The Depth Report – Houghton Mifflin Harcourt (HMHC) - Improving Business Model
We expect that somewhere around 100% of the people reading this are familiar with Houghton Mifflin Harcourt (ticker: HMHC). The company began publishing educational materials in the 1800’s. Almost everyone who has gone to school in the United States has had a Houghton Mifflin textbook in their hands. The business is simple to understand. HMHC sells educational materials to states and individual school districts. There is also a small publishing business that constitutes 9% of EBITDA which the company is considering selling.
Catalysts to Unlock Value:
We see four changes in the business which could help the stock.
Reduced Expense Structure:
HMHC has reduced its expense structure. A company presentation from 2019 indicates a planned reduction in adjusted fixed costs as well as reduced additions to PP&E related to software platforms and applications. Houghton Mifflin is projecting a 2.5% improvement in free cash flow margin for a mid-cycle year. (We’ll go into the business cycle for educational materials later in this report.) Results from the first 9 months of 2020 indicate better expense control primarily in SG&A. In addition, the move from publishing large heavy textbooks to electronic delivery will provide a lift for future gross margin.
Recovery from an Extraordinarily Bad 2020:
2020 was a terrible year for the company due to Covid-19. States and school districts that had planned on buying new textbooks didn’t want to meet in person, and were also in the process of overhauling their educational plans for students due to concern about in-person schooling. The good news for HMHC is that those are not lost sales, and those districts will still buy educational materials. The sales just got delayed. In general, we like buying stocks that are down (at least partially) due to extraordinary, but temporary circumstances.
Houghton Mifflin is also well-positioned for a Covid-19 educational world. The last 12 months have been tough for students, and we’ve seen many reports and heard from many parents that virtual school isn’t working out well. Students are falling behind. HMHC also produces supplemental materials that help students who are struggling. We expect that more students are going to need this kind of help in the next few years.
There are also reports of large increases in homeschooling, and interest in homeschooling. Homeschooled kids are still going to need textbooks. In addition, with more parents teaching material they may not have seen in a couple of decades, we believe the new homeschoolers are likely to want more of the supplemental materials as well.
Change in Business Model:
The third change in the business is the most impactful. The entire business model is changing from one where the company would sell, print, and deliver huge heavy textbooks every 6-8 years to contracts where HMHC electronically delivers the new version of a textbook each year directly to students’ tablet or computer. The new model provides for annual revenue with big upfront payments, and reduced cost of book production and delivery.
As a comparable, think about when Amazon started to change its business model from storing and shipping physical books to electronic delivery to devices including its own Kindle readers. The cost of producing that book disappeared for the publisher. Amazon’s warehousing cost for electronic books went to $0. And “shipping” cost became a small amount of bandwidth as books were essentially emailed to devices. All of this led to lower cost and faster delivery. HMHC is moving in the same direction, and as a result, will be able to lower cost, deliver the newest version of a textbook every year, and get supplemental educational materials to struggling students without delay.
Smoother More Predictable Revenue and Earnings:
While we are enthusiastic about Houghton Mifflin’s prospects to recover from 2020’s extraordinary weakness, and to successfully overhaul its business model, we want to emphasize the two factors that can make results in a given quarter or year erratic. First, there is an irregular cycle in textbook adoption. Since each state has its own schedule, and since states vary in size, the sales opportunity in a given year will also vary widely. In a year when a large state like California, Texas, or Florida is buying textbooks, the market is much larger than in other years.
The second factor is that decisions are binary. While each state has its own procedures, typically, the state will approve a few textbooks, and each district will make their own selections. This doesn’t make the educational materials publishing business a bad business. It just means that results can be lumpy.
The shift to a new annual delivery model which more closely resembles software as a service means that instead of recognizing lumpy revenue from individual states once or twice a decade, HMHC will be able to collect substantial amounts of upfront revenue, and recognize that revenue throughout the length of the contract. This will smooth out earnings over time, and make results more predictable. In general, the stock market is more willing to put a higher multiple on predictable earnings and cash flow than it does for inconsistent earnings streams.
How We View the Business:
We advise thinking about HMHC as a long-term investment with an improving business model, and looking at results across a multi-year cycle. In 2019, the company produced a presentation showing trough billings of $1.4B, mid-cycle billings of around $1.6B, and peak billings of around $1.7B. Billings are defined as sales plus change in deferred revenue so there’s a small additional level of complexity in modeling the financials. We used a trough case a little worse than company guidance, and a peak case a little bit better. Here’s what we see:
Our view is that the best way to view the business is over the course of a cycle. Given the variability in both state awards, and the decisions of individual districts, right now, it’s best not to be too attached to the results of a particular quarter. We expect that the company moving past 2020 will help. In addition, longer-term contracts will help start to smooth out financial results (as discussed above). If you assume the mid-cycle free cash flow is the average for a multi-year cycle, then it’s not hard to imagine HMHC trading at 10-11x making the stock a double from here.
We’ve seen some concerns regarding HMHC’s debt levels. As of the last quarter, net debt was $376MM. That’s only 1.8x mid-cycle EBITDA. In addition, with free cash flow in the $115MM - $200MM range for mid-peak cycle, the company is capable of deleveraging quickly. Finally, the publishing business is being considered for sale. While we don’t expect a huge price for that business, proceeds can be used to reduce the current debt load.
Public School Spending Levels:
Business interruption and high unemployment over the past year has taken a toll on local and state finances. While that could potentially mean educational spending cuts, we think that’s unlikely. Local school districts are largely funded by property taxes, and we expect that Federal spending on education won’t come down with the current administration. As discussed above, there is also a sense that due to school closures, and distance learning, a lot of students have fallen behind, and cutting educational resources seems an unlikely outcome.
The Timing of New Awards:
We’ve outlined why 2020 was a bad year for educational spending as districts kept their current materials and delayed making new decisions. While more schools are starting to open for in-person learning, there is still resistance to large group gatherings during a period of high Covid-19 cases. We don’t have any way to predict when these meetings and awards will start to resume, but do reiterate our point from before: School districts will want to continue to update materials meaning that while sales may be delayed, they are not lost. Today’s delay will lead to tomorrow’s demand.
The case for Harcourt Mifflin is very simple. The stock is down after a bad 2020, but the reason for those poor results won’t last forever. The business is moving from discrete irregular sales to a more predictable software as a service delivery model. Finally, new electronic delivery reduces printing costs, delivery costs, and enables annual updates for students. As the business recovers and becomes more profitable and predictable, we expect to see the stock start to trade for around 10x free cash flow or about double the current $5 stock price.
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From the HMHC 2019 10-K, page 104.