Breach Inlet Capital Sends Public Letter to Board of Houghton Mifflin Harcourt

Expresses Belief that Veritas’ $21 per Share Offer Severely Undervalues Houghton Mifflin’s Prospects as an Emerging Leader in the Digital Learning Space

Announces its Intention Not to Tender its Shares into the Offer and Criticizes the Board’s Failure to Make Every Effort to Negotiate the Best Possible Deal for its Shareholders

CHARLESTON, S.C.–(BUSINESS WIRE)–Breach Inlet Capital, LP, an investment firm focused on underfollowed and misunderstood small cap equities, delivered a letter to the Board of Directors of Houghton Mifflin Harcourt Company (NASDAQ: HMHC) today. In its letter, Breach Inlet Capital outlines the reasons why it will NOT be tendering its shares into Veritas Capital’s offer of $21 per share.

The full text of the letter follows:

February 23, 2022

Members of the Board of Directors

Houghton Mifflin Harcourt Company

125 High Street

Boston, MA 02110

Dear Members of the Board:

As you know, Breach Inlet Capital, LP is a significant shareholder of Houghton Mifflin Harcourt Company (the “Company” or “HMHC”), with an ownership interest in the Company exceeding that of all independent members of HMHC’s Board of Directors (the “Board”) combined. We made our initial investment in HMHC in February 2021 at ~$6/share based on our belief that the Company’s strategy to restructure and capitalize on the accelerated shift towards digital learning would create significant shareholder value.

Since then, we have witnessed management begin to successfully execute HMHC’s digital transformation and have remained enthusiastic shareholders, having constructively engaged with management numerous times. We remind you that along with our substantial ownership, we have a history of helping public companies create value for shareholders. For example, in 2020 we issued a public letter to Great Canadian Gaming’s (“GC”) Board of Directors, wherein we argued that Apollo’s proposed acquisition for C$39/share undervalued GC.1 Ten days after our letter, Apollo increased its purchase price for GC by ~15% to C$45/share.2

We are writing this letter to inform you that we are extremely disappointed in the Board’s decision to sign a definitive merger agreement allowing Veritas Capital to acquire HMHC for a paltry $21/share.3 We do not believe Veritas’ offer fully reflects the fair value of the Company. Accordingly, we will NOT be tendering our shares into Veritas’ offer to acquire HMHC for $21/share. As detailed below, our logic is straightforward:

We believe the potential value to be unlocked by HMHC’s transformation and the secular shift to digital learning weighs against a premature sale of the Company.

Our thesis remains that HMHC is in the nascent stages of a value-enhancing transformation in the midst of a thematic shift toward digital learning. In CEO Jack Lynch’s own words, HMHC is benefiting from “…the promise of digital learning increasingly [taking] hold across the nation…” Further, HMHC’s Schedule 14D-94 filing is tangible proof that HMHC’s transformation is far from complete. The filing states that “given the momentum we are seeing across our business”, the Company is “at an important inflection point and ready to embark upon the next phase of growth.” Clearly, shareholders will not capitalize on the full potential of HMHC’s transformation in an expedited sale to Veritas at what we believe is an objectively low offer price. A complete transformation has the potential to structurally increase both HMHC’s profits and its valuation multiple, resulting in significant upside from Veritas’ offer.

We believe conservative estimates and a below-market multiple objectively demonstrate that HMHC is undervalued at $21/share.

Given HMHC’s successful divestiture of its Books & Media Segment in 2021, our analysis focuses on the remaining Education Segment. The Education Segment’s billings averaged ~$1.2b from 2016-2019 (before COVID-19).5 At the January 2022 Citi Conference, Mr. Lynch said: “We feel like we’re set up really well for growth in 2022.”

Because we think HMHC should generate ~$1.1b of billings in 2021 and the outlook appears bright, we believe the Company could generate ~$1.2b of billings this year. Of critical importance, HMHC has also guided to 65% incremental free cash flow (“FCF”) margins above $850mm billings.6 Simply assuming a reversion to $1.2b billings then implies FCF of ~$230mm ($350mm x 65%) or FCF/share of ~$1.75 ($230mm FCF / 132mm shares7).

We do not believe there is a perfect comp for HMHC, thus we consider multiples for the broader indices. For perspective, the forward Price-to-Earnings (“P/E”) ratio of relevant indices are: ~22x Russell 2000, ~25x NASDAQ 100, and ~20x S&P 500.8 Then, consider several fundamental traits that make HMHC a highly valuable and above-average company: (1) secular tailwind of 1:1 device-per-student ratio, (2) 30%+ market share9 in an oligopolistic Core Curriculum market, (3) competitive advantages including a comprehensive end-to-end digital platform, (4) annual organic growth algorithm that exceeds 6%10 driven by persistent K-12 student enrollment growth & share gains in the Extensions / Supplemental market, (5) success of HMHC’s transformation to digital/SaaS as evidenced by its guiding annual recurring revenue (“ARR”) to comprise 12-15%11 of billings, (6) high 65% incremental margins with ability to further reduce both fixed & variable costs, and (7) a pristine balance sheet featuring a growing net cash balance.12

Given that P/E ratios of major indices are all above 20x and our view that HMHC is an above-average company, we think HMHC is worth at least 20x FCF.13 Nonetheless, conservatively assuming only 16.5x FCF and applying that to our estimated 2022 FCF/share of ~$1.75 implies HMHC’s fair value is ~$29/share.

Note the fair value estimate above also does not include three factors. First, HMHC’s growing net cash balance will be increasingly additive to the enterprise value in the future. In addition, HMHC could have significant synergies with Veritas’ Cambium Learning Group. Veritas could eliminate redundant costs and cross-sell products to drive revenue synergies. Third, HMHC has ~$800mm in Federal NOLs and another ~$1.4b in state tax loss carryforwards.14 At a 25% tax rate, the Federal NOL alone could provide $200mm+ in tax savings equating to another ~$2/share of value.

Veritas’ offer is inferior to McGraw Hill’s acquisition multiple, yet HMHC is a superior company.

There are three companies in the industry oligopoly: Savvas (Private), McGraw Hill (Private), and HMHC. Platinum Equity acquired McGraw Hill (“MH”) last year for $4.5bn or 9.2x 2021 EBITDA. HMHC has guided to 31% variable expenses and $446mm fixed expenses.15 Assuming HMHC generates ~$1.2b billings this year, then implies HMHC will generate ~$380mm of 2022 EBITDA (~$1.2b billings – (31% x ~$1.2b billings) – $446mm). This also means that Veritas’ offer equates to only ~7x our estimated 2022 EBITDA (~$2.7b / ~$380mm). Applying MH’s buyout multiple of 9.2x implies HMHC would be worth ~$27/share.

However, we believe HMHC is a superior company to MH and should command a higher multiple for two key reasons: (1) HMHC is entirely K-12 while MH has a higher-education division that faces challenging enrollment headwinds and (2) MH has little share in the Extension/Supplemental market. Therefore, we would argue that HMHC should be valued at a premium to MH or over 10x EBITDA. Assuming 10x our estimated 2022 EBITDA, this implies HMHC’s fair value is again ~$29/share. This again does not account for HMHC’s growing pile of cash, potential synergies with Veritas portfolio companies, and massive NOLs.

We believe HMHC’s valuation premium may be further enhanced as the market begins to view the Company as a subscription-based business.

As HMHC increases its mix of ARR, the Company may eventually be viewed as a SaaS or subscription business. Such businesses are commonly valued on revenue multiples. As small cap value investors, we adhere to the more conservative valuation approach: a profit-based method. We believe a profit-based valuation highlights why Veritas’ offer is unacceptable. But to further stress the upside potential HMHC shareholders may be forgoing if the Veritas transaction is approved, consider the following example.

A research note on HMHC recently stated: “Management believes its closest comps (based on moving toward a SaaS model focused on the K-12 sector) are INST and PWST.”16 Currently, Instructure Holdings (“INST”) and Powerschool Holdings (“PWSC”) each trade for ~7.5x 2022 Revenue.17 If we assume HMHC’s billings (i.e., revenue) return to ~$1.2b and receives a comparable EV/Revenue valuation to INST and PWSC, HMHC’s fair value would be ~$70/share.

We believe the timing of HMHC’s sale is perplexing, given forthcoming 2022 guidance and a seemingly incomplete sale process.

We find it disturbingly convenient for Veritas to sign a merger agreement just prior to HMHC earnings report, especially given HMHC’s fundamental momentum. The 4Q21 earnings report was due on February 24, 2022.18 As part of that report, HMHC was likely to provide guidance for 2022. Given CEO Lynch’s optimism about business fundamentals, we believe the release of 2022 guidance would have forced Veritas to pay more than $2.8b for the Company.

Further, we are concerned that an exhaustive sale process did not take place. HMHC’s press release announcing Veritas’ offer states: “…the Company held discussions with several potential strategic and financial bidders, including Veritas, through a formal process.” Meriam Webster defines the word ‘several’ as: “More than two but not many”. As a company with both strong financial performance and critical strategic relevance, we believe many parties would have interest in HMHC. In sum, we believe that a full process should have occurred after releasing 2022 guidance and should have included discussions with many strategic and financial parties.

To conclude, we think selling HMHC for $21/share is an egregious decision and we will NOT be tendering our shares into the offer.

Best Regards,

Chris Colvin, CFA

Founder and Portfolio Manager

Breach Inlet Capital, LP

______________

1 Source: Breach Inlet Capital Sends Public Letter to Board of Great Canadian Gaming
2 Source: Apollo Agree to Increased Purchase Price of C$45 per Share in Cash
3 Source: Houghton Mifflin Harcourt to be Acquired by Veritas Capital
4 Source: Houghton Mifflin Harcourt Schedule 14D9
5 Source: Education Billings In 2018 & 2019 and Education Billings In 2017
6 Source: Houghton Mifflin Harcourt Investor Presentation, January 2022
7 Source: Houghton Mifflin Harcourt Q321 Form 10-Q
8 Source: P/Es & Yields on Major Indexes
9 Source: Houghton Mifflin Harcourt Investor Presentation, December 2019
10 Source: Based on Breach Inlet Capital’s estimates.

11 Source: Houghton Mifflin Harcourt Investor Presentation, January 2022
12 Source: Houghton Mifflin Harcourt Q321 Form 10-Q
13 Note: Assuming D&A equates to CapEx over the long-run, then P/FCF is a fair approximation of P/E.

14 Source: 2020 10K. Assumes ~$220mm of Federal NOL utilized in sale of Books & Media segment last year.

15 Source: Houghton Mifflin Harcourt Investor Presentation, Q321
16 Source: BMO Capital Markets, January 2022.

17 Source: Sentieo
18 Source: Houghton Mifflin Harcourt Schedules Full Year 2021 Results

Contacts

Breach Inlet Capital, LP

Chris Colvin, CFA

Founder and Portfolio Manager

info@breachinletcap.com