Born to Fail

Team Name: Rutgers Business School Myles Volosov, Tushar Paul, Xinyu Lu University Name: Rutgers – Newark Report Title: HMHC: Born to Fail

Since its founding in 1880, Houghton Mifflin Harcourt Company (HMHC) has become one of the “big three” education publishers, deriving it revenues from the sale of print and digital textbooks and instructional materials, trade books, reference materials, multimedia instructional programs, license fees for book rights, content, software and services, test scoring, consulting and training. HMHC went public in November 2013, so its financial data is limited. However, we feel that based on the available financials, changes in industry, and competitors, we can make a sound argument that HMHC will cease operations by 2020.

HMHC is no stranger to financial hardship. In 2012, prior to its IPO, the company sought

Chapter 11 bankruptcy protection to eliminate more than $3 billion in debt. As a result, more than 20 affiliates also entered bankruptcy. The company’s general counsel stated “the global financial crisis over the past several years has negatively affected Houghton Mifflin’s financial performance in a business that depends largely on state and local funding”. This bankruptcy resulted in handing over the company to its lenders, causing shattering losses for its initial investors. The factors that led to HMHC’s bankruptcy continue to exist today, and the company continues to operate in a challenging environment. During the company’s 2013 IPO, Paulson &

Co. and five other private equity firms were the only ones who stood to benefit. Although the company was losing large sums of money, 100% of the shares sold were insider shares owned by the private equity firms that had no intention of allocating any of these proceeds back to the company. From a going concern perspective, continued operations and shareholder value seemed not to be of paramount concern. Instead, this was a quick way to make money by disposing this company on unsuspecting investors.

HMHC’s financials indicate that no fundamental change has occurred; the company is still distressed, and is again heading towards failure. HMHC has had a net loss every year since 2009. As expected, going public did not have any improvement on profitability since there was no reinvestment of proceeds or restructuring. An analysis of HMHC’s statement of cash flows reveals that the last time the company had positive cash flows was before its IPO. Its earnings yield is currently -3.40%, and the main drivers of its losses seem to be a steady decrease in sales year over year, a steady increase in cost of goods sold, and rising debt obligations. HMHC’s price-to-book ratio is 1.52, lower than Pearson’s 2.02, clearly reflecting the fundamental flaws that exist. Its book-to-market ratio of 0.6598 shows that the security is already overvalued. Its market cap to sales ratio of 1.993 shows a less favorable market valuation than Pearson’s 2.161.

HMHC has never issued a dividend. In terms of reinvestment strategy the company has a payout ratio of 0%, and a return on invested of -4.50%. Investors should be wary of a company that pays nothing to its investors while maintaining a negative return on invested capital. HMHC has an asset utilization rate of 0.4769. Thus, for every dollar HMHC spends, it receives less than half that in return. If revenue growth and net income stay flat, as they have since its IPO, the company will wither away. Indicators suggest revenue growth will decrease causing the company to deteriorate even more quickly. The company’s capital structure is unsustainable without a rebound in earnings. In fact, HMHC is perfectly positioned to fail. In time, the market will realize the underlying issues plaguing HMHC, and correct its outlook.

The education and textbook publishing industries are evolving. The Internet and technology have fundamentally changed the way that education is presented and consumed.

Students have more options when making their academic purchasing decisions than ever before. As instructors seek technology to increase their teaching effectiveness, less emphasis is being placed on traditional printed textbooks and lectures. Educational institutions want a more customized approach that will suit the needs of their particular students, rather than simply purchasing a “one size fits all” textbook or educational package and then arbitrarily assigning it to their courses. In fact, many universities are opening their virtual doors to the entire world by allowing people to take full-length courses for free. For example, Princeton will be offering an

Introduction to Sociology course with Professor Mitchell Duneier this year. Under “Suggested

Readings”, the syllabus states, “All assigned readings are open source materials which can be found through the web. You do not need to purchase anything. Although the lectures are designed to be self-contained, will be recommending additional readings throughout the course for those who wish to delve further into particular topics”. An Amazon search using the key words “Introduction to Sociology” yielded 11,288 results for printed books, yet Princeton has concluded this course could at the very least be just as effective using open source materials.

Lately, several foundations and certain sophisticated open source organizations are specializing in online learning, for example, Acrobatiq is a Carnegie Mellon University company, with 10 years of open source platform experience, currently commercializing extremely sophisticated online courses using lower cost content being put together by industry experts.

Competition is a key component of business because it creates an efficient and fair marketplace where useful products thrive and useless products eventually fail. HMHC is competing with on-line products that provide similar or improved utility at no cost. If customers have these two alternatives, what logical basis would lead them to choose anything but the competitor’s product? This is not the first time an industry has seen such a radical shift towards alternative products that are free to the consumer. The music industry has already faced similar changes. The old formula in the music industry was to release albums, maximize radio play, sell as many copies as possible, and go on tour to perform as many shows as possible to generate revenue. However, streaming services like Pandora, Spotify, and YouTube have created an environment in which anyone with a device that can connect to the Internet now has millions of free songs at their fingertips. As a result, album sales slumped to crippling levels, forcing the music industry to restructure its entire business model. Fortunately, the music industry was able to harness the lucrative power of advertising and subscriptions to compensate for lost profits.

The classic formula for educational publishers is eerily similar to that of the music industry. Publishers would produce a textbook or other educational material, use sales representatives to market and sell their materials, sell and distribute as many copies as possible, and update their materials as often as possible. The music industry has always been more technologically inclined than the world of print because it always used the most advanced medium to deliver music at any given time from record players to cassettes, CD’s, and eventually digital streaming, which marked the demise of the old music industry model. By contrast, the print-based model for education has changed remarkably little for centuries. Like any other business, education and publishing will have to modernize its approach. Technology is rendering the services of educational publishers obsolete. Unfortunately for HMHC, this change could mark the end of its operations. It is so detrimental in fact; Houghton Mifflin Harcourt as it currently exists will not have the opportunity to adapt because adapting would mean the inability to produce a sound profit. Even if Houghton Mifflin Harcourt attempted to adapt, similar companies have already failed when trying to take on a modernized approach. Cengage Learning

Inc., one of largest providers of online educational material filed for bankruptcy in 2013. All corporations exist to maximize shareholder value; Houghton Mifflin Harcourt will certainly not be the exception to the rule.

In addition to its collegiate operations, a large share of HMHC’s revenue comes from the pre-k through high school market. The changes here are even more startling than those occurring in higher education. The global financial crisis reduced spending by state and local governments, so teachers must make due with whatever books they have or seek digital offerings for more updated and relevant materials. With the recent adoption of common core education standards, much of the current inventory maintained by publishers will be rendered obsolete.

Common core focuses on in-depth learning on targeted topics, rather than the more conventional liberal arts approach to education. Students cover fewer topics at each grade level, but in greater detail. Common core also requires the use of technology in most disciplines, leading teachers to use digital means to shape their curriculum while textbooks lag behind.

Teachers will be held accountable for more than their students’ pass rates on standardized tests.

It will require teachers to differentiate their instruction so that all students have the opportunity to learn. The Internet is already perfectly positioned to take on these challenges, whereas publishers would require a complete reinvention of their product offerings to suit the needs of the modern day classroom.

HMHC’s other business line is publishing fiction, nonfiction, and reference materials.

Mass publishing of literary works presents unique obstacles. The rise of self-publishing has already eroded the traditional publishers’ profits. Previously, authors did not have the resources to print and distribute their work to customers. E-books have not only changed the way people read, but have also created a direct connection between customers and authors. Independent authors can distribute their works to millions of people around the world in a matter of minutes via a simple upload, and now have the freedom to market and price their own books. In an article by Hugh Howey on AuthorEarnings.com, independent publishing accounted for 39% of daily unit sales of e-book genre bestsellers, compared to only 34% of books published traditionally.

Independent publishers have already obtained the largest market share, and this number is expected to keep growing as readers benefit from lower priced books and authors benefit from being able to keep more of their revenues. For the first time in publishing history, publishers also face a major piracy problem. Illegal copies of books are now published on the web with very little protection for the publishers. This is especially true for popular works; the more popular, the more likely an illegal digital version will be made available. Of course, these popular works are also the ones that would have benefitted the publisher’s revenues the most if the works were not available on-line. Some authors have noticed this trend, and provide their own works free on their websites in order to promote themselves. Piracy, both in music and in print, is very difficult to control. The music industry has failed to disrupt piracy, and the resulting legal battles may last many years. It is unlikely that publishers will dedicate a large amount of resources to combatting piracy, and even if they did, it is not the only problem they face.

HMHC is especially vulnerable because it is the least diversified of the big three publishers. Multinational corporations now own most large publishers, whereas HMHC has remained independent. McGraw-Hill recently sold off its entire education unit to Apollo Global

Management LLC for $2.5 billion in order to focus on financial services, since it is the parent company of Standard & Poor’s rating services, S&P Capital IQ, Platts, J.D. Power and

Associates, and is also the majority owner of the S&P Dow Jones Indices joint venture.

McGraw-Hill’s board chair, Harold McGraw III, stated “this agreement generates the best value and certainty for our shareholders and will most favorably position the world-class assets of

McGraw-Hill education for long term success”. This comment reflects the state of educational publishing. In order to generate the “best value and certainty” for its shareholders, McGraw-Hill left the educational publishing market. Mr. McGraw clearly did not regard the company’s educational division as part of its “world class assets”, so he divested it. Pearson’s business model is also far more diversified than MHMC, since it owns and publishes the newspaper and its accompanying website, a 50% stake in Group, a range of specialist financial magazines, and is a vendor of financial data. Pearson also specializes in providing computer-based testing solutions through its subsidiary, Pearson VUE. With McGraw-

Hill entirely out of the education sector, Pearson is positioned well to weather the storm that lies ahead, while HMHC stands stranded.

HMHC is in the unique position of being a bankrupt company that also happens to be publically traded. Private equity firms as a whole and John Paulson in particular represent some of the most sophisticated investors in the world. Nonetheless, they disposed of their investment in 18 months. If the company was in such healthy fiscal shape, why did they make such an accelerated effort to divest themselves of HMHC? The answer to this question is simple: The private equity firms realized the distressed condition of their acquisition and dispose of it as quickly as possible. Surely if the company exhibited potential, they would have reinvested at least some of the proceeds and made an effort to restructure the company so that it could thrive.

However, HMHC can no longer compete; each of its business lines faces critical threats. Higher education is rapidly changing to utilize either proprietary or open source materials in the classroom. K-12 budgets are shrinking while common core standards are taking hold. Authors no longer need the services of traditional publishers, and can now act independently. In the same way that the Internet dealt a blow to the music industry, publishers are awaiting their knockout blow. Technology has caught up and is producing superior products at more attractive prices.

Other publishers such as McGraw-Hill and Pearson prepared for this change either by selling off that segment of their business entirely or by diversifying their operations accordingly. Only 15 months have passed since HMHC’s IPO, but its financial statements are as grim as they have ever been. The company continues to have flat revenues, operating losses, and a negative return on invested capital. HMHC is outmatched in almost every category when compared to the other major publishers, an impressive feat in an industry that is failing as a whole. HMHC should probably have closed in 2012, but exists today as a result of Wall Street’s ability to attempt to create a profit even in the strangest of circumstance.