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the depth report - $HMHC
Improving Business model

We expect that somewhere around 100% of the people reading this are familiar with Houghton Mifflin Harcourt (ticker: HMHC). The company began publishing educational materials in the 1800’s. Almost everyone who has gone to school in the United States has had a Houghton Mifflin textbook in their hands. The business is simple to understand. HMHC sells educational materials to states and individual school districts. There is also a small publishing business that constitutes 9% of EBITDA[1] which the company is considering selling.

Catalysts to Unlock Value:
We see four changes in the business which could help the stock.

Reduced Expense Structure:
HMHC has reduced its expense structure. A company presentation from 2019 indicates a planned reduction in adjusted fixed costs as well as reduced additions to PP&E related to software platforms and applications. Houghton Mifflin is projecting a 2.5% improvement in free cash flow margin for a mid-cycle year. (We’ll go into the business cycle for educational materials later in this report.) Results from the first 9 months of 2020 indicate better expense control primarily in SG&A. In addition, the move from publishing large heavy textbooks to electronic delivery will provide a lift for future gross margin.

Recovery from an Extraordinarily Bad 2020:
2020 was a terrible year for the company due to Covid-19. States and school districts that had planned on buying new textbooks didn’t want to meet in person, and were also in the process of overhauling their educational plans for students due to concern about in-person schooling. The good news for HMHC is that those are not lost sales, and those districts will still buy educational materials. The sales just got delayed. In general, we like buying stocks that are down (at least partially) due to extraordinary, but temporary circumstances.

Houghton Mifflin is also well-positioned for a Covid-19 educational world. The last 12 months have been tough for students, and we’ve seen many reports and heard from many parents that virtual school isn’t working out well. Students are falling behind. HMHC also produces supplemental materials that help students who are struggling. We expect that more students are going to need this kind of help in the next few years.

There are also reports of large increases in homeschooling, and interest in homeschooling. Homeschooled kids are still going to need textbooks. In addition, with more parents teaching material they may not have seen in a couple of decades, we believe the new homeschoolers are likely to want more of the supplemental materials as well.

Change in Business Model:
The third change in the business is the most impactful. The entire business model is changing from one where the company would sell, print, and deliver huge heavy textbooks every 6-8 years to contracts where HMHC electronically delivers the new version of a textbook each year directly to students’ tablet or computer. The new model provides for annual revenue with big upfront payments, and reduced cost of book production and delivery.

As a comparable, think about when Amazon started to change its business model from storing and shipping physical books to electronic delivery to devices including its own Kindle readers. The cost of producing that book disappeared for the publisher. Amazon’s warehousing cost for electronic books went to $0. And “shipping” cost became a small amount of bandwidth as books were essentially emailed to devices. All of this led to lower cost and faster delivery. HMHC is moving in the same direction, and as a result, will be able to lower cost, deliver the newest version of a textbook every year, and get supplemental educational materials to struggling students without delay.

Smoother More Predictable Revenue and Earnings:
While we are enthusiastic about Houghton Mifflin’s prospects to recover from 2020’s extraordinary weakness, and to successfully overhaul its business model, we want to emphasize the two factors that can make results in a given quarter or year erratic. First, there is an irregular cycle in textbook adoption. Since each state has its own schedule, and since states vary in size, the sales opportunity in a given year will also vary widely. In a year when a large state like California, Texas, or Florida is buying textbooks, the market is much larger than in other years.

The second factor is that decisions are binary. While each state has its own procedures, typically, the state will approve a few textbooks, and each district will make their own selections. This doesn’t make the educational materials publishing business a bad business. It just means that results can be lumpy.

The shift to a new annual delivery model which more closely resembles software as a service means that instead of recognizing lumpy revenue from individual states once or twice a decade, HMHC will be able to collect substantial amounts of upfront revenue, and recognize that revenue throughout the length of the contract. This will smooth out earnings over time, and make results more predictable. In general, the stock market is more willing to put a higher multiple on predictable earnings and cash flow than it does for inconsistent earnings streams.

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