Description

Introduction: Houghton Mifflin Harcourt Co (HMHC) has had a long, hard road since its May 2015 investor day, where the prior mgmt team published highly bullish 5-year projections that they proceeded to miss quarter after quarter.  While there have been industry challenges that contributed to HMHC’s decline, most of it was self-induced by the prior management team. For the first time in years, the prospects for HMHC look favorable, at a time when the stock is washed-out and at all-time lows.  Holders are giving up on HMHC right when things are poised to turn in the Company’s favor. Given the long lead-time of major K-12 adoptions, it takes 18-24 months to ‘right the ship’ that a prior mgmt team has led off-course. The new mgmt team’s efforts are now bearing tangible results, just in time for a major upturn in the adoption cycle.  The new adoption market will double in 2019 versus 2018, and marks the beginning of a rebound in the cycle, following the 2017/18 trough. HMHC will conservatively generate well over $1/share of FCF in each of 2019 and 2020, implying >20% FCF yield and <5.5x EBITDA multiple.

Recent History: The prior management team did an extremely poor job setting expectations, managing investor relations/education, and most importantly, executing HMHC’s core operations.  Linda Zecher, who came from MSFT, placed too much focus on adjacent markets, to the detriment of HMHC’s core basal product. While she was focused on trying build the ‘Netflix of early education’, she reallocated resources away from refreshing HMHC’s core products for key adoptions.  HMHC is a market leader, which has consistently garnered dominant share of large adoptions in California, Texas, and Florida (the largest adoption markets). However in 2016, HMHC saw its English Language Arts (ELA) product flop in California, as HMHC did not develop a new curriculum for the adoption (contrary to what Linda had told investors) but instead tried to resell an old one.  The following year, HMHC’s California social studies had a high-profile failure, as its product was not accepted into the adoption at all. These problems were the direct result of prior mgmt’s operational missteps and misdirected focus away from the core business. By the middle of 2017, the entire mgmt team had been replaced by the BOD. The new mgmt team is a significant improvement on the transparency/IR front, and they have realigned the Company’s focus on developing new product for upcoming adoptions.  They have also demonstrated tangible results in rationalizing the cost structure. Jack Lynch assumed the CEO role in Feb 2017, and before that, he had a long career in education, including at Renaissance Learning and Pearson. He is well respected throughout the industry.

Thesis:  The market for K-12 textbooks is cyclical, and it peaked in 2014.  Since 2016, the adoption cycle has been in a cyclical decline, with a trough in 2018.  With Texas Reading, California Science, and Florida Math all in 2019, next year promises to be the biggest adoption year since 2014.  In 2014, HMHC generated $280mm of FCF, or $2.25/share on today’s share count (>40% FCF yield). While, I am not modeling FCF at that level, I conservatively estimate HMHC’s 2019 and 2020 FCF yields at >20%.  HMHC is well positioned for these 2019 adoptions, having received a 100% alignment rating on its TX Reading product and a recommendation for approval from the California Science panel, while the Florida Math approval process is currently underway.  2020 will also be a strong year, driven by Florida Reading and the second year of the 2019 adoptions. Bottom Line: With the new mgmt team driving cost efficiencies and highly-relevant product for 2019/20 adoptions, HMHC will conservatively generate well over $1/share of FCF in each of 2019/20, implying >20% FCF yield and <5.5x EBITDA multiple.  Importantly, my bullish view on HMHC does not assert that this is a terrific industry or that the stock will go back to its 2015 highs;  however, it is premised on the data-driven belief that K-12 textbooks are a misunderstood market, often confused with trends in higher education, and that K-12 remains a stable (albeit cyclical) industry.  Ultimately, HMHC is just too cheap, given where we are in the cycle and its prospects for outsized FCF generation in coming years.

Near-Term Setup: 2018 will certainly be a down year for the industry, with HMHC’s addressable market down over 10% in the 1H, due to a trough in the cyclical adoption cycle.  However, even in this environment, HMHC has maintained ~flat yoy billings and cash EBITDA. This outperformance is driven by share gains in their AAP addressable market, supplemented by growth in Extensions (which is only partially included in AAP numbers).  Mgmt has reiterated its guidance for ~$1.4bn of billings, which will result in EBITDA growth and improved FCF versus 2017. The stock’s 15% sell-off post 2Q earnings, suggests that holders have given up and are discounting mgmt’s 2018 guidance, given 1H softness.  However, mgmt’s confidence in their 2018 guidance is supported by the fact pattern. First, despite significant market declines in 1H (due primarily to the winding down of the Cali Reading adoption), HMHC’s billings were only down -1.5%, versus FY guidance for +0.9% at the midpoint.  Second, due to the seasonality of purchases, ~60% of billings are booked in the second half of the year, and mgmt has good visibility into 3Q (which comprises >40% of annual billings). Third, Florida Science purchases will be made in the 3Q, and that is the only new major adoption in which HMHC is participating in 2018.  Indications for both HMHC and MHSE (McGraw Hill) are that the Florida Science adoption’s market size came in as expected. Additionally, MHSE’s FY’18 billings guidance echoes HMHC’s guidance for improvement in 2H. When HMHC reaffirms guidance on 3Q earnings, I expect it to be a meaningful catalyst for the stock, clearing the way for investors to focus on 2018/19 growth.

Competition: The K-12 market is dominated by HMHC, MHSE (private, Apollo), and Pearson (PSON), and there are several smaller players which choose to compete only in select adoptions.  While some of the small players have had success on a niche basis, the Big 3 maintain a considerable advantage. The market is highly decentralized, comprised of 15,600 public school districts and 132k public and private elementary and secondary schools, and the adoption process is long and complex.  Each state and district has its own standards requirements. Educators demand a comprehensive curriculum that small players often aren’t positioned to deliver. Furthermore, educators rely on the brand name and credibility of the large established players. Finally, sales/distribution is a significant challenge, given the fragmented end market.  Without the scale of the big 3, small players can only compete on a select, targeted basis. HMHC is primarily focused on US K-12 whereas PSON and MHSE have significant exposure to higher-education, professional, consumer and other categories. MHSE is a strong competitor, whereas PSON has deprioritized its US K-12 business and has been trying to divest the segment for some time.

Market Share: HMHC has historically tended to outperform competitors in large adoption years.  There are at least two ways to look at HMHC’s market share: (i) share as a % of AAP market, and (ii) share of HMHC’s addressable market (mgmt defined).  Adoptions in which HMHC does not participate are excluded from its definition of addressable market, whereas the AAP market is the total market defined by an industry trade group (AAP).  Both definitions of the market are imperfect (for example, the AAP data does not include bookings by some of the smaller players); however, they are the best data the industry has and directionally indicative of market trends.  HMHC’s market share, under each of these definitions, is summarized below. Their share was significantly impacted in 2016 and 2017 by inferior product, that was developed by the prior mgmt team. However, HMHC has begun to gain back share in 2018, and it appears well positioned to reassert its dominant position in next year’s large adoptions.  In 2Q’16, HMHC acquired SCHL’s Ed-Tech segment, and so share can be calculated including or excluding this segment. The comparison of HMHC’s billings to the AAP defined market is not apples-to-apples (e.g., I make an adjustment to exclude the acquired Ed-tech business, for comparability purposes), but it is informative, nonetheless.

K-12 Market: The US K-12 market for instructional materials totals over $30bn (~5% of total US K-12 expenditures), and its growth is driven primarily by (i) adoption calendar, (ii) state/local budgets, (iii) student demographics, and (iv) education policy (i.e., new standards like common core).  The US is divided roughly 50/50% into “adoption” states and “open territory” states. Adoption states legislate subject adoptions (math, social studies, language arts, etc.) and schedule these adoptions years in advance. The largest adoption states are FL, TX, and CA. Open territory states are more ad hoc in their approach, as individual districts decide when/what to purchase; and therefore, market size in these states is more difficult to forecast.

Longer-Term History: In 2007, Houghton Mifflin Riverdeep acquired Harcourt for $4bn and divested its higher-ed division to Cengage for $750mm, to become HMHC.  In the wake of the financial crisis and resulting extraordinary spending cut-backs by school districts and consumers (far worse than a normal down cycle), HMHC struggled with its heavy debt load.  From 2009-12, the Company went through multiple financial restructurings that ultimately concluded with a pre-packaged bankruptcy in 2012 that resulted in debtholders owning substantially all of the company, while completely deleveraging the balance sheet.  HMHC came public in Nov-13, with much of the shareholder base comprised of former debtholders who had converted their debt holdings to equity. Paulson and Anchorage were the largest of these. Paulson exited after the investor day in 2015. Anchorage remains the largest shareholder with a 16% stake, but the other hedgies in the holder base have largely turned over since then.  In 2015, HMHC acquired Scholastic’s (SCHL) Ed-Tech business focused on intervention.

Balance Sheet:  HMHC has a $768mm TL due May 2021, which is their only funded debt.  Their revolver was drawn $50mm at 6/30 for seasonal working capital purposes but repaid in July.  There are no financial covenants. Given the seasonal working capital build, I use average LTM cash for purposes of calculating net debt and EV.  FCF generated in 2019-20 should allow HMHC to reduce its TL balance by roughly half, in advance of its maturity in 2021. I expect HMHC will look to refinance its TL as its LTM metrics improve, driven by growth in 2019/20.

Deferred Revenue Accounting: The ongoing shift to digital has resulted in growth of deferred revenue over the past several years.  The primary reason for this deferred revenue is that GAAP requires the “digital” portion of total billings to be recognized over a period of several years.  So, while selling costs are incurred upfront, most of the associated digital revenue is deferred. For this reason, when analyzing and modeling this business, it is important to consider total billings or “cash” revenue (GAAP revenue + deferred revenue) and cash EBITDA (Adjusted EBITDA + deferred revenue).  In addition to normal capex, publishers also have “plate” spend, which is the capitalized cost of developing textbooks. Therefore, EBITDA net of plate (“post-plate”) is used for valuation purposes. Lastly, due to HMHC’s NOLs and tax assets, they will not be a cash tax payer for at least “the next several years” (see 4Q earnings call).

Conclusion: In 2015, the prior mgmt team convinced investors that growth seen in 2014 would continue into subsequent years; when in fact, the adoption cycle and prior mgmt’s missteps would lead to three years of market declines and earnings misses.  Now, just as the market seems to have given up on HMHC, the new mgmt team’s initiatives are bearing fruit and poise the Company for significant cash flow growth in coming years. While risks remain, HMHC’s current price is a deep discount to intrinsic value, and I believe the stock will be worth >$10/share (~70% upside) as mgmt meets its 2018 guidance and demonstrates growth in 2019 and beyond.

DISCLAIMER:  DO NOT RELY ON THE INFORMATION SET FORTH IN THIS WRITE-UP AS THE BASIS UPON WHICH YOU MAKE AN INVESTMENT DECISION - PLEASE DO YOUR OWN WORK.  THE AUTHOR AND HIS FAMILY, FRIENDS, EMPLOYER, AND/OR FUNDS IN WHICH HE IS INVESTED MAY HOLD POSITIONS IN AND/OR TRADE, FROM TIME TO TIME, ANY OF THE SECURITIES MENTIONED IN THIS WRITE-UP.  THIS WRITE-UP DOES NOT PURPORT TO BE COMPLETE ON THE TOPICS ADDRESSED, AND THE AUTHOR TAKES NO RESPONSIBILITY TO UPDATE THIS WRITE-UP IN THE FUTURE.

Catalyst

Mgmt to reaffirm guidance when they report 3Q earnings

Demonstrated execution in 2019 adoption, driving FCF growth