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, CFAManaging PartnerLaughing
Water Capital, LP
About Laughing Water CapitalLaughing Water
Capital is a value focused investment firm based in New York that
specializes in businesses undergoing transformational change.
ContactLaughing Water Capital, LPMatthew
Sweeney, (917) 306-0461msweeney@laughingwatercapital.com
1 https://static1.squarespace.com/static/5d93ed0b59166652b0d66427/t/6140aa00b501454ed0c93167/1631627777129/LWC+-+HMHC+-+ValueXVail+-+final.pdf2
https://d18rn0p25nwr6d.cloudfront.net/CIK-0001580156/e1c52a26-50d5-473c-b1ee-00415ba6799b.pdf3
HMHC at Citi Apps Economy Conference4 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 2/1/225 HMHC Q1’21 conference call6 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_218
https://d18rn0p25nwr6d.cloudfront.net/CIK-0001580156/e1c52a26-50d5-473c-b1ee-00415ba6799b.pdf9
https://d18rn0p25nwr6d.cloudfront.net/CIK-0001580156/e1c52a26-50d5-473c-b1ee-00415ba6799b.pdf
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