeep stock). By the end of 2008, the company had nearly $7 billion of total debt and total debt/EBITDA stood at ~9x.

The downturn hit the education business hard as municipalities began to postpone their spending on new textbooks. That year Reed Elsevier wrote down their $300 million stake in Riverdeep to $20 million.  O’Callaghan tried to sell Houghton.

Between a 48% decline in its end markets over the prior four years and the ongoing debt service obligations of the remaining leverage, the company’s finances became unsustainable with their debt/EBITDA standing at 15x. The company filed for Chapter 11 bankruptcy protection in May 2012. 

During bankruptcy, the company reduced its debt load from $3 billion to $250 million and emerged about a month later. They also reduced head count by 690 (or 18% of total) and reduced SG&A by $136 million (or 21% of total). The company went public on Nov-13-2013 at $12. All of the proceeds went to selling shareholders.

The company hired former Microsoft executive, Linda Zecher, to become CEO. She made it a key focus of trying to build a direct-to-consumer pre-K - 12 business in a very crowded, hard to differentiate market.  As a result, HMHC spent unwisely in trying to ramp up its consumer education business and missed the basic blocking and tackling within its core education business such as not having the best Reading product in California last year. Meanwhile its expenses rose meaningfully with little consumer based revenue to show for it. This led to HMHC losing market share to McGraw Hill over the past few years, poor financial results and ultimately Zecher’s ouster towards the end of 2016.

On 2/15/17, John (Jack) Lynch, Jr. was named as the company’s president and CEO. Most recently, Lynch was the CEO of Renaissance Learning, a leader in K-12 learning analytics, owned by Hellman & Friedman and Google Capital. The board chose Lynch due to his experience in the technology/digital side since successfully integrating that with traditional print is an increasingly large part of the future of education in America.

Realistic, Near-term Opportunities: As education content has an increasing mix shift away from print towards digital, this should provide the business a few key benefits. First, it limits the ability of schools to delay their content purchases once a contract expires, as the school will lose access to that content. Second, because digital content has a lot more interactive features, the perception is that the content is more valuable and therefore HMHC is able to charge more for its content and increase revenue per student. Third, while the upfront costs to produce digital content are higher than print, the cost of goods sold to deliver that content on an ongoing basis is less, which improves gross margin. Every 10% mix shift in print to digital sales improves gross margin by 150-200 bps.

Capital Allocation: A little over two years ago, under prior management, HMHC purchased Scholastic Corp.’s (NASDAQ: SCHL) EdTech business for $575 million in cash. Including the midpoint of the expense synergy guidance range of $10-20 million, HMHC paid ~10x after-tax free cash flow (since it is not a taxpayer). The rest of HMHC’s free cash flow was used by the prior management team to buy its stock back at much higher prices.

Valuation: Looking at HMHC’s unlevered, after-tax free cash flow generation from 2009 through 2015 (i.e. a 7-year cycle prior to 2016, which had a bloated cost structure from the consumer business ramp up), the company generated nearly $1.1 billion in normalized free cash flow. This cash flow generation takes operating cash flow, adds back cash interest expense, taxes, severance, restructuring and other charges and then deducts stock-based compensation, net capex and purchase of intangible assets. Essentially, HMHC’s free cash flow can be thought of as EBIT since cash interest was added back while at the same time HMHC was not much of a cash taxpayer during this period due to its high debt load and associated interest expense.

Thus average “cash EBIT” over this 7-year period was $153.3M. However, except for the last two quarters of 2015, this 7-year period did not include the earnings benefit from HMHC’s acquisition of Ed Tech, which does $55M-$60M in average EBIT including expense synergies. Therefore, for a rough number, the core education business (pro forma for Ed Tech) generated average operating income of $210M over the prior 7-year cycle.

The company has figured out how to reduce certain core expenses such as pre-publication expenses. The company reengineered its workflow. It used to develop print and digital separately, but now they have combined those teams to develop products simultaneously. Management claims these expenses have come down over $20M over the past few years, but it is difficult to see that with the Ed Tech acquisition now in the mix. As a result, the assumption is these costs are sustainably lower by $20M for the next 7-year cycle compared to the prior one.

HMHC has guided to a cost savings program of $70-$80M (compared to the company’s cost base in 2016, which was bloated in large part due to the consumer business ramp up) to be realized on a run-rate basis exiting 2018. In addition to that, Lynch has said there are various other opportunities for the company to be more efficient in the way it manages its business, but has not laid out specifics or given a range of savings.

At the same time, there should be a gross margin lift from the increasing print to digital mix. Using 300 bps lift on $1.3 billion in direct education billings (excluding the Ed Tech business) over the next few years would add ~$40M in EBIT. All together this equates to ~$230M in average “cash EBIT” from the prior 7-year cycle, which was depressed given the poor tax receipt collection by state and local government as a result of depressed home prices from 2009-2015. Over the next 7-year cycle, with the expected gross margin lift from a greater digital mix and end market growth getting back closer to a normalized spending environment, operating income for the education segment should average ~$285M.

HMHC will not be a cash taxpayer at least through the end of the decade and has ~$4 per share in tax shield present value. Given its business is 93.6% U.S. and has a normalized tax rate pushing 40%, should there be any future tax reform that lowers the U.S. corporate tax rate, HMHC would likely benefit greatly.

Using a sum-of-the-parts valuation, I get to ~$21.00/share over the next 2-3 years or upside of ~75%, which assumes no corporate tax reform.

Education: 8.0 x ~$340M of EBITDA = ~$22.00/share (implied multiple based on Apollo’s purchase of McGraw Hill Education in March, 2013; higher multiple assigned to K-12 business given its stability and growth whereas a lower multiple is used for the Higher Education business since it has been declining and faces a more difficult and uncertain future)

Trade Publishing: 9.0 x ~$15M of EBITDA = ~$1.00/share (based on comps of SCHL & JW.A)

Tax Shield: ~$4.00/share

Net Debt: (~$5.65/share)

Management: Prior to becoming CEO of HMHC, Lynch was CEO of Renaissance Learning, a leader in K-12 learning analytics. In his time at Renaissance Learning, he led the company through a transformation that resulted in a period of innovation and rapid growth. With over 25 years of management experience in the software and information industry, Lynch is highly respected in the field of education technology. He has been active in the K-12 education industry since 1999 and was the founding CEO of bigchalk.com, where he created an education network serving 40,000 schools. He was later president and CEO of the Pearson Technology Group. Prior to joining Renaissance Learning, Lynch was a member of the executive board of Wolters Kluwer.  

Joseph Abbott, HMHC’s CFO, comes from Morgan Stanley where he was an investment banker in the Global Media and Communications group. He led the firm's advisory of clients in the education content and information sector and has strategic, financial and investor relations expertise. Thus far, he has led the charge on cost savings opportunities.

Potential Catalysts:

Given private equity’s prior history of owning this company, it would not be surprising to see a private equity bid for HMHC. The ingredients are there to make it work—a depressed valuation, stable/growing business, consolidated industry and cheap capital. A PE firm could take it private now, execute on the cost savings plan and milk the cash flow over the next 5-7 years. Additionally, it could potentially sell off the Trade Publishing business to a strategic buyer, continue to invest in the technology/digital side of its education business and then take the company public once reported earnings more closely matches free cash flow (i.e. when there is a more stabilized print/digital mix).

One can look at the success Apollo has had with McGraw Hill Education (financials are public) since taking it private on 3/23/13 for $2.56 billion for which Apollo put up $950 million of equity. It paid 1.3x LTM billings, 6.2x adjusted EBITDA and 6.5x adj. EBITDA-capex. Since taking it private ~4.5 years ago, Apollo has been able to take on increasing debt and cash out nearly its entire equity by paying itself approximately $900M in dividends over the past few years. Net debt now stands at $1.945 billion or 5.1x adj. EBITDA – capex.

The results within its K-12 education segment are impressive. In 2012, McGraw Hill’s K-12 business had adjusted EBITDA of $56.6M and in 2016 it had adj. EBITDA of $136.7M (on $758.5M of billings)—an increase of 141.6% over 4 years. In 2016, the K-12 segment’s adjusted EBITDA margin was 18.0% margin compared to 16.1% in 2014. From 2014 to 2016, adjusted EBITDA grew 15.7% on a billings increase of 3.3%.

The bottom line is that one can see what kind of improvement is possible to the K-12 business when the right kind of disciplined owner manages this business. For example, on average over the past few years, McGraw has spent approximately $92M in pre-publication expenses and $30M in capital expenditures for the entire company (including other businesses such as higher education, international and professional), which has consistently generated ~$2.0 billion in billings over the past few years. Said another way, McGraw’s combined spend on pre-pub expenses and capex amount to 6.6% of billings on average over the past few years. Capex as a percentage of adj. EBITDA (which already includes pre-pub expenses) is 8.7%.

Comparing HMHC’s numbers to McGraw helps explain why there are likely at least $70-$80M of expenses that can be removed from the business. Over the past few years, HMHC spent on average ~$115M in pre-publication expenses and ~$85M in capex against average billings of ~$1.5 billion. As a percentage of billings, HMHC’s combined spend on pre-pub expenses and capex were double that of McGraw Hill’s or 13.2% of billings.

McGraw’s healthy margin expansion since going private is thanks in part to the growth of its digital billings in the K-12 market increasing to a 43% mix in 1H’17 from 36% in 1H’15. HMHC has the same opportunity to grow this mix and help expand its margins. This will be a key focus of Lynch’s by ensuring HMHC’s technology platform is robust.

While McGraw’s K-12 billings have been flat YTD in 2017, the company estimates the total Adoption & Open Territory K-12 market in 2019 will be approximately 22% larger compared to 2016, which bodes well for McGraw-Hill Education and HMHC—two of the largest players in the K-12 market.

Risks: The main risk to its core education business is increased competition from “open-sourced content” or a movement called Open Education Resources (OER). OER are teaching, learning, and research resources that reside in the public domain or have been released under an intellectual property license that permits their free use and repurposing by others. Open educational resources include full courses, course materials, modules, textbooks, streaming videos, tests, software, and any other tools, materials, or techniques used to support access to knowledge. Utah, Florida and Washington have initiatives to produce and disseminate open-source K-12 textbooks. The privately funded CK-12 foundation, established in 2007 with the mission to reduce the cost and increase access to K-12 educational materials, currently publishes K-12 OER aligned with state curricula standards. CK-12’s resources are currently used in 38,000 schools in the U.S. and they are free. Here is a link to the CK-12 website: http://www.ck12.org/student/.

I believe this is more of a risk within private schools where only 10% of all U.S. students reside. Most states and local districts want their public schools to have approved, standardized educational materials for teachers to use. This way all kids within a particular region receive relatively equal tools for their education and at the same time teachers and schools can be judged accordingly. This removes an additional variable in the analytical equation.

For example, in adoption states like California, if a public elementary school wants to use non-approved educational materials, it will not receive state funding for such purchases. This was case in point at our local elementary school (which resides within a wealthy urban area) with its recent purchases of common core materials despite parental pushback. This from a school that is able to raise $600,000 in annual donations from parents for arts and music programs as well as additional teacher aids. If a school like this is not willing to forgo funding from the state, I highly doubt many public schools throughout the U.S. will unless funding rules change. Moreover, when it comes to state and local government bureaucracy, it is something you can almost certainly bet on not getting much better over time. 

Important Disclosure

The provision of this report does not constitute a recommendation to buy or sell the security discussed herein.  The report is an example of the author’s company write-ups / research process; its breadth and coverage may differ materially from other such reports.  Certain statements reflect the opinions of the author as of the date written, are forward-looking and/or based on current expectations, projections, and/or information currently available.  The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term.  The views are those of the author acting in his individual capacity and not as a representative of any firm; in no way does this report constitute investment advice on behalf of any firm.

Catalyst

Better execution due to operational changes new management is making over the next couple of years, which include lowering its cost structure to be more in-line with its closest competitors.

Private equity could offer to buy out the company at a significant premium to where the stock currently trades at and still earn a very good return on its investment.