Houghton Mifflin Harcourt Company (HMHC, Financial) is a global leader in Pre-K to 12 educational content and services. The company has dominant domestic market shares in reading, math and sciences, over 40% in the three largest areas of curriculum. They have globally recognized brands; rich, iconic and proven content; an established reputation as an educational innovator; and a deep competitive moat around their franchise.
The company went through a pre-packaged bankruptcy in 2012 to mend an over leveraged balance sheet. New management was brought in from Microsoft and the broader technology industry to lead the transition of the business to a new model, incorporating digital content as part of learning transformation. Products have been re-configured to incorporate the appropriate amount of digital instructive content to enhance the learning experience and learning outcomes. We think we are in very capable hands - the new team has the experience, savvy, and professionalism to take the business to the next level.
The market for educational content is large and has improving fundamentals. The outlook for state and local educational budgets is better after several years of deferred purchases. We believe there will be the funds plus the desire/focus to spend on education. We believe incorporating digital content that necessarily will be updated and served by the content provider will actually make the bond between districts and publishers tighter. The business will evolve into more of a sustainable subscription business relationship as opposed to a lumpy textbook adoption cycle, which we believe will be favored by the markets. . .rightfully so.
In addition, Houghton is expanding into adjacent growth markets. They will leverage their institutional relationships and brands to grow their educational services offerings, the education-related consumer market, the early childhood market, and the assessment market. Each are presently small businesses with, we think, large opportunities to grow.
The company will also selectively pursue acquisitions to enrich their content and overall growth profile. The company recently announced an acquisition of the Educational Technology business of Scholastic, which we believe will establish Houghton as the leader in the intervention market. We are excited about this transaction, since we think this is a top-notch offering and a natural fit, which the much larger Houghton salesforce can grow faster than its previous owner could. We believe the company paid a bargain price, especially after they realize the expected synergies.
We also favor the company’s compelling financial model. The company has been investing heavily in creating digital content and we think soon should reap the benefit of a significantly higher margin profile than when it was a pure print business. Accounting for the new business model is a little complicated since digital components, though paid for upfront, get deferred over the life of the contract for financial reporting. Thus, we look at this on an adjusted cash flow basis. We believe that metric will grow at a low double digit pace for the next five years. We believe they will generate significant free cash flow, which we expect to be used for acquisitions and stock buy backs, which already have started. At 10 times adjusted cash flow and 15 times free cash flow, conservative multiples that we think will be exceeded, and without any further acquisitions, we believe the stock should more than double over the next four years.
From Baron Funds’ second quarter 2015 commentary.
