Description

Houghton Mifflin Harcourt (“HMHC” or the “Company”) is a cash cow at the beginning of a multi-year growth cycle trading at a 2016 and 2017 FCF yield of 11.7% and 16.1%, with an unlevered balance sheet.  Elements of the story remind me of SCI’s setup since early 2014, for those who are familiar with that name.  I have found HMHC to be exceptionally misunderstood by investors and the Street, as modeling the business proves difficult due to deferred revenue accounting and a complex end-market.  However, the Company’s recent investor day helped to clarify what was a previously opaque long-term cash flow growth opportunity, and I believe the stock has meaningful upside as this information is disseminated into the marketplace (the investor day slides were only just posted today, 5/20).  Reflecting its ongoing share buyback program, HMHC should generate $2.80/sh of FCF in 2016 (a trough year for addressable market), and then accelerate rapidly into 2017-19.  At 15x 2016 (trough year) FCF, HMHC is worth $42/sh (+75% upside).

Thesis:

• Cash Flow: At its investor day (on 5/12), mgmt provided meaningfully increased clarity on its long-term cash flow growth opportunity and guided to ~$1.7bn of cash generation over the next five years.  This, even assuming a very conservative nine point haircut to its current market share and excluding the recent SCHL Ed-Tech acquisition (the “SCHL Acquisition”).  FY’14 was a standout year for market share, given adoptions in some of HMHC’s strongest categories and operational missteps by Pearson, and it’s reasonable to expect that market share may drift down a few points over time; but a haircut to 35% (from 44% currently) is a draconian modeling assumption, which mgmt explicitly called out as conservative.  In fact, HMHC's market share has been in the ~40% range since its acquisition of Harcourt in 2007.  Assuming a more reasonable (but still conservative) haircut to 40% market share by 2019, I model FCF generation of over $2bn (~60% of market cap) over the next five years.
• Capital Returns: At year-end 2014, HMHC had $743mm of cash and $243mm of debt (<1x EBITDA) on its balance sheet.  Mgmt has been under pressure from large shareholders to return capital, but was unable to act given its window was closed while the SCHL Acquisition negotiations were underway.  Since the SCHL acquisition was announced, mgmt refinanced and increased its term loan by over $550mm (from $243mm to $800mm), while also upping its share buyback authorization from $200mm to $500mm.  Concurrently with a secondary offering by Paulson (on 5/15), mgmt accelerated its share repurchases by acquiring $150mm of shares directly from Paulson.  Since the SCHL Acquisition was announced, mgmt has revealed its aggressive posture with regard to share buybacks, and it remains constructive on the remainder of its share repurchase authorization.
• Balance Sheet:  Pro forma for the SCHL acquisition, HMHC will still have only ~2x of gross debt and less than ~1x on a net basis.  Therefore, HMHC maintains significant capacity to further leverage its balance sheet (at least ~1.0-1.5x) even after deploying its current cash balance to share repurchases. 
• Cyclical Trough: At its investor day, mgmt laid out a compelling case that 2015/16 is a cyclical trough, and HMHC is at the beginning of a multi-year growth cycle.  “Adoption” states offer good visibility for years out on market size, making these relatively straight-forward for the Company to model.  While market size in open territory states is more difficult to predict, the tailwind of rising real estate prices and tax receipts, combined with pent up demand, will drive significant growth in coming years.  These cyclical tailwinds, combined with significant growth in adjacent markets, should propel billings to nearly $2.2bn by 2019 (from $1.6bn in FY’14), based on my model (detailed herein).  
• Confused Street: The deferred revenue characteristics of this business, driven by an accelerating shift to digital, are misunderstood by the Street and investors.  By focusing on GAAP revenue and earnings (instead of billings), anyone would completely miss the cash flow and growth profile of this business.  For example, in 2013 and 2014, GAAP revenue was +7.2% and -0.5%; however, billings (i.e., cash revenue) was +12.0% and +16.1% during these periods.  Unfortunately much of the Street seems to be confused by this concept, or has chosen to ignore it.  For example, MS is modeling FCF of only $1.1bn over this period, versus mgmt’s recent (conservative) guidance for ~$1.7bn.    
• Orphan Stock: HMHC lacks great public comps and a natural investor base.  It seems to be the unwanted stepchild of those Street analysts that cover it, and there isn’t a single “buy” rating on the name.  At GS and MS, it is covered by the Services analysts.  At Citi, it’s covered by the Media analyst.  This lacking coverage has allowed significant misunderstanding to persist in the market, and is a big reason why this opportunity exists. 
• Adjacent Markets: Mgmt has identified significant growth opportunities in markets adjacent to its core basal market.  These adjacencies include professional development and services ($2bn addressable market), early childhood institutional market ($500mm), intervention ($1.2bn), and consumer education ($13bn).  HMHC is currently a small player in each of these fragmented adjacent markets, and they present a meaningful growth opportunity for the Company.
• Acquisition Opportunity:  While further consolidation of the big-3 players (HMHC, McGraw Hill, Pearson) in this space is unlikely, there is substantial opportunity for tuck-in acquisitions like the recent SCHL Acquisition.  The acquired Ed-Tech division of SCHL focuses on intervention, a market segment in which HMHC has been underrepresented.  The opportunity to leverage scale with this acquisition is significant, as Scholastic has ~60 sales reps versus HMHC’s ~400.  Further, the transaction will have closed in plenty of time to capitalize on the major California adoptions in 2016.  Similar future strategic acquisitions could provide a tailwind to HMHC’s cash flow growth going forward.
  
  

Business:  HMHC is the largest developer of instructional materials in the US K-12 market.  It leverages its library of proprietary content to develop digital and print media for sale by its sales force of over 400 reps to school districts across the US.  ~90% of sales are generated by its education segment which focuses on comprehensive (basal) educational programs across various subjects and grade levels, supplemental and intervention products targeted at addressing struggling learners, and assessment and other services focused on improving accountability and training within schools.  The remaining ~10% of its sales are from its trade publishing segment, which markets consumer books in print and digital formats and licenses book rights to other publishers.  These consumer books are primarily sold in retail stores and to wholesalers, and include titles such as Lord of the Rings, CliffsNotes, Life of Pi, etc.

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's results were impacted, and it 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.  Important recent developments include:

• 3/19- HMHC announces it is rescheduling its investor day, fueling speculation that a deal or other event was in the works.
• 4/24- HMHC announcers the SCHL Acquisition.
• 4/28- HMHC pre-announces 1Q sales and Adjusted EBITDA slightly above Street, in support of its bank debt refinancing.
• 4/29- HMHC files an 8k indicating that Paulson (largest shareholder) has requested an underwritten public offering of at least $100mm before 7/31/15.  Paulson’s request was pursuant to the Investor Rights Agreement as a >15% shareholder (the “Paulson 8k").
• 5/1- HMHC files an S-3 to refresh a stale shelf registration from the prior year.  This is separate from the Paulson 8k and is not an indication that more shares are coming to market in an underwritten offering. 
• 5/6- HMHC upsizes its new TL to $800mm, and the BOD increases the share buyback authorization from $200mm to $500mm.
• 5/7- HMHC reports 1Q results, including 51% market share in adoption states and billings +2.4%.
• 5/12- HMHC holds its investor day in New York, and provides long-term financial targets.  However, mgmt did not immediately publish the slides due to timing of the Paulson secondary.  The slides and webcast replay didn’t become available until today, 5/20 (located here: http://ir.hmhco.com/events.cfm).
• 5/13- HMHC launches a roadshow for the secondary offering of 10.6mm shares + 1.6mm share greenshoe by Paulson.  Also, they announce they plan to repurchase $150mm of stock directly from Paulson concurrently and separately from the shares they are offering to the public. 
• 5/15- The Paulson shares price at $23, and the deal is expected to close on 5/20, at which point the investor day slides will be posted to the website.
  
  

K-12 Market: The US K-12 market for instructional materials totals over $30bn (~5% of total US K-12 expenditures), and is experiencing growth driven primarily by these factors: (i) adoption calendar, (ii) state/local budgets, (iii) student demographics, and (iv) education policy.  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 them years in advance, making timing of these adoptions relatively easy to forecast.  The largest adoption states are FL, TX, and CA.  Open territory states are more ad hoc in their approach, as individual districts decide when and what to adopt; and therefore, market size in these states is more difficult to forecast. 

The Great Recession and resulting plummet in tax revenues led to extraordinary cutbacks in purchase of instructional materials, as well as teacher layoffs.  As real estate values have since bounced back, resulting in property tax revenue growth, state and local governments have shored up their budgets and begun reinvesting in education.  For example, the Brown administration recently announced that California income tax collections exceeded estimates by more than $1.6bn in April, pushing income tax revenue for the year to an $8bn increase versus the comparable 2013-14 period (source: http://www.sacbee.com/news/politics-government/capitol-alert/article20047671.html).  Brown is pushing for much of this surplus to be directed toward schools (source: http://www.latimes.com/local/politics/la-me-pol-state-budget-20150515-story.html).

In 2014, Florida implemented an English language arts (ELA) adoption and is scheduled to adopt Social Studies in 2015 for purchase in 2016.  Texas purchased math and science in 2014, and adopted social studies and high school math for purchase in 2015.  California adopted math in 2013 for purchase in 2014 and 2015, and is scheduled to adopt ELA (one of HMHC’s strongest subjects) in 2015 for purchase in 2016.  While spending has rebounded in adoption states, open territory states spending has yet to accelerate, presenting a potential meaningful tailwind and further upside for HMHC as these districts return to the marketplace to replace textbooks that are now 7-10 years old.  Even as the AAP forecasts 2016 to be flattish relative to 2015, HMHC is well-positioned for growth, given its current momentum and dominance in the ELA subject area (California ELA adoption in 2016).  After 2016 in 2017-19, a rapidly expanding adoption market and growth in open territories should fuel accelerating growth in billings and FCF for HMHC.
     

In addition to a favorable adoption calendar and improving state/local budgets, student demographics are also favorable.  The NCES projects total PreK-12 enrollment to increase +6% from 2011-22, with K-8 growing +8%.  This compares to ~flat growth from 2002-2011 (source: http://nces.ed.gov/pubs2014/2014051.pdf).  Among the states experiencing the fastest student population growth are adoption states FL, TX, and CA.  Lastly, education policy could be a tailwind for the K-12 market, as certain states implement Common Core in coming years. 

Competitors: The K-12 market is dominated by HMHC, McGraw Hill (private, Apollo), and Pearson (LON:PSON), who combined have ~90% market share.  There are significant barriers to entry in this market, given the importance of brand, content, relationships, and sales force scale.  The market is highly decentralized, comprised of 15,600 publish school districts and 132k public and private elementary and secondary schools, and the adoption process is long and complex.  As such, tech startups operate only on the margin of this marketplace, and there is low risk of significant disruption to the established players.  HMHC is primarily focused on US K-12 whereas Pearson and McGraw Hill have significant exposure to higher-education, professional, consumer and other categories.  McGraw Hill’s strategy of only competing in select categories and markets, operational missteps by Pearson, and HMHC’s successful initiatives have led to its achieving 44% market share in 2014, up six points from the prior year.  Mgmt hopes to maintain and build on this dominant market share, and commentary from industry participants suggests they are well positioned to do so.  HMHC's market share has been in the ~40% range since its acquisition of Harcourt in 2007.  In adoption states, HMHC has historically captured ~50% market share, and was at 52% in FY’14 and 51% in 1Q’15.  

Deferred Revenue Accounting: The ongoing shift to digital (now >40% of revenue versus mid-20s% in 2012) has resulted in a substantial acceleration in growth of deferred revenue.  As deferred revenue builds, the variance between GAAP revenue and billings (i.e., cash revenue) has also grown.  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, the majority of the associated digital revenue is deferred.  This dynamic meaningfully distorts the growth profile of the business for those analysts that are only focused on GAAP P&L metrics.  For example, in FY’13 and FY‘14, GAAP revenue was +7.2% and -0.5%; however, billings (i.e., cash revenue) was +12.0% and +16.1% during these periods.  Similarly, while EBITDA (per the P&L) was +1.6% in and -18.3% in FY’13 and FY’14, “cash” EBITDA was +22.8% and +51.8%.  Therefore, 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). 

Mgmt Guidance: At its investor day (5/11), mgmt laid out long-term financial targets, but stressed that they apply a conservative 9% market share haircut to their projections, taking their market share from 44% in FY'14 to 35% by FY'19.  Further, these targets do not include any of the cash flow or synergies from the SCHL Acquisition.  Even with these very conservative assumptions, mgmt’s guidance for ~$1.7bn of cash flow generation over the next five years is far above Street.  For example, MS is modeling FCF of only $1.1bn over this period.  Below are mgmt’s financial targets and select commentary from the investor day:

• 2014-19 Net Sales CAGR: 5%
• 2014-19 Billings CAGR: 5%
• 2014-19 Adjusted EBITDA CAGR: 11%
• 2014-19 Adjusted “Cash” EBITDA CAGR: 7%
• 2014-19 FCF CAGR: 8%
• 2014-19 Gross Margin Expansion: ~300bps
• 2014-19 Adjusted EBITDA Margin Expansion: ~600bps.
• 2019 Deferred Revenue Balance: >$1.5bn (versus ~$525mm at YE’14)
• 2014-19 FCF Generation: ~$1.7bn 
  

“…I just want you to understand that when we do our modeling, we do our modeling based on a 35% market share and a 20% IRR. We do that so that we do our modeling conservatively. I would be disappointed, as I know with the rest of management, if we only performed at a 35% level. So I would argue that the $2 billion of revenue -- $2 billion of billings in 2019 is a conservative look as to how we would do in 2019… Now, if you look at what's going to happen to our cost of sales in SG&A, we believe through the digital transformation conservatively, we can add six points to margin. That's going to come out of our manufacturing cost being reduced by six points. However, that'll be slightly offset by the fact that we're going to be spending more money on our platforms and technology licenses, and also as the services becomes a larger part of the portfolio, that carries with it a larger cost of sales.  So optimistically, we think we can grow at least 6 points of margin over the next five years as this transition to digital continues to manifest itself.” -Eric Shuman, CFO (Investor Day, 5/12/15).

Model:  Modeling this business has been a challenge for investors and the Street, given the deferred revenue dynamics and complex end markets.  However, mgmt’s long-term financial targets and additional disclosure during its recent investor day are very helpful in understanding the Company’s cash flow growth opportunity.  I build my model using AAP addressable market estimates and my market share assumptions, overlaid on mgmt’s guidance and long-term targets.  All key assumptions are generally in-line with mgmt's long-term financial targets, except that I’m taking a less draconian view on market share, with HMHC’s share gradually moving down to ~40% by 2019 (versus 44% currently) as compared to mgmt’s assumption of 35% market share by 2019.  FY’14 was a standout year for market share, given a ‘perfect storm’ of adoptions in some of HMHC’s strongest categories and mis-steps by its key competitors, and it’s reasonable to expect that market share may drift down a few points over time; but a haircut to 35% (from 44% currently) is a draconian modeling assumption, which mgmt explicitly called out as conservative.  In fact, HMHC's market share has been in the ~40% range since its acquisition of Harcourt in 2007.  From 2014-19, I model billings growth at a 6.1% CAGR, and cash EBITDA growth at an 8.6% CAGR (both excluding the SCHL Acquisition).  Over the five year period, I estimate over $2bn of cash flow generation (~60% of market cap).  Note that I model the pending SCHL Acquisition separately from the legacy business here, and I begin to reflect cash flow from this acquisition in FY’16 (no impact in 2015). 

Valuation: Pre-publication costs (or “plate”) include the art, prepress, and other costs incurred in the creation of the master copy of instructional materials (books, digital media, etc.).  Mgmt expects cash outlays for plate to hold steady at $110-120mm annually.  GAAP requires that these costs be capitalized and amortized, so they are not reflected in EBITDA (given the add-back of amortization).  Likewise, mgmt’s Adjusted EBITDA calculation excludes these plate costs – this is referred to as “pre-plate” Adjusted EBITDA.  Given plate is a recurring cash outlay, it is appropriate to deduct this cash flow (found under the investing section of the cash flow statement) from Adjusted EBITDA to calculate “post-plate” Adjusted EBITDA.  Based on my model, HMHC currently trades at 8.3x and 7.2x FY’16 and FY’17 Adjusted "Cash" EBITDA (post-plate).  As a multiple of FCF/sh, the stock trades at 8.6x and 6.2x FY’16 and FY’17 (yield of 11.7% and 16.1%), which reflects the impact of share shrinkage from stock repurchases with FCF. 

Conclusion: With the additional disclosure offered at the investor day and Paulson’s secondary offering behind us, HMHC is setup extraordinarily well for per-share FCF growth and multiple expansion in the coming quarters and years.  In the current stock market where the combination of yield and growth is elusive, HMHC stands out as a truly under-appreciated opportunity at its current price.  While holdover debt investors from the restructuring continue to own a meaningful stake in the Company, Paulson’s secondary and ongoing turnover of shares has improved the float and holder composition.  Mgmt has proved itself conservative in its modeling, and the Street has set a low bar for the stock – providing a primed setup for outperformance over the next 12-36 months.  Reflecting its ongoing share buyback program, HMHC should generate $2.80/sh of FCF in 2016, before accelerating rapidly into 2017-19.  At 15x 2016 (trough year) FCF, HMHC is worth $42/sh (+75% upside).


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

FCF growth acceleration
Commencement of share repurchases
Dissemination of long-term financial guidance and improved investor understanding of FCF growth opportunity, as laid out at the Company's recent Investor Day (5/12)