Description

Led by seasoned CEO Jack Lynch, HMHC is a leader in the U.S. K-12 instructional materials market. Arriving in 2017, Lynch renewed the company’s focus on its core textbooks business while also expanding its extensions business to over half of overall billings or cash revenue. Today, this underappreciated, yet rapidly growing, extensions business could be worth more than HMHC’s total enterprise value. Yet, despite strong execution and credible investor day projections, the market continues to materially discount what is perceived to be a levered, cyclical textbook company. In our view, the company’s recent performance and forward-looking guidance are game changers: HMHC is set to generate over $300MM in FCF over the next 3 years and significantly deleverage its balance sheet as its mix shifts towards the extensions business. We believe HMHC stock could nearly double to $12.20 per share over the next year based on a 12x multiple of average unlevered FCF from 2020-2022.

A Not-So-Storybook History

HMHC was founded in the late 1800s and has a rich history as both a consumer (trade) and education publisher. The storied company IPO’d in 1967 and changed hands several times after the turn of the century with Vivendi, THL, Bain, Blackstone and Riverdeep all taking turns levering up the company. After two restructurings in 2010 and 2012 related to the heavy debt load and weakness in core adoptions, HMHC went public again in 2013. CEO Jack Lynch took over in 2017 and, unlike his predecessor, had prior experience in education at Pearson and Renaissance Learning. Today’s HMHC is a vertically integrated content creator and distributor, primarily serving public schools in the U.S., with leading market shares of 30% and 10% in the core and extensions markets, respectively.

Supplemental Material on this Misread Industry

The U.S. K-12 instructional materials market is largely misunderstood with its quirky accounting and cyclicality muddling the picture. The key components of this $11B market are 1) the core/basal market - traditional textbooks and 2) the extensions market - targeted solutions for students and teachers. Secular trends include the shift from print to digital and the focus on individualized learning. Public school funding for instructional materials largely come from local and state governments, which pitch in roughly 90% of monies spent. In contrast to higher-ed, the U.S. K-12 market has seen a slow but steady rise in $/pupil spend which, when combined with modest growth in student population, drives low single digit growth for the overall market.

The core market, which is $2.5B in size, is effectively an oligopoly with HMHC, McGraw-Hill and Pearson collectively having roughly 80% share. The market has meaningful barriers to entry: a fragmented customer base of 13,600 public school districts requiring a large sales force, a standards-based curriculum mandate that entrenches existing suppliers and substantial content development costs. Typical concerns relate to cyclicality, threats from open education resources (OER) and its overall growth trajectory. In our view, while adoptions can be deferred, there is a visible replacement cycle which occurs every 5-7 years. In addition, the shift from print to digital will eventually soften the impact via annual licensing. We also believe that while OER has gained share, that risk is limited given OER lacks the scale to become a national threat. Finally, while core growth may be challenged as extensions selectively take wallet share, HMHC’s core is still a solid, cash flow generative business whose infrastructure complements its growing extensions business.

“Heinemann, as you can see, has had a compounded annual growth rate over the last five years of 15%. It is now the second largest business within our portfolio . . . if it were a standalone business, it would be one of the fastest growing and largest standalone businesses in K-12.” – HMHC CEO Jack Lynch Investor Day 10.17.19

The extensions market, estimated at $6B, is faster growing and steadier than the core market given its exposure to the secular growth trends in personalized learning and lack of adoption cycles. As an overview, extensions are learning solutions that are near-adjacencies to the core product and are comprised of supplemental, intervention and professional solutions. Supplements are products that aid in a certain skill while intervention solutions are products that help students who are significantly behind grade level. Finally, professional solutions are products and services that help teachers develop and implement curriculums. Due to extensions’ secular growth and lower cyclicality, the market has seen interest from private equity firms, which often pay low to mid-teens EBITDA multiples. HMHC’s largest extensions business, Heinemann, has over $300MM of billings and is a reputable developer of literacy tools. Given its strong growth, this asset itself could garner a 12x+ EBITDA multiple or at least $900MM in a sale. Another 25% of HMHC’s extensions business includes smaller, but growing, supplemental/intervention tools which could be worth north of $400MM. While one could argue that HMHC should separate the two businesses, we believe that the company’s presence in 90% of U.S. schools, driven by its substantial core market share, better positions it to grow its extensions business.

No More Head-Fakes: A Real Opportunity

“Over the last several years, we began to stray away from our core . . . the most notable example of that was last year's California reading adoption.… Going forward, we will refocus on our core and concentrate our investments where we will get the greatest returns.” – HMHC CEO Jack Lynch Investor Day 7.23.17

To understand why this opportunity exists, we need to revisit HMHC’s trying path since its IPO. In short, prior management failed to execute and message appropriately. Specifically, the company took its eye off the ball and whiffed on two critical adoptions in California, which hurt 2016-2018 performance.  Management instead focused on competitive adjacency markets, such as direct to consumer, which also resulted in meaningful expense creep. The other failure was management’s misguided projections at its 2015 investor day of a continued ramp in EBITDA and FCF off a very strong 2014. Separately, the financial reporting of the company has also been a source of confusion for investors and caused solid quarters to appear as a “headline miss.” GAAP rules which require HMHC to defer large portions of digital sales (now over 40%) can result in a timing mismatch between revenues and their associated costs. By contrast, management guides and manages the business on a cash basis, which creates challenges for those trying to compare financial metrics with other media/information services companies. These past unforced errors and accounting vagaries of the industry have sullied the company’s reputation, weakened management credibility and burned many investors.

“Our strategy and the actions . . . dramatically improve free cash flow at all points in our cycle, from positive free cash flow in the trough to substantially higher free cash flow in the peak.” – CFO Joe Abbott HMHC Investor Day 10.17.19

Through the Corsair Lens, we see great operational execution in 2019 and bullish projections for future cash flow, creating a compelling entry point in the stock. On the operational side, HMHC returned to form as it won a massive 56% market share in Texas’s English Language Arts core adoption. The large award, along with HMHC’s broader 10% win-rate growth in reading, signifies that HMHC has regained its focus. Another highlight has been the rapid growth of extensions, which overtook the core as the largest source of billings. Extensions has structurally higher EBITDA margins and benefits from HMHC’s network of sales reps and digital learning platform. Importantly, this execution gives management some hard-earned credibility.

Perhaps even more significant was HMHC’s unveiling of its unlevered FCF margin forecast during its October 2019 investor day and what that will mean for future adoption cycles. Led by the growth of its higher margin and less lumpy extensions business, along with better cost containment, HMHC projected ‘higher highs’ and ‘higher lows’ in cash flow that were above expectations. We believe these projections are achievable given they are based on a believable cost structure, an average core market share win-rate and continued growth in extensions. Finally, management is also committed to bridging the gap between GAAP metrics and cash-based guidance – going forward, this should result in less confusion and more positive reactions to quarterly results.

Path to Sustainable Growth and Financial Performance

“Free cash flow growth is being driven by innovation and how we create value for our customers . . . creating stickiness and committing to a capital constrained continuous development model is reducing variability in our cash flow and increasing visibility into future free cash flow growth and we're applying that free cash flow to improve our balance sheet . . . creating a capital structure that better fits our business” – CFO Joe Abbott Investor Day 10.17.19

Management has successfully transformed HMHC from a heavily textbook-reliant business to a faster growing, higher margin producer of integrated core/extensions content. The next three years should be mid-cycle for core adoptions with overall margins steadily rising as the mix of extensions grows. Valuing the company on a conservative blended multiple of 12x 2020-2022 average unlevered FCF yields a stock price of $12.20, or 91% above today’s price. Today’s seasonally adjusted $550MM of net debt is more than manageable, especially considering the company is expected to generate over $300MM of FCF during the next 3 years. We believe that HMHC’s steady cash flow and debt paydown, combined with clearer and more credible financial guidance, will serve as helpful catalysts for the shares. Ultimately, if public markets don’t give HMHC the respect it deserves, its rapidly improving mix of businesses should attract PE buyers, just as it had in the past.

Catalyst

-- FCF Generation

-- Debt Paydown

-- Improved disclosures surrounding cash based guidance (perhaps disclosing expected deferred revenue)

-- Term Loan Refi