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Despite being seen by many as an outmoded textbook publisher, Houghton Mifflin Harcourt benefited from a boom in digital learning during the pandemic. Now, investors are fighting over the future of the company as it seeks funding for its buyout by Veritas.

Shareholders such as Engine Capital argue that the buyout significantly undervalues Houghton. They believe Veritas could unlock significant value by helping the company ride a wave of digitization sweeping the education sector.

But some potential lenders see a legacy textbook business that is playing catch-up to more digitally savvy competitors. They worry that pressure to pursue debt-funded acquisitions could exacerbate already high pro forma leverage.

“Every company in this space is trying to become more digital, so that’s a major risk here,” said a buysider familiar with Houghton’s term loan offering. “But if it comes with a decent OID, there might be a place for it in the portfolio.”

Houghton’s take-private is the latest in a string of deals in the educational publishing sector.

After McGraw Hill and Cengage called off their merger in 2019, Platinum Equity bought McGraw Hill for $4.5bn last year. Pearson continues to gobble up smaller acquisition targets, as does Cengage. Pearson itself recently fielded (and rejected) a buyout offer from Apollo.

In February, Veritas and Houghton announced they had reached a buyout deal at $21 per share, implying a total enterprise value of $2.8bn.

The deal is backed by a $1.48bn seven-year term loan B (rated B2/B+ by Moody’s and Fitch, and talked at S+CSA+ 500bp­­–525bp, with a 50bp floor and a 97–97.5 OID). Financing includes a $390m second lien and $1.274bn of equity, according to Fitch.

On March 22, the same day that lead arranger BofA launched syndication of the TLB, hedge fund Engine Capital issued a press release claiming that Houghton should be valued above $25 per share, which would imply an EV closer to $3.2bn.

While Engine is the most vocal investor pushing these claims (the firm, which holds a 2.7% stake, issued a detailed presentation to explain why it will not tender its shares) other shareholders including Breach Inlet Capital and Prasad Phatak have voiced similar objections.

Some of these investors point out that Veritas could merge Houghton with its portfolio company Cambium Learning Group.

Engine says this tie-up could unlock $140m of potential savings that are not currently reflected in the price Veritas is paying for Houghton. 9fin reached out to Veritas and Cambium for comment about the potential for a merger, but did not receive a response by the time of publication.

Commitments for the loan package are due Friday, April 1, which was the original expiration date for shareholders to tender for the acquisition. Houghton has since extended the tender deadline to April 6, so lenders will have to commit before the outcome of the tender is clear.

Houghton’s share price is up more than 1,700% since March 2020. The company generated $270.2m of adjusted EBITDA in 2021, up from $88.7m in 2020 and $136.5m in 2019.

Sales were $1.05bn last year. That’s up from $840m in 2020, but shy of the $1.211bn Houghton booked in 2019 (for full financials, clients can see the company’s profile on 9fin here).

A mixed bag, but promising. However, as currently structured, the LBO will raise leverage to around 7x, from less than 2x currently — and some sources felt that was uncomfortably high for a company whose digital business significantly lags competitors.

Digital products made up 41% of Houghton Mifflin’s billings in 2021, and the company is looking to further invest to bring that up to 50% by 2023, according to a report from Moody’s. By comparison McGraw Hill draws 83% of its billings from digital.

“Physical printing of textbooks is not an industry that is very interesting, and it should probably be run with fairly low leverage,” said a CLO manager source familiar with the company. “The only part of the business that’s really interesting is the e-book part.”

Not all observers are ready to write off the textbook. Some point out that although classroom use of digital tools is higher than its ever been, elementary school kids still use textbooks, and that home internet access is still a barrier for some students when it comes to remote learning.

While Houghton’s pro forma leverage is high, it is somewhat comparable to McGraw Hill (rated B3/B-/B+) after a series of acquisitions last year.

McGraw Hill’s leverage rose to around 6.4x following Platinum Equity’s $4.5bn buyout of the company last August. It then rose again to 7x when McGraw Hill bought digital learning company Achieve3000 in October, according to Moody’s.

Of course, McGraw Hill draws a higher proportion of its revenue from digital than Houghton does. Still, multiple sources told 9fin they felt Houghton could support this kind of leverage thanks to its strong free cash flow.

Moody's expects Houghton will be able to delever to the low 6x area over the next 12-18 months, thanks to recent cost-structure improvements, its ongoing shift towards digital offerings, and increased K-12 spending with the support of federal stimulus funding.

Nevertheless, the cash flow picture is somewhat complicated by seasonality, with sales weighted towards the summer months ahead of the school year.

“We do see them generating good cash flows, but one challenge specifically for Houghton Mifflin is the seasonality and cyclicality of its cash flows,” said Moody’s analyst Dilara Sukhov.

Revenue is also vulnerable to changes in state budgets, which opens up a level of political risk — not just in terms of spending, but also in terms of content.

In the US, there are 19 so-called “adoption states” (including Texas, Florida and California) where the state’s education department selects a single approved publisher for all public school systems.

Those state deals, which are decided every 6-8 years, can be a huge win for the publisher who lands the contract — or a huge loss for the publisher losing the business.

They can also be contentious. Just last year, Houghton Mifflin showed support for the Black Lives Matter movement in a blog post, drawing criticism from parents and lawmakers who argue that critical race theory should not be taught in schools.

Nine states have passed legislation banning the teaching of critical race theory and another 20 states of introduced or plan to introduce legislation, according to Brookings.

Other states are “open adoption” states in which the education department provides a list of approved vendors that schools can choose to use.

Whichever model is used, there is momentum to suggest these state and local governments will continue to spend in order to upgrade their systems.

Just this month, a new Congressional spending bill included $42.6bn for K-12 schools through the remainder of the year, raising the prospects of further investments, sources noted as a boon for the industry.

In its first opposition to an acquisition since being founded in 2013, Engine Capital prepared a press release, a dedicated website and a 21-slide presentation to persuade other investors to join its cause.

It claims that financial analysis provided by Evercore (which advised Veritas on the deal) is “flawed,” “conflicted” and that “its fairness opinion is riddled with mistakes”.

Engine is pushing for Veritas to add more equity value to the deal, or abandon the acquisition in favor of a Dutch auction of certain shares that could theoretically raise the company’s overall equity value.

Evercore, Veritas, Houghton Mifflin and Cambium Learning did not respond to 9fin’s requests for comment. Lead arranger BofA declined to comment.

It’s unclear whether Engine has any hope of forming a blocking group, but it is not alone in its objection to the deal. Others have claimed the deal is undervalued; some have also questioned the timing of its announcement (two days before a scheduled earnings call).

Alongside Breach Inlet Capital and Prasad Phatak, Laughing Water Capital has also said it will not tender shares, and Dealreporter recently reported that Burgundy Asset Management has issues with the deal.

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