Laughing Water Capital Issues Public Letter to Board and Employees of Houghton Mifflin Harcourt
Believes Veritas Capital's $21 per Share Offer Price Significantly Undervalues the Company and Questions the Timing of the Proposed Transaction
Announces Intention Not to Tender its Shares and Encourages Employees to Review the Facts Before Making a Decision
ROCKVILLE CENTRE, N.Y., March 01, 2022 (GLOBE NEWSWIRE) -- Laughing Water Capital, LP (together with its affiliates, "LWC"), a value focused investment firm that specializes in businesses undergoing transformational change, today issued a letter to the Board of Directors and employees of Houghton Mifflin Harcourt Company (NASDAQ:HMHC) (the "Company"). In the letter, LWC explains why it will NOT be tendering its shares into Veritas Capital's $21 per share tender offer to acquire the Company. The full text of the letter follows:
Dear Members of the Board and Valued Employees:
Laughing Water Capital, LP (together with its affiliates, "LWC" or "we") is a significant stockholder of Houghton Mifflin Harcourt Company ("HMHC" or the "Company") and has been a public cheerleader for the Company over the last year, having publicly presented our belief that HMHC had the ability to ~double earnings per share over the next 3-5 years, while seeing its stock appreciate to more than $55 per share.1 As management has previously largely agreed with our assessment on numerous occasions – most recently in HMHC's New York offices on December 9, 2021 – we are extremely disappointed by the Board of Directors' (the "Board") decision to support a tender offer from Veritas Capital ("Veritas") that seemingly will allow Veritas to capture the spoils that HMHC's employees have worked so hard for, and that HMHC stockholders have waited so patiently for. We do not believe that this tender offer is in the best interest of stockholders, and we do not believe it is in the best interest of employees, and we will thus NOT be tendering our shares.
Troublingly, it appears that management has presented this tender offer as a fait accompli in internal communications to employee-stockholders, noting only that the offer is dependent on "customary closing conditions," rather than informing employee-stockholders that they have the RIGHT TO CHOOSE whether they will support this transaction by tendering, or NOT tendering their shares.2 We believe it is misleading and disingenuous to withhold such information from employees when informing them of this POTENTIAL transaction.
We further question the timing of this POTENTIAL transaction, as the deal was announced only two days before HMHC's previously scheduled Q4'21 conference call, where management would have surely provided guidance for FY'22, and provided information about the continued growth of HMHC's SaaS offerings, which clearly deserve a higher multiple than traditional education assets. This is noteworthy in light of CEO Jack Lynch having publicly commented, "We feel like we're set up really well for growth in 2022" on January 5, 2022.3 We would be remiss if we did not consider the possibility that management purposely accelerated this POTENTIAL transaction in order to prevent stockholders and employees from having access to all of the information – including FY'22 guidance and the ongoing SaaS transformation – needed to make a properly informed DECISION on whether or not to tender their shares.
We also question the price the Board chose to endorse. We give full credit to the hard work that has been accomplished since Mr. Lynch and Joe Abbott began their respective tenures as CEO and CFO of HMHC, but also note that stockholders suffered mightily through this period. In fact, on the date of Mr. Abbott's hiring as CFO (March 14, 2016), which we believe represents the beginning of HMHC's transformation into the company it is today, HMHC shares closed at $19.77. Nearly 6 years later, with a vastly improved cost structure, an overly conservative capital structure and a more predictable pure-play education business that is growing in exciting new ways, HMHC is undoubtedly a much better and stronger business today. Yet, the Board has approved a transaction at only $21.00 per share.
Putting aside this historical marker, simply examining the Company's "normalized" ability to generate free cash flow ("FCF") suggests that HMHC can generate ~$1.80 per share in levered FCF in an average year, giving zero credit for likely continued growth, continued margin expansion and very obvious improvements to the Company's current interest rate payments, which are well above market.4 We would further note that management has explicitly endorsed continued growth, continued margin expansion and improvements to the Company's interest rate payments, suggesting that this estimate is conservative. The price recommended by the Board thus represents ~11.7x normalized FCF.
If HMHC specifically - or the K-12 Content Industry more broadly – was about to plummet off a cliff, then perhaps this multiple would be justifiable. However, there is no cliff on the horizon. In fact, due to massive Federal stimulus dollars meant to address Covid related learning loss, Mr. Lynch himself has estimated that over each of the next three years K-12 education spending should expand by $67 billion, which suggests that rather than a cliff, the Company is hurtling toward a launch pad.5
We believe that Mr. Lynch overstated the case when he suggested that the market could improve by $67 billion, but if one were to examine the 25% of the "American Rescue Plan" that is mandated for learning loss, and assume that 15% of this money will go to curriculum, and that HMHC will capture share that is commensurate only with the Company's 10% Extensions market share, then HMHC would generate an additional ~$159 million in billings annually over this period, which suggests an additional $0.80 of FCF per share per year, assuming no incremental operating leverage beyond the Company's stated 65% incremental FCF margin.
We would not argue that this super-normal FCF potential should be capitalized indefinitely in the form of a drastically higher acquisition multiple, but to suggest that stockholders should sell at an extreme discount to normalized levels in advance of super-normal levels boggles the mind.
In our view, a more appropriate multiple would be a minimum of 15x steady state normalized FCF, which suggests a price of $27 per share. Given the aforementioned likelihood of future growth, margin expansion, ability to drive free cash per share through balance sheet and capital structure optimization, and near-term super-normal earnings, perhaps 18x, or $32.40 per share would be more appropriate.
Again, we question the way in which this POTENTIAL transaction has been presented to employees of HMHC, the timing of this POTENTIAL transaction which seems designed to prevent stockholders from having the information necessary to make an informed decision and the valuation of this POTENTIAL transaction. We are thus forced to ask ourselves additional questions:
1) Management has repeatedly stated that the market has not yet fully recovered from the impacts of the pandemic, most recently on the Q3'21 earnings call. Given the rock-solid balance sheet and substantial FCF being generated by the Company, there is clearly no NEED to sell the Company at this time. So why should stockholders CHOOSE to tender their shares at a low multiple now?
2) Management has clearly indicated that the last several years have seen increased investment in "Plate CapEx" as the Company's digital platform was being developed, but that the heavy lifting is now complete so future expenses will be lower. Why should long suffering stockholders CHOOSE to allow Veritas to benefit from these investments, without paying a full price for them?
3) Management has clearly indicated that due to Federal stimulus dollars meant to address the Covid learning gap, the K-12 instructional materials market should greatly benefit over each of the next 3 years. Given management's stated belief that the Company can generate 65% incremental FCF margins, these stimulus dollars represent the potential for enormous incremental FCF. Why should stockholders CHOOSE to tender their shares now, and allow Veritas to reap this bounty?
4) In our view, with a net cash balance, at present the Company's balance sheet is woefully inefficient, contributing to a depressed share price. Further, during our December meeting with management we explicitly stated our fear that an unlevered balance sheet was an invitation for private equity buyers to storm the gates, and attempt a "take under" of HMHC. Management acknowledged this risk, yet it now appears that they and the Board intentionally left the door wide open, and set out a welcome mat. Why should stockholders CHOOSE to tender their shares to Veritas now, rather than having management appropriately lever the Company, and internally tender for shares in order to increase the per share value of the Company?
If the Company were to apply net leverage of 3x 2021 EBITDA-Pre-publication Costs (conservative by industry standards, and the Company's own history), and then tender for shares at $21, it could shrink the float by 29%, while increasing normalized FCF to $2.54 per share.6 At the paltry 11.7x FCF multiple that the Board has approved, this implies per share equity value of $29.71. At a more appropriate 15x multiple, this implies per share equity value of $38.10.
Why is this not a better path forward when those stockholders who would prefer to sell for $21 can still sell for $21, while those stockholders who continue to believe in the business can realize a 41%-81% better outcome?
5) In July of 2021 the Company hired Chris Symanoskie as the new head of Investor Relations, and during a December 9th meeting with LWC, management detailed its plans to improve HMHC's Investor Relations efforts, including planning a full Capital Markets Day following the likely refinancing of the Company's debt in February of 2022. Management specifically mentioned it was attempting to recruit sell-side research coverage from analysts that focused on SaaS based Ed-tech companies, including Udemy, Inc. (UDMY), PowerSchool Holdings, Inc. (PWSC) and Instructure Holdings, Inc. (INST). These companies trade at an average of 7.1x trailing revenue. Why would the Board elect to try to sell the Company from currently depressed levels, rather than following through with a plan that could clearly elevate the public share price, and thus raise the floor for any potential buyer of the Company? Why should stockholders CHOOSE to tender their shares to Veritas in advance of these planned improvements to the Company's IR efforts, which if successful could see the Company's revenue multiple more than triple?
6) The timing of Mr. Symanoskie's hiring also calls into question the completeness of the Board's sale process. Examining public filings related to Veritas' 2018 acquisition of Cambium Learning shows a process that lasted ~10 months, and included contacting 99 potential buyers.7 In our view, the Company would not hire a new head of Investor Relations at the same time it was considering a sale process, which suggests at most the Board spent a "few" months considering a sale of the Company. We apologize for using the vague term "few," but given the Company's statement it held discussions with "several" potential buyers, "few" seems appropriate. In any event, "several" is drastically less than 99. Did the Board undertake a full and complete sale process designed to maximize stockholder value? Or was the search limited to those potential buyers that management and the Board had a preference for?
7) Mr. Lynch has commented, "Partnering with Veritas will provide HMH with the opportunity to accelerate our momentum."8 How exactly will Veritas accelerate momentum? As mentioned above, the Company clearly has access to capital through its presently under-levered balance sheet, so it is not that the Company needs capital from Veritas. Further, management and employees have been executing phenomenally well, so it seems unlikely that the Company needs additional help there.
Is it possible that rather than Veritas providing HMHC with the opportunity to accelerate momentum, Veritas will instead allow management to operate without the scrutiny that comes from being a public company? We recognize that re-making a company in public is no easy task, but management wanting to avoid scrutiny does not mean that stockholders should CHOOSE to tender their shares at an insufficient price after what appears to have been an abbreviated sales effort.
Is it possible that Veritas will accelerate momentum through realizing synergies? Mr. Lynch has communicated to HMHC employees that there are "no plans for any reduction in workforce at this time"9 (emphasis ours), and there has been no announcement at this time to suggest that HMHC might one day be paired with Cambium Learning, which is also owned by Veritas.
However, surely HMHC employees are aware of the history of workforce reductions in the education world more broadly as Private Equity has been consolidating the industry in recent years. Are employees to believe that Veritas will not eventually seek to reduce overlap between Cambium Learning, a company that boasts a presence in 94% of U.S. school districts, while HMHC claims a presence in 90%? Are they to believe that Veritas will not eventually seek to increase sales of its Extensions products by linking them to HMHC's Core offerings through the Ed Platform that HMHC employees have worked so hard to develop over the last few years?
We estimate that between consolidating the HMHC and Cambium sales forces and attaching Cambium's Extensions offerings to HMHC's Core, Veritas could realize more than $300 million of cost and revenue synergies, or more than an additional $2.00 per share of FCF. Why should employee-stockholders – whose jobs are potentially on the line – not be entitled to share in these synergies? At the meager 11.7x multiple that the Board has approved, that suggests an additional ~$23.00 per share of value creation that will accrue entirely to Veritas, rather than to the Company's stockholders.
To be clear: We believe the synergies alone could be worth billions of dollars to Veritas. Should employees be comforted by the statement that there are no plans to realize these synergies at this time? Should stockholders CHOOSE to support this transaction by tendering their shares at a price that not only undervalues the Company on a standalone basis, but also allows any future potential synergies to accrue entirely to Veritas?
8) As demonstrated above, we do not believe this transaction is in the best interest of stockholders, who are being asked to tender their shares at a price that is well below our estimate of fair value, and we do not believe this transaction is in the best interest of employees, who are being doubly dishonored by being asked to tender their shares at a price that is not only low on a standalone basis, but insanely low on a synergized basis at a time when their jobs are likely months away from the chopping block.
If neither stockholders nor employees stand to benefit, then who does benefit? The obvious answer is management, although we cannot be certain as thus far there has been no disclosure around whatever sweetheart deal management may have been offered as part of this transaction. But will management be thrown in the same bucket as the rank and file employees whose jobs will likely be on the line as a result of this transaction? Or will they be granted new options packages when Cambium and HMHC inevitably merge, and then given the opportunity to realize tens of millions worth of gains when the combined entity likely once again comes public several years later? Why should employee-stockholders not be entitled to participate in some of this potential upside?
In conclusion, we believe this PROPOSED transaction comes with more questions than answers as it does not appear to be in the best interest of stockholders or employees. We thus WILL NOT TENDER OUR SHARES, and we invite the Board and management to ponder the above questions internally when considering if they are fulfilling their fiduciary duties. We believe an honest assessment would lead the Board to conclude that it is in the best interest of the Company, its stockholders and employees to withdraw its support for Veritas' woefully insufficient tender offer. We further invite employees and other stockholders to ponder these questions as they consider their own response to the PROPOSED transaction.
Sincerely,
Matthew Sweeney, CFA
Managing Partner
Laughing Water Capital, LP
About Laughing Water Capital
Laughing Water Capital is a value focused investment firm based in New York that specializes in businesses undergoing transformational change.
Contact
Laughing Water Capital, LP
Matthew Sweeney, (917) 306-0461
[email protected]
1 https://static1.squarespace.com/static/5d93ed0b59166652b0d66427/t/6140aa00b501454ed0c93167/1631627777129/LWC+-+HMHC+-+ValueXVail+-+final.pdf
2 https://d18rn0p25nwr6d.cloudfront.net/CIK-0001580156/e1c52a26-50d5-473c-b1ee-00415ba6799b.pdf
3 HMHC at Citi Apps Economy Conference
4 Normalized FCF defined as average 2016-2019 billings, $850M billings breakeven, and 65% incremental FCF margins, as suggested by management, and share count as of 2/1/22
5 HMHC Q1'21 conference call
6 2021 adj. EBITDA – Prepub = $214M. Assumes 5% interest on $787,552 gross new debt, and $642,000 net debt.
7 https://www.sec.gov/Archives/edgar/data/1466815/000119312518323759/d627705dprem14c.htm#tx627705_21
8 https://d18rn0p25nwr6d.cloudfront.net/CIK-0001580156/e1c52a26-50d5-473c-b1ee-00415ba6799b.pdf
9 https://d18rn0p25nwr6d.cloudfront.net/CIK-0001580156/e1c52a26-50d5-473c-b1ee-00415ba6799b.pdf
