Description

Houghton Mifflin publishes curriculum and learning materials for K-12 schools in the U.S.  HMHC has been written up several times in the past and I would refer you back to those for additional write-ups as they are excellent.  I think the market is completely mispricing this stock after today's news and felt that I had to post this.

How did the stock get to $2/shr?

Post pandemic spending on learning materials declined for the following reasons.  1)  Schools were closed for much of 2q  2)  Budgets were diverted to supply electronic devices, preparing for safe return to school, distance learning, etc...  The company experiences wild seasonal working capital swings as all of the sales happen in 3Q.  The company was on pace to burn $200mm+ in 1H-20 before the pandemic hit as a result.  If the sales didn't bounce back in 3q (like they always do), the company would have immediately been thrown into a liquidity crisis.  Everyone was aware that budgets were down and what remained was diverted to ipads, school safety and distance learning.  As a result, HMHC hit $1/share or $125mm mkt cap and hasn't bounced much given its prior levels.

What was today's news?

3q-20 generated $233mm of FCF offsetting the $250mm of burn in 1H.  The liquidty risk is off the table.  With modest additional FCF in 4Q - the company will hit its goal of avoiding FCF burn in 2020.  Given the almost certain bounce in demand from here and the modest valuation, I would have expect to cause a meaningful rally.

However, on top of taking liquidity concerns completely off the table.  The company announced a transformational cost saving program had been fully implemented.  Management announced $95mm+ (let’s call it $100mm?) of annual cost saves.  Based on a conversation with management, I suspect that 70-85% of these savings are on the I/S and the remainder are in capex.  As a result of this news, if the company were to have a repeat of the 2020 TROUGH billings, they would generate roughly $225mm+ of EBITDA and $130mm of FCF or $1/share.  in other words, HMHC is trading at 3.0x PF Trough EBITDA with a 50% LFCF yield!

Where did the cost savings come from? 

The company realized with all of its workers at home that many were unnecessary.  Further, conversion to digital reduces their capex needs.  In the historical world, the company had to keep additional workers to spool up for the surge in development capex prior to large state adoptions.  (Many states in the U.S. buy curriculum by adopting a book for the whole state to buy.  The adoptions are repeated in 5-10 year cycles and require competitors to redraft the entire text to meet the board's requirements.)  This meant that workers were semi-idle in some years and running flat out in others.  Now that most curriculums will be digital, they will consistently upgrade the curriculum during the license period.  As a result, they will not have surges in capex needs - allowing them to curtail the pool of employees associated with the program development - remaining employees would have full utilization.

What is the upside?

1)  The competitive landscape has been eviscerated.  McGraw Hill and Cengage are on death's door and are not investing in innovation.  Pearson sold its US K-12 unit to private equity.  In the past, Pearson had reportedly been extremely irrational competitor on price.  that practice has changed.  however, the PE group doesn't have the balance sheet to invest in innovation either.  While there are some groups on the edge that compete here and there in some states, ED TECH innovation has not attempted to enter core curriculum.  Core curriculum most hit pedagogical hurdles and drive learning outcomes.  There is an enormous R&D hurdle to develop a system to clear these barriers on a state/national basis.  HMHC digital innovation is starting to really differentiate it from the rest of the group.  It has a leading position in digital and offering innovative products like HMHC anywhere.  It has been picking up share as a result.

2)  2020 is almost certainly to be a trough.  Budgets were diverted away from curriculum in 2020.  now - nearly every student in the U.S. has a electronic device - which must be populated w digital curriculum.

3)  The adoption calendar was scheduled to be way below mid-cycle in 2020 - but is set to rebound next year.  This can add $200mm to revenues

4)  Fiscal stimulus may contain more than $100bn for education with much ear-marked for curriculum.  HMHC is a leader with $1.2bn of 2020 sales!

5)  a blue sweep might drive further increases.

6)  HMHC has the largest sales force in the industry and a solid reading intervention tool that will be in high demand as learning outcomes have faded.

HMHC can do $225mm of EBITDA and $130mm of FCF with $1.2bn of billings (2020 should be about $1.2bn).  Each incremental $100mm of revenues adds $65mm of FCF!  Even a modest lift in billings next year could drive EBITDA to $300mm and $200mm of FCF.  This would END any leverage concerns and place the stock at a STAGGERING valuation for something that competes in an oligopoly and high barriers to entry. 

HMHC could quickly deleverage and then might start to trade on a more realistic EBITDA multiple.  When this business was viewed as stable, it traded at 10x+.  I referenced this in a note today but the upside potential is staggering.  I suspect that all of the large holders began to sell when the Robinhood rally sent HMHC to $3/share on thin air.  Now they all have tiny positions and may be using this rally to complete their exit for mutual fund tax loss season.  The upside here is staggering based on EBITDA multiples but also supported by LFCF yields as well.  What are you risking with the stock at option value and 3.0x trough leverage.  Conversely - I see upside to $7/share at 6.0x $225mm of EBITDA which would correlated to a 14% LFCF yield on a company with 2.0x PF net debt/ebitda.  6.0x $300mm gets me into the teens.  Should the company get back to mid-cycle revenues of $1.5bn - the stock returns start to get silly.

Catalyst

Fiscal stimlus

end of tax loss season

sellside upgrades

3q earnings which further elaborate on cost savings and revenue upside in 21