|Shares Out. (in M):||139||P/E||0||0|
|Market Cap (in $M):||2,390||P/FCF||0||0|
|Net Debt (in $M):||540||EBIT||0||0|
|Borrow Cost:||General Collateral|
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Houghton Mifflin Harcourt Company
Big Three Textbook Publishers’ Share Shrinking
Our billings, which we define as net sales adjusted for the impact of deferred revenue, decreased $61.8 million, or 4%, from 2014 to 2015.
Houghton Mifflin Harcourt Company (HMHC) publishes textbooks for the U.S. K-12 market (88% of 2015 sales, the balance was from trade book publishing). At $17.22, the company trades for 16.4x trailing EBITDA and 2.4x book value. HMHC has not produced positive earnings, neither GAAP nor adjusted, as far back as records are available. Over the last decade, textbook publishers have been buffeted by three trends: digital distribution, a proliferation of new entrants and changes to sales and distribution. These trends appear to be entrenched – from HMHC’s standpoint, they also appear to be destroying its business. Accordingly, we recommend shorting its shares.
The following table summarizes HMHC’s current valuation and capital structure.
In 1880, Henry Houghton, George Mifflin and two others founded a Boston based printing and publishing partnership called Houghton, Mifflin & Co. The partnership formed an education publishing business in the late 1880s and by 1921, grew to be the forth-largest education publisher in the U.S. The company went public in 1967 and remained so until Vivendi acquired it for $2.2 billion in 2001. The following year, Vivendi sold Houghton, Mifflin for $1.66 billion to Thomas H. Lee Partners, Bain Capital and Blackstone Group. The private equity firms sold HMHC to Riverdeep PLC, an entity controlled by Irish investment banker Barry O’Callaghan, for $3.36 billion on 12/22/2006. On 7/16/2007, O’Callaghan acquired Harcourt for $4 billion and merged it with Houghton, Mifflin. The privately held business sported $7 billion of debt, much of it provided by Anglo Irish Bank. By the summer of 2009, the debt was choking HMHC; the company was recapitalized on 2/22/2010. As part of the recapitalization, Paulson & Co., Guggenheim Partners, Fidelity Investments, Apollo Management and Avenue Capital became major shareholders. The new capital structure retained to much debt and the company filed Chapter 11 on 5/10/2012, emerging on 6/22/2012. On 11/19/2013, HMHC went public at $12.00. Paulson & Co. relinquished their board seat and sold their remaining HMHC shares during the summer of 2015. Of the companies involved in the recapitalization, only Fidelity (with 8.2% of HMHC shares) and Marc Lasry (Avenue Capital, 2.6% of HMHC shares) are still invested.
As recently as 12/31/14, HMHC’s balance sheet included $500 million net cash. Since then, management initiated share buybacks and made one large acquisition; as a result, the business now has $540 million of net debt, i.e., a $1 billion swing in two years. The following table summarizes the cash from operations and investing portions of HMHC’s cash flow statements since 2010:
Cash Flow Since 2010
Note that HMHC’s cash from operations tripled in 2014, but fell in 2015. Management explained the fall-off in 2015 as the result of large sales in Texas and Florida during 2014 and unfavorable changes in operating assets and liabilities, e.g., a decrease of $105 million of deferred revenue. We infer from their explanation that 2014 was the top of the cycle. Some analysts have pointed out that as HMHC’s business shifts to more online sales, deferred revenue increases. They go on to argue that the GAAP numbers systematically understate the company’s economics. HMHC’s disclosure around this issue is parsimonious at best. However, note that HMHC capitalizes both pre-publication costs and software development costs, so we are skeptical that there exists a major miss-match between HMHC’s revenue and costs. Regardless, deferred revenue is cash received, so it is included in the period’s cash from operations, so the company’s cash flow statement captures the effect without the need for adjustments. One final point on the cash flow figures above: note that when acquisitions are included, HMHC spent $273 million more investing than it generated from operations. The following table shows the same data excluding acquisitions and with the addition of a column showing free cash flow (FCF, the sum of the three previous columns).
Cash Flow Since 2010
The data in the table show that HMHC generated $374 million of free cash flow since 2010. If 2014’s performance were typical, or perhaps a preview of things to come, then HMHC would be a bargain. However, the performance over the last five years, taken together, is not particularly inspiring for a business with a $2.3 billion market cap. Of course, this is looking in the rear view mirror.
The following is an excerpt from HMHC’s most recent 10-K (highlight added):
Our business is and will continue to be impacted by the rate and state of technological change, including the digital evolution and other disruptive technologies, and the presence and development of open-sourced content could continue to increase, which could adversely affect our net sales.
Our industry has been impacted by the digitalization of content and proliferation of distribution channels, either over the Internet, or via other electronic means, replacing traditional print formats. The digital migration brings the need for change in product distribution, consumers’ perception of value and the publisher’s position between retailers and authors. Such digitalization increases competitive threats both from large media players and from smaller businesses, online and mobile portals.
Free or relatively inexpensive educational products are becoming increasingly available, particularly in digital formats and through the Internet. For example, some governmental and regulatory agencies have increased the amount of information they make publicly available for free. In addition, in recent years, there have been initiatives by non-profit organizations such as the Gates Foundation and the Hewlett Foundation to develop educational content that can be “open sourced” and made available to educational institutions for free or nominal cost.
HMHC management refers to “open-sourced content” and mentions that some government agencies and non-profit organizations are involved in making more information available for free. What they are referring to is a movement called Open Education Resources (OER), a term coined at UNESCO’s Forum on the Impact of Open Courseware for Higher Education in Developing Countries  held in July 2002. Here is how the William and Flora Hewlett Foundation defines 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. 
Ok, so HMHR’s 10-K includes a reference to the OER movement, but these paragraphs were lifted from the Risks section of the 10-K – perhaps they are just legal boilerplate? Also note that OER was coined at a conference focused on higher education, HMHC’s market is K-12 – perhaps the OER movement doesn’t impact the K-12 market. Think again. Utah, Florida, and Washington State, to name three, have initiatives to produce and disseminate open-source K-12 textbooks. The Scholarly Publishing and Academic Resource Coalition (SPARC) lists current open-source initiatives by state at the following address: http://sparcopen.org/our-work/list-of-oer-policies-projects/ In the meantime, 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/. Interestingly, the open-source textbook movement is not limited to the U.S.; in fact the U.S. is not even in the vanguard – Poland is the first country to support a national open textbook program.
The Boston Consulting Group (BCG) recently published a report entitled The Digital Disruption of Education Publishing – here is one of the report’s conclusions (highlight added):
The four leading publishers with a presence in the U.S. (Pearson Education, McGraw-Hill Education, Cengage Learning, and Houghton Mifflin Harcourt) all face profit pressures and strong headwinds hampering growth.
Headwinds? HMHC recently estimated that they command 50% market share in the U.S. K-12 textbook market – what headwinds is BCG referring to? The graph at the top of page one (prepared by BCG from data obtained from Simba Information) suggests that HMHC has a much smaller (and shrinking) share of the K-12 market – what’s going on here?
In 2003, the U.S. K-12 textbook market was $4.3 billion. If HMHC’s 50% market share statistic is about right, the 2015 market was $2.8 billion, i.e., the K-12 textbook market shrunk 35% (not accounting for inflation) over the last eleven years. The BCG report features the following graph.
K-12 Market Moved Away from Textbook Purchases
The graph shows that Basal textbooks (what HMHC produces) represented 30% of K-12 instructional spend in 2012, down from 39% in 2008. So HMHC has a dominant position in a collapsing market.
How can this be - surely kids still need textbooks and surely HMHC can provide learning tools over the Internet. As mentioned above, BCG thinks that the combination of digital distribution, a proliferation of new entrants and changes to sales and distribution are pressuring HMHC’s business model. Since it is unlikely the Internet is going away anytime soon, we will assume HMHC will have to adapt to digital distribution. Regarding new entrants, that is a function of barriers to entry. Historically, the barrier to entry in the K-12 textbook market was sales and distribution, so let’s take a look a how sales and distribution works in the K-12 textbook market.
K-12 Textbook Sales and Distribution
Historically, textbooks were either specified at the state level in what are called “Adoption States” or at the local level in “Open Territory States.” If a municipality in an Adoption State expected state funding for its textbook purchases, it must adhere to the guidelines set at the state level. The sate-wide textbook specification in Adoption States is primarily a relic of the Civil War - in the late 1800s, Southern states wanted to regulate depictions of the war and developed statewide textbook specifications to this end. The following map shows the split between Adoption States (shaded) and Open Territory States (white).
Adoption States vs. Open Territory States
In the past, California, Texas and Florida represented one third of the K-12 textbook market- spend. (California alone often spends over $400 million annually on K-12 textbooks). More importantly, textbook decisions made in California and Texas set the pattern for the whole country. Here is a description of how textbook specifications are developed in these two states:
In both states [CA and TX], publishers present their wares at public hearings to members of a textbook review committee, which also hears testimony from representatives of advocacy groups. The textbook committee members, many of them teachers from around the state, review the instructional materials to see if they accord with state standards on content and match up with state curriculum guidelines. Committee members are wooed by publishers’ sales representatives, who sometimes offer free trips, special seminars, innumerable sample books, and other perks. The committee then makes recommendations to the state board of education, which usually consists of elected and/or appointed members who are not specialists in history, reading, math, or science. The state board then makes the final decision whether to accept or reject a book, or perhaps adopt it contingent upon the publisher making specified changes.
This was an ideal market structure for HMHC, which employs 400 sales representatives who could focus attention on the textbook committees of influential states, e.g., California and Texas, then disseminate those decisions to other state textbook committees around the country. Complex and politicized textbook approval processes and cozy relationships between sales reps and decision makers made for substantial barriers to entry and three publishers (HMHC, Pearson and McGraw-Hill) came to dominate the K-12 textbook industry.
While this process benefitted HMHC, it did not produce superior educational outcomes. For instance, in the 2003 National Assessment of Educational Progress Fourth Grade Math Test (administered across the country), eleven of the fifteen lowest-scoring states were Adoption States.  A similar pattern was observed at different grade levels and in different courses over multiple years. Not surprisingly, many educators were not enamored with the textbook selection system. One critique we came across described many K-12 textbooks as being “unreadable, incoherent, dishonest and boring.” Regardless, this market structure was thought to be a permanent fixture of the K-12 textbook industry. Here is how education historian Diane Ravitch described the situation in 2004:
The [American Association of Publishers] AAP, sadly, uses its considerable clout to protect the adoption process in the big states that benefits a very small number of publishing giants and disadvantages a large number of small publishers who simply cannot afford to meet the expensive requirements of the process and to break into the textbook market. 
So what changed? As noted above, OER was coined in 2002. By that time, the Internet had become part of the public zeitgeist, e.g., Craigslist had been around for seven years, Napster had come and gone and we had lived through the dot.com boom and bust. Thinking from first principles, if one were to design a way to disseminate educational materials and was familiar with the Internet but had not seen a textbook, it stands to reason that the textbook would never have been invented. For instance, the Internet offers timely distribution at zero variable cost and very low fixed costs (other than producing the material). This property also allows mistakes to be fixed as soon as they are discovered. Educational material distributed on the Internet also may be updated continuously at little cost. Internet dissemination also allows for a richer product, e.g., interactive tests, video and audio feeds.
While the Internet was becoming a daily fixture in contemporary society, textbook prices were inflating faster than healthcare costs, home prices and just about everything else, i.e., it was good to be a textbook oligarch. The following chart shows the price increases of college textbooks (a proxy for K-12 textbook prices) since 1980 compared to medical services, home prices and the CPI.
Then came the financial crisis, which depressed state tax revenue, and state spending on education fell. The following graph shows the delta between 2008 and 2014 of education spending by state.
The chart indicates that education spending fell in most states. In summary, by 2010, the following conditions were in place:
Nearly universal Internet access.
Widespread awareness of the Internet’s capabilities (Youtube, Wikipedia).
Dissatisfaction with available textbooks among many educators.
Several decades of textbook price inflation.
Funding shortfalls in most states.
These conditions encouraged the growth of the OER movement – of course, it doesn’t hurt to have the Gates Foundation and the Hewlett Foundation underwriting many OER initiatives. With this in mind, it is not all together surprising that HMHC has not generated positive EBIT (with or without adjustments) as far back as we have financial statements. Not only are HMHC’s 400 sales reps less likely to be useful than they were a decade ago, the very culture and cost structure of the company is a relic from a bygone era. Here is how BCG summarized the conditions for the textbook industry in 2014:
Publishers were once protected from competition by high barriers to entry. They had the relationships with authors, knowledge of buying processes, and distribution clout to ensure their position—and their dominant market share. But their positions are now under attack as the business shifts toward digital content and away from a reliance on print textbooks.
BCG lists a number of ideas for how the textbook incumbents can realign their business, but think of the impact CK-12 is likely having on HMHC’s margins, i.e., it is hard to compete with free. Consider also the possibility of CK-12, or some other well funded open-source organization like CK-12, being able to develop a virtuous cycle of collaboration with educators who contribute to the development of educational materials and then advocate the adoption of those materials by their school system. Consider the case of Utah, historically an Adoption State. The Utah Education Network (UEN) traces its origins back to 1956 when the University of Utah was awarded $100,000 grant to explore educational uses for closed circuit TV. On 1/25/2012, the Utah State Office of Education announced that it was supporting the development of open textbooks for high school math, science and language arts and that it recommends that all schools across the state consider these open textbooks for adoption. Here is a link to the K-12 Utah has developed to date: http://www.uen.org/k12educator/ A cost analysis based on Utah’s experience with open textbooks concludes that open source textbooks all in costs (including printing by a third-party vendor) are about 40% of the cost of traditional textbooks. Utah may be at the vanguard, but it is not unique.
The Council of Chief State School Officers, a non-profit organization of public primary and secondary school administrators, published the following 2015 survey results regarding OER adoption across the U.S.
Survey Responses: K-12 Public School Administrators 
Note that 27 states currently use OER at some level, including California and Texas (the historical trend setters). Also note that the California administrators indicated that there were no OER initiatives planed – while this may be true at the K-12 level, California is in the midst of developing 50 open-source textbooks for the most popular classes taught in their state universities. Interestingly, the California initiative is being funded by the state together with grants from the Gates and Hewlett foundations. Publishing incumbents complain about funding sources of these initiatives, but the states point out that they are paying for textbooks – checkmate. While higher education is a different market than K-12, higher education has been the leader in other educational initiatives which are making their way to the K-12 market. For example, online courses currently account for 14 percent of total undergraduate courses while about 4 percent of K-12 are taking online courses.
The Bull Case
We first started studying HMHC a year ago and were intrigued by the $491 million of cash it generated ($308 net of capital spending and pre-publication costs) during 2014 and its conservative balance sheet. Since then, the company added $533 million of debt while producing $348 million of cash ($162 million net of caital spending and pre-publication costs) during 2015. On the positive side (from a long perspective), HMHC’s debt consists of an $800 million term loan (LIBOR + 3%) which is not due until 5/29/2021, so there is little chance of a debt crisis at the company.
As we understand the bull case, it consists of three elements: 1) rebound in state spending on schools, 2) a miss-match between HMHC’s costs and revenue and 3) enrollment increases. State spending has yet to rebound to 2008 levels, so this remains a possibility. The assumption, however, that increased spending translates into increased textbook budgets is problematic, for reasons stated above, e.g., increased OER adoption. Regarding the miss-match, HMHC’s disclosure leaves much to be desired. For instance, management defines net sales as “billings for products and services less revenue that will be deferred until future recognition and product returns.” But HMHC management does not disclose “billings” and is inconsistent with other disclosure, e.g., net sales deferred. The following table summarizes the key financial elements around this issue.
The fact that deferred revenue (a liability) is realized over time depresses current (net) revenue and current GAAP earnings, but the cash received is reflected in real time in the cash flow statement as part of cash from operations. To the extent HMHC would be able to generate $491 million of cash from operations less $183 million of pre-publication costs and capex, i.e., $308 million of free cash flow, it is a bargain at a $2.4 billion market cap. But textbook publishing is cyclical and it looks like $308 million was earned at the top of the “new normal” cycle (based on the dynamics outlined in this report). This leaves us with enrollment increase. The following table summarizes public school enrollment in the U.S. since 1990 and projected through 2024. The data indicate that there is likely to be a slight uptick of 0.6% per year enrollment growth over the next eight years. This is a positive tailwind for HMHC, but given the other headwinds, we don’t think it is enough to make much difference.
Enrollment in Public Schools