The following segment is excerpted from this fund letter.
Houghton Mifflin Harcourt (HMHC)
During the quarter, we took a central position in Houghton Mifflin Harcourt, a small cap education company which is undergoing a strategic business shift aimed at improving its customer captivity, value addition and margin profile. Houghton Mifflin is a leading education and learning technology company that primarily serves students and teachers in K-12 school districts in the areas of core curriculum, supplemental services and professional learning services. Houghton Mifflin was founded in the early 1900s and there are most likely few readers of this letter who do not recognize the name of your time as a student. Over the past few decades, HMHC has become an industry juggernaut, with its core math, science and reading products penetrating more than 90% of K-12 elementary schools, reaching 56 million students per year. year. Their educational enterprise consists of Heart study program offers in which they have 30% market share under an oligopoly, as well as the fastest growing Extensions business that consists of supplemental materials, professional learning services, and intervention programs for students in need of additional learning support. Because of their scale, resources, and investment in technology, Houghton Mifflin offers the most comprehensive, results-driven solutions in the elemental landscape. While the core business is strong, the most attractive aspect of this investment is HMHC’s digital efforts as well as its expansion offerings which suggest additional opportunities for growth at very high incremental margins as they are increasing their penetration of annual spending on educational materials.
Although the shares have risen significantly from their COVID lows, I believe HMHC is classified (and valued) as a slow growing, unprofitable cyclical company with a weak track record of value creation. Reality suggests that HMHC is a dominant cash-generating business currently at an inflection point, with a new streamlined cost structure capable of delivering strong fundamentals through all cycles. I think the poor bottom line, the nature of education spending tied to state adoption cycles, the not-so-simple accounting tied to digital product sales, and the COVID-related impact on the world of education have provided an attractive investment setup with the ability to buy stocks at a very favorable price.
Given HMHC’s track record, relationships and market share in Core offerings, it should come as no surprise that the company has been able to capture significant customer demand for its digital learning tools. Prior to the pandemic, many school districts that were significantly behind in the student-to-device ratio (computer, tablet, etc.) had no choice but to adapt during a period that left many schools permanently behind. closed for long periods. These factors necessitated the demand for remote learning tools that quickly moved the industry to a 1:1 student-to-device ratio in nearly all elementary classrooms, paving the way for the continued digital transformation of Houghton Mifflin. Going forward, this is the rare situation where the structural changes accelerated by COVID will provide positive and lasting tailwinds for the business. This massive and accelerated repositioning should prove permanent as it would be hard to imagine that many constituencies would be interested in taking a step back from using effective, fast and efficient digital tools so that students can continue to lug around textbooks and physical worksheets.
With the best products, the largest commercial presence in the industry and long-standing relationships with districts, HMHC has been able to make significant inroads into this growing new digital landscape by providing the necessary, accredited and customer-focused tools. outcomes needed to keep COVID-related learning loss at bay. Multi-year efforts have resulted in the development of a fast-growing digital business with over $120 million in annual recurring revenue, currently responsible for over 40% of TTM billings. HMHC successfully adapted to the product market, with digital sales up 123% year-on-year in the third quarter and net retention rates up 150%. As expected, the digital business comes with a much higher margin profile and, going forward, the continued mix shift towards digital learning products should result in higher overall margins for the business. business as well as significantly increasing free cash flow generation. If this happens, I believe the incorrect categorization of HMHC described above disappears, leading to a potential multiple expansion.
A good investment setup can sometimes be for management to make a significant bet – either personally or by shifting resources – on a specific product or range of services, which is exactly what happens within HMHC . Following the early 2021 sale of HMHC’s large print and media division – HMH Books & Media – it’s no secret what management is focused on as the business frees up resources to directing towards digital technology services while shining on the capital allocation front by paying down a large part of the debt and a significant reduction in fixed costs.
In addition to the very effective internal efforts of the leadership team, there are currently significant tailwinds in the industry in the form of increased education spending by states and local districts, with strong impetus provided by “catch-up” spending for learning related to COVID loss. These incoming dollars – in the tens of billions – not only provide attractive downside protection, but are also expected to go disproportionately in some cases to industry-leading education companies. With over $10 billion spent on educational materials per year (of which $7.5 billion is for extension offerings), there remains a long streak for growth given HMHC’s industry-dominant sales force. and only 10% billing penetration. Curriculum adoption is an interesting process which, unfortunately, is not always focused on the student or achieving the best results, but on HMHC’s track record, presence and industry reputation. offer huge competitive advantages because their pitch will always be listened to, their RFP submissions will always be read, and buying their products will never get anyone fired. I see no reason why HMHC will not be able to capture much of the shift to digital education over time.
Going forward, I am confident that HMHC will be able to effectively deploy future cash flows into sales resources, product development, share buybacks and potential mergers and acquisitions to generate further value. We should continue to see very strong results over the next few years, and there are multiple ways to own our shares very well, especially given our purchase price of what I estimate to be multiple single digits. normalized free cash flow. I look forward to providing more details on this investment in future letters and possibly adding to our position if the opportunity arises.
In early January, a [seemingly] leak story leak sparked a rumor that Houghton Mifflin was potentially considering a sale following an offer made by a private equity firm. Details have not been disclosed and this rumor has not been confirmed or denied by management. I still don’t understand the benefit of putting the business up for sale at this point, or why management would consider accepting a lower price than anything significantly above today’s valuation, of especially as the company’s strategic efforts and digital transformation are just beginning to shift and could provide a sustainable avenue for increased growth and free cash flow generation in the future.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.