Description

HMHC (“HMH” or the “Company”) is the largest vendor of instructional materials for K-12 schools.  The Company is in 90% of K-12 schools, with 30% market share in Core curriculum offerings and 10% market share in Extensions offerings.  On a dollar basis, HMHC accounts for 10% of the total $200 per student instructional materials spend.[1]

HMHC has been written-up a number of times, most recently by Motherlode.  For additional granularity on the business, we would direct you to these write-ups in addition to the September 2021 presentation by Laughing Water Capital:

https://static1.squarespace.com/static/5d93ed0b59166652b0d66427/t/6140aa00b501454ed0c93167/1631627777129/LWC+-+HMHC+-+ValueXVail+-+final.pdf

We are adding our thoughts following press reporting that HMHC has engaged an advisor to explore a sale, with interest from private equity firms.  We believe HMHC is an ideal takeout candidate for private equity – and have laid out our analysis below – but also hold the view that at the current valuation the market is overlooking the business transformation that has taken place over the past two years, and are happy owners of the stock in the standalone case.

Over the past two years, management: 1) Sold its legacy publishing asset to News Corp. for ~$350mm (~1.8x revenue, which was accretive given WholeCo revenue multiple at the time of ~1.2x), with proceeds used to de-lever the balance sheet (HMHC today maintains a net cash position).  2) Substantially rationalized costs: gross margins and EBITDA margins have each expanded >1,000bps.  3) Adopted and scaled the “digital first connected” strategy.  The digital / connected business began gaining traction following federal funding grants during Covid for remote learning, and now represents 40-50% of new billings.  Contribution margins for the digital / connected segment are estimated to be 80% (vs. 60% for print)[2]. 

At the current share price of $18.12, HMHC trades at ~8x our underwriting EBITDA of ~$290mm, or ~10x EBITDA after subtracting LTM 9/30/21 pre-publication costs (analogous to capitalized software).

Despite the material increase in share price over the past year (up ~3x), we believe HMHC stock remains undervalued.  We will avoid repeating the long thesis that has been well articulated in recent write-ups, and instead focus on the prospects of a takeout. 

From the perspective of private equity, we believe the sponsor thesis for HMHC is:

1)  Mid-single digit organic revenue growth, driven by a high-growth recurring revenue stream that is increasing in contribution to the overall business (~12-15% of billings in 2021).  Cyclicality in revenue has been reduced due to the secular trend towards digital learning and is evident in digital / connected growth rates (>100%) and net retention rates (>150%). 

2)  A large cross-selling opportunity exists in Extensions, where HMH is the largest player and well-positioned to increase penetration (currently ~10%) closer towards its share in Core (~30%).  Extensions represent a market opportunity of ~$7.5bn, 3x the size of the Core curriculum.1

3)  Attractive FCF profile (unlevered FCF conversion = 75% of EBITDA) and significant operating leverage given 65% incremental FCF margins1.

4)  Opportunity to expand EBITDA margins (mid-20% range and growing) as a result of: accelerated shift to digital, additions to management’s ongoing cost program enabled by private ownership and sponsor expertise, cross-selling initiatives, and bolt-on acquisition opportunities.

5)  Ideal platform to consolidate the fragmented EdTech industry.  There are a number of privately held assets that would fit well with HMHC, particularly within Extensions.  A scaled EdTech platform should be attractive for both public market and private equity investors at exit.

6)  Financing capacity: Industry standard is for lenders to underwrite to Cash EBITDA, a metric which adds annual change in deferred revenue to Adjusted EBITDA.  GS research forecasts 2022 change in deferred revenue of $69mm, which represents 1/4 of our underwriting EBITDA and is purely incremental financing capacity.  Change in deferred revenue should also grow over time, along with EBITDA, which would enable future dividend recaps and/or principally debt-financed acquisitions.

LBO math

Having evaluated returns across a range of scenarios, we believe a sponsor can comfortably pay a material premium to the current share price.  In the analysis below, we have assumed a take-out price of $25.00 (+40% from here), which equates to a purchase EBITDA multiple of 11.5x.

We have assumed transaction leverage of 5.0x applied to Cash EBITDA, calculated as Underwriting EBITDA plus 2022 change in deferred revenue.  The use of Cash EBITDA for leverage purposes is consistent with industry practice.  Equity represents nearly 50% of total consideration, which is consistent with historical precedent for sponsor deals, and may be conservative based on recently completed transactions.  The 5% interest rate on debt assumed is estimated based on HMHC’s financial profile.

Our principal operating assumptions include:

1)  Revenue growth: Equity research forecasts through 2023.  Revenue growth held constant at 4% thereafter (may prove conservative given the digital piece). 

2)  EBITDA margins: Held constant throughout the forecast period, based on 2022 Underwriting EBITDA of $291mm

3)  Capex: Equity research forecasts through 2023.  Moderate capex leverage assumed thereafter.

4)  Pre-publication costs and change in NWC: Equity research forecasts through 2023.  Held constant as a % of revenue thereafter.

Based on the financing and operating assumptions above and an assumed exit multiple of 11.5x (in-line with the entry multiple), we arrive at a five-year Sponsor MOIC and IRR of 2.3x and 18.5%, respectively, in-line with industry norms.

The analysis above does not model any strategic / platform value for HMHC or the synergy / margin opportunity that a sponsor would presumably incorporate as part of their underwriting case.

As a secondary point, HMHC’s CEO was previously CEO of a business called Renaissance Learning, which he successfully scaled and exited to Hellman & Friedman.  He owns $7mm of HMHC stock and stands to make multiples of that in a sale.

[1] HMHC Investor Presentation, Q3 2021.

[2] Laughing Water Capital, Sept 2021.

Catalyst

- Take-out

- Digital % of bookings