Significant Shareholder Prasad Phatak Sends Letter to Houghton Mifflin Harcourt Company Board of Directors Opposing Veritas Capital Transaction
Prasad Phatak, a significant shareholder of Houghton Mifflin Harcourt Company ("Houghton Mifflin" or the "Company") (Nasdaq: HMHC) today issued the following letter to the Company's Board of Directors (the "Board").
March 7, 2022
Board of Directors
Houghton Mifflin
c/o Corporate Secretary
125 High Street
Boston, MA 02110
Dear Board Members,
I am a shareholder of Houghton Mifflin Harcourt Company ("Houghton Mifflin" or the "Company"), with a total ownership position nearly twice as large as that of all the independent directors combined. For context, I previously ran an investment partnership for over 10 years and have been a shareholder of the Company for nearly two years, with a cost basis of ~$5.00/share. I am writing to express my disappointment in the Board's recommendation to accept an offer (the "tender") for $21.00 per share by Veritas Capital ("Veritas"). I believe the offer significantly undervalues the Company and although I am not opposed to a transaction in principle, in my view the offer does not sufficiently compensate shareholders for the significant growth prospects and opportunities ahead for the Company or the reinvestment risk of deploying capital in today's more uncertain environment.
While there appears to have been an organized sale process for the Company and I applaud the Board for considering strategic alternatives, I believe that not all companies need to go private to maximize value and that value is rarely maximized with a financial buyer. At the tender offer price of $21.00 per share, I believe shareholders would be better served by HMHC continuing to stay public and giving management additional time to drive shareholder value, as they have successfully done over the past several years.
I believe the Veritas tender offer at $21.00 per share undervalues Houghton Mifflin and do not intend to tender my shares for the following reasons:
- Based on the Company's own billings projections and my estimates of the resulting free cash flow, the offer represents just 8.2x mid-cycle unleveraged free cash flow at the midpoint. Below is an analysis of the offer price based on the Company's expectation of its mid-cycle unleveraged free cash flow12:
HMHC Mid-Cycle Unleveraged Free Cash Flow and Deal Valuation |
|||||||||||||||
($ in millions) |
|||||||||||||||
Low |
Midpoint |
High |
|||||||||||||
Mid-Cycle Billings (incl. Divested Publishing Segment) |
$ |
1,500 |
|
$ |
1,575 |
|
$ |
1,650 |
|
||||||
Less: Est. Publishing Billings |
|
(200 |
) |
|
(200 |
) |
|
(200 |
) |
||||||
| Pro Forma Mid-Cycle Billings | $ |
1,300 |
|
$ |
1,375 |
|
$ |
1,450 |
|
||||||
Fixed Costs |
|
(850 |
) |
|
(850 |
) |
|
(850 |
) |
||||||
Billings Above Fixed Costs |
$ |
450 |
|
$ |
525 |
|
$ |
600 |
|
||||||
Variable Margin Est. |
|
65 |
% |
|
65 |
% |
|
65 |
% |
||||||
| Estimated Mid-Cycle Unleveraged Free Cash Flow | $ |
293 |
|
$ |
341 |
|
$ |
390 |
|
||||||
Transaction Value multiple |
|
9.6x |
|
8.2x |
7.2x |
||||||||||
Importantly, on HMHC's public earnings conference call held on August 5, 2021, the Company's CFO, Joe Abbott, stated: "...while we have not put out longer-term billings guidance there, what we can say is that as you look out, really no structural reason why pre-pandemic levels of billings aren't achievable...".
For a leader in the K-12 education space operating in an industry oligopoly, with dramatically reduced cyclicality and with positive free cash flow at all points in the billings cycle3, there is no doubt that this multiple is far too low. Additionally, the Company has gone to great lengths to disclose its recurring revenue growth and digitally connected billings as it transitions to a SaaS business model, both of which should command materially higher multiples over time. In fact, management has publicly stated that it is even stronger post pandemic as a result of its digital-first offering. The Company's variable profit margin4 has continued to exceed management guidance and management has alluded to another step down in fixed and variable costs as more billings transition to digital and costs associated with physical delivery can be pruned.
Finally, with a dramatically improved balance sheet and free cash flow profile, the Company no longer has significant capital constraints that would prevent additional investment to fuel growth. In particular, the Company has spoken repeatedly about the potential for strategic M&A transactions to further grow its capabilities and extend its lead in K-12 education. As of the 12/31/21 balance sheet, the Company is now in a net cash position and has the flexibility to execute strategic acquisitions. The Company also has over $1.5bn in federal and state NOLs as of 12/31/20, implying that HMHC won't be a significant taxpayer for years, a significant asset for a public company.
-
Financial buyers rarely bring synergies and by definition seek a financial return. It is not terribly surprising that a suitable strategic buyer was not found given the oligopoly dynamic in the K-12 education space. Any "strategic" would likely be an operating business that needed to enter the industry, which is a higher bar to consider. Private equity buyers largely invest for the benefit of their limited partners, seeking financial returns over time. Almost by definition, that return is coming out of the pockets of current shareholders unless the private equity sponsor can add significant industry expertise or synergies. I suspect while not being obviously advertised, Veritas eventually plans to merge HMHC or leverage infrastructure with some of its other portfolio holdings, adding to its potential financial gains without paying a significant transaction premium for control of the Company. Relevant K-12 education holdings of Veritas are below:
- Cambium Learning Group ? Acquired December 2018
- Finalsite ? Acquired December 2021
Interestingly, the transaction press release cites Veritas' extensive experience in the K-12 education sector. Though they are undoubtedly experienced investors, the list above is hardly experienced for this sector. Their experience as investors, however, is exactly why the Board should be dubious of the price offered. Conversely, the Company's own management team, and in particular CEO Jack Lynch, has been involved in the K-12 education sector since 1999. It is not clear to me who is providing the experience to whom in this transaction. On that note, if the Company remains public, I am highly supportive of the existing management team continuing to execute and encourage the Board to restructure management's incentive plans to provide aspirational compensation for aspirational performance, further aligning with shareholders for long-term financial and operational excellence.
- Premium is irrelevant and is largely cherry picked. The announced deal premium was 36% above the so-called "unaffected price" prior to media reports that the Company was exploring a transaction. However, HMHC stock traded to nearly $18 after Q3 2021 earnings in November 2021 and the Company expected a strong Q4 and more growth in 2022 based on recent public commentary. In that context, the offer price is not a material premium vs. what the public market afforded HMHC before any media reports surfaced about a potential transaction. Had a leak simply been given to markets on November 8th, 2021 for example, the tender offer would look even more underwhelming. I believe many shareholders were looking to the Q4 2021 earnings announcement and 2022 guidance as the next catalyst for the Company's share price, especially given management's bullish commentary at recent investor conferences and an expectation that a debt refinancing could also make it easier to initiate a stock repurchase plan. Indeed, Q4 results were at the high end of management guidance for unleveraged free cash flow and exceeded expectations for billings, suggesting the stock may have been near the tender price without a deal announcement.
- Pursing a deal via tender offer is often unfair to investors. It has not gone unnoticed that the Board elected to pursue this transaction via a tender offer. This pathway avoids a shareholder vote and any chance for Institutional Shareholder Services ("ISS") to weigh in on the fairness of the transaction or provide a recommendation for holders. Additionally, choosing to announce a deal prior to giving 2022 financial guidance, providing shareholders with no access to management and having no public conference call all reek of a Board that seems intent upon forcing this deal on public shareholders. Part of the Board's fiduciary duty is to consider the Veritas deal versus all alternatives, not just other private approaches.
The Path Forward
Rather than selling to Veritas, the Board can instead provide a better alternative to investors by:
- Leveraging the balance sheet to 2.5x-3.0x LTM Net Debt / EBITDA (probably less than Veritas intends) and using additional proceeds to tender shares between $21 and $22 for holders that desire liquidity. This is an improvement versus the Veritas offer and allows remaining shareholders to benefit in the Company's future growth prospects.
- Restructuring management incentive compensation to allow for outsized financial gain in the event of outsized financial performance, improving on what management will likely get in rolling their equity into the Veritas deal. I believe shareholders would overwhelmingly support this aspirational pay for aspirational performance plan.
In short, the Board can easily replicate and even improve on the Veritas offer and allow for public shareholders to continue to benefit from the Company's growth. Perhaps CEO Lynch said it best, when he stated: "With accelerating billings growth, strong free cash flow and a transformed cost structure, we are at an important inflection point, and the time is right to move into the next phase of our long-term growth strategy alongside a partner that brings significant industry experience." I agree with most of Mr. Lynch's comments but believe the Company's bright financial future should accrue to existing shareholders and believe the Board should pursue an alternative plan.
Thank you for your consideration. I look forward to discussing this at your convenience.
Sincerely,
Prasad Phatak
1 Mid-cycle billings per management estimates given during November 2019 Investor Day.
2 Fixed costs and variable flow-through margin per management estimates as of 11/4/21 Q3 2021 Investor Call.
3 Applying the same analysis to trough expected billings of $1.2bn would still yield approximately $228mm of unleveraged free cash flow based on the Company's new cost structure and variable margin guidance.
4 Based on 2021 results, implied variable flow-through margin was 78%.
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