Chris Colvin thinks Veritas is stealing $HMHC (podcast #98)

Chris Colvin returns to the podcast to discuss why he invested in Houghton Mifflin Harcourt (HMHC) and why he thinks the deal to sell HMHC to Veritas is much too cheap. You can see Breach Inlet’s letter to HMHC here and my notes on HMHC here.

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Transcript begins below

Andrew Walker: All right. Hello and welcome to another value podcast. I am your host, Andrew Walker and with me today, I am excited to have for the second time my friend, Chris Colvin. Chris is a portfolio manager and the Founder of Breach Inlet Capital. Chris, how is it going?

Chris Colvin: Great. Great. I really appreciate you having me again.

Andrew: Hey, I appreciate you coming back on. And I'll talk about that why in a second. But first, let's start this podcast the way I do every podcast. First with a quick disclaimer for everyone. Nothing on this podcast is investing advice. Please do your own work. Consult your own financial advisor. Just keep all of that in mind.

And then second, with a pitch for you, my guest is going back, time flies. You were one of the first ten or fifteen guests on the podcast back in November 2020. People can go listen to that for the full pitch. But you are a super sharp small-cap investor. The last idea you pitched, I thought it was so eventy. I thought it was so good, and it worked out really well. And people should go listen to that. That was Great Canada- Great Canadian Gaming. That worked out well. And I am seeing a lot of parallels to the idea we are going to talk about today.

So with that out of the way, the stuff we are going to talk about today is HMHC. I know you've got a long history with it. There's an acquisition offer out there which I think is too cheap. I know you think it is too cheap. But I'll just turn it over to you. What's going on with HMHC?

Chris: Yeah, sure. Thanks again for having me. And hopefully, this has a similar outcome or better than Great Canadian did. And disclaimer, as you said, "Do your own research". My firm does have a position in HMHC and I would also say we are not looking to form a group with any investors.

So HMHC, it is been around since the 1800s. They became public in the 1960s and then went private again in 2001. And they were owned by a couple of private strategics between '01 and '13 before they became public again. So given that background, this thing has definitely been bought out before and owned by both private equity and strategic. We got involved and I should say first, I looked at this in 2015, around the time I was launching my fund. And I passed on it because the prior CEO had a very unclear long-term strategy, and profits were declining pretty precipitously. So I passed on it, put it in my file or watch list file, and said, "Hey if the CEO changes and they kind of change the strategy. There are some good things about this business".

And we got officially involved, took a stake early last year when it was around 5, 6 bucks a share. And our thesis was transforming from good to great business. So you had a business with a 30% market share in an oligopoly. There are effectively 3 players that have an 80% share. So, they are the largest. And that was in the core curriculum for K through 12 schools. So great market share in their moat. The primary moat they had was their brand. As they say, in this case, "You do not get fired at a school for picking Houghton Mifflin's books". So that was a very sticky moat from a 100-year-plus brand.

So, that was why it was a good business. And we believe it is transforming from a great business, or into a great business because they sold, or are in the process of selling their non-core consumer books business, and that has since been completed. But at that time, it was up for sale. So that was part of our thesis. And with that, they were transitioning to more recurring revenue, as books are now, instead of being a hard textbook that you and I had in school, switching to an iPad and software program.

So, switching to more recurring revenue. They were cutting a bunch of costs. They have a lower cost structure and make it far less capital intensive so that growth, consistency, and cash flow profile were becoming far more attractive. So, good to great business.

Then you had some unique tailwinds. One was school is reopening. Secondly, you had government stimulus which ended up being, I think 200 billion dollars is allocated for K through 12. And COVID accelerated this concept of one device for each student. Before COVID, on average you had one device for every 2 students. And that has really become one-to-one as obviously kids were homeschooled. So you have these nice tailwinds that would help them and their transformation, and accelerate earnings growth and recovery.

And the third element of our thesis was an experienced CEO, Jack Lynch, who had transformed or founded 5 different companies in the ed-tech space. This was, I guess, his fifth, so he had a lot of experience and success.

And then lastly, it was [inaudible]. On the math, we were doing normalized earnings. It was trading, at that point, sub-five times. And that normalized earnings ended up being very conservative given they continue to cut costs and a rebound in billing. So, that was the reason that we initially invested. Obviously, it worked out well this first year of ownership. But we were looking forward to owning it many years from here. We had, I think, a $40 price target, looking out eighteen to twenty-four months.

And I actually had lunch with the CEOs live in Charleston part-time. So, I had lunch with them, actually 3 days before that Bloomberg article came out. And from that lunch, I took away that this is going to be looking to create long-term value for shareholders, and thinks that stock is cheap. It was about fifteen or sixteen bucks then.

After that lunch, we saw the Bloomberg News stating that they were looking at getting acquired, or that private equity suitors were approaching. We sent a private letter to the board stating we are not going to tender or vote yes if it is less than $30 a share. Because again, we thought fair value looking on a few years was forty. And obviously, ultimately, they announced that Veritas would be, it is trying to acquire them for $21 per share through a tender structure. And we wrote a public letter outlining the reasons we do not support that. Why we would not tender our shares.

Since that letter, 3 other shareholders have written public letters. And I know of others that have considered this or are certainly not happy with this. Since our letter, the tender doc came out. So, I am happy to walk through the 4, 5 reasons we are against the tender but that is some background.

Andrew: Let's see that in a second, but let's just pause it. That was a fantastic overview. But if I was just to summarize it, you invested this in early 2021, did well with it. It is done well. But right now, the situation is this company is under a merger contract. There's a tender offer outstanding to buy out the whole company at $21 per share. You and-- I know Laughing Water and Engine have both publicly come out with a letter. I do not know who the other one is.

I've heard from several shareholders. One of my friends, Jonathan, has been pushing me for years to look at this company since I've got text messages from him when it was at $3 per share, and I've just had trouble looking. But he was like, "I am so happy having Chris on. This is way too cheap." Veritas is still in the company. I know there are other shareholders out there who think this is too cheap. But that is the overall situation right now, right? $21-per-share offer on the table. You and some other shareholders are pushing back, "This is too cheap", "We either need to stay public", or "This offer needs to get raised a lot higher". Is that a fair characterization?

Chris: Yes.

Andrew: Great.

Chris: And I think that is one of the reasons we are against it. As has been outlined in the letter since ours, I think, there is a much better path for all shareholders.

Andrew: I am going to let you go through that path in a second but I just want to agree with one thing. You mention you had lunch with the CEO 3 days before the rumors broke. Obviously, I didn't have lunch but, as I was prepping for this podcast, I think it was a Goldman conference at the very start of January. And I put in my notes, I put in my Twitter thing for people to go see. He sounded so bullish. He was talking about how great 2022 growth was going to be, all the recurring revenues, how the business was firing on all cylinders. I couldn't believe that he would say that 2 months, 2 weeks before they would get into deep sales talk to sell the business at a fine premium, but it is still like, 9 times EBITDA. It is nothing great for all the growth and how well he was talking about the business doing.

Chris: Yeah, I agree with you. Disregarding back my lunch because I am not going to quote exactly but overall the summary from the lunch was focused on creating long-term value. I think there is a lot of opportunities, and think we are really cheap. And I specifically asked about private equity taking him out that was one of my concerns. And I said if they bring an offer above fair value or at fair value, that would bring that to the board. And obviously, we have different views of what fair value is and we can get into that.

Andrew: So, why do not we just start with that. Twenty-one dollars per share, your letter which it is going to be included in the show notes. I had a link to it on Twitter. We'll include it in the show notes so people can go read up on it fully. But why do not you just walk through, why $21 per share isn't fair? Because I think the company would say, "Hey, we ran a full process. You can go read the tender docs. We reached out to a lot of people. There's Party A, there are strategics, there are financial people". I think it was like, fifty or sixty people in total. We ran a full process. Veritas came out with the highest bid. It was a 35% plus premium to the unaffected share price. If you are going to turn this down, you are basically saying all these financial strategic buyers were completely wrong that this was a full and fair process that we ran. Who are you to push back on this?".

Chris: Yeah. I think the first thing is, the process. And this is something that wasn't in our letter because the tender document had not come out that disclosed the process, or this would have been at the top of our letter.

We believe this was a flawed process. Number one, if you look at the timing. So they started the first meeting to discuss strategic alternatives was in June of last year. They would have just reported trough billings. Their billings at that point were $400 million annualized. For perspective, in a normal environment, they should be doing 1.2 to 1.4 billion. Why would you consider strategic alternatives when you are just coming off of trough billings, trough earnings.

Andrew: It reminds me of our last podcast, it was Great Canadian who sold themselves right before the vaccine came out, right?

Chris: Similar. Right.

Andrew: Literally, right before casinos could fully reopen they sold themselves. It is similar in that way but please continue.

Chris: Yup, definitely. Definitely parallels. And then, that is the beginning of the process, the end of the process, the timing. I also struggle with it because they announced the deal 2 days before fourth-quarter earnings were due. And not only were those earnings ultimately very strong that we'll get into but they would have typically offered 2022 guidance. And I would make the argument if you just look at our fourth-quarter earnings, as you said earlier, it implies they are buying this for 9 times. McGraw-Hill was bought for just over 9 times, and that is, I would argue, not as good of a business. So on trailing, had they not announced this process, I truly believe, had they not announced the tendering process that this would be a $20-plus stock today. Because if you put a little premium to McGraw-Hill on trailing earnings, talking about times like, you are talking about a twenty-four, twenty-five dollar stock.

So, number one was the timing on the process. Secondly, I think I saw also in some of your tweets is the initial forecast was completely sandbagged. And that forecast came out in November after announcing third-quarter earnings. And that is what the initial bids were based on. So, they contacted sixty parties, and ultimately fifty-eight of those were gone before the revised forecast. So, this initial forecast, to be specific, said that 2021 EBITDA would be 190 million. Trailing EBITDA at that point, trailing twelve months was two-forty.

So, bidders looked at this forecast and said, "Wow, there is going to be a huge drop in earnings in the fourth quarter of '21, and then in '22, you are guiding to two-seventy. So now, there is going to be this hockey stick". I think any bidder, private equity firm that is looking at tons of deals every week quickly looks at that forecast and says, "Something does not smell right here and we'll pass", which is what you saw most do. Now, I do not know that but to me, that initial forecast was certainly sandbagged, and I feel confident in saying that. They ultimately reported their '22 guidance, '22 forecast, $270 million of EBITDA.

Andrew: If I can just pile on here, the initial forecast, which is done in November. So, there are six weeks left in the year, a hundred ninety-six in EBITDA for 2021, two-hundred seventy million in EBITDA for 2022. Then, January comes out, bids are almost due and they have to be revised. 2021 EBITDA comes in at two-seventy, as you said. They did 2022 in 2021. They were off by 40% on their 2021 projections in six weeks, and then they update their 2022 EBITDA from 272 to 286, 2023 EBITDA goes from 308 to 350. These are massive moves, especially for a business which I think we'll probably talk about this in a second. A digital recurring revenue subscription business that should have insane amounts of operating leverage, right? So, when your EBITDA goes from 270 to 300 or whatever, all of that is going to come through to the bottom line.

Chris: Yeah. I think it is important to point out, the initial forecast came out in November, right? I think early mid-November. I think, November 6 or something. So that is the six weeks you referenced. But initial bids were due December 15th. How in the world did the board not go to bidders and say, "You know what, this initial forecast is way low". Two weeks left in the year, you got to have a good sense that you are going to be way above a hundred and ninety million of EBITDA or a hundred and ninety-six million. So, yeah, sandbagged the initial forecast.

And then, to your point on the revised forecast. So, that came out in January. And at that point, there were only 2 of the 60 bidders remaining. And one of those not disclosed, I think it was Party B may be in the document.

Andrew: It is.

Chris: But they ultimately passed because I think, they had their own kind of, it was either integration or financing or funding issues. So, you are left with one real bidder, Veritas. And let's talk about that forecast real quick. The operating leverage for '22 is negative. And the operating leverage after '22 was low to mid-30s, and they have publicly touted 65% incremental margins for a year plus.

Andrew: I've got this in my notes but they are literally in their investor deck. I put the tweet. They've got a slide that says 65% of incremental billings flow through to free cash flow average not 65% of EBITDA, 65% of incremental billing. This is a business with insane operating leverage. And as you are saying, their forecasts are calling for almost D operating leverage as they grow.

Chris: Yeah, D operating in '22, and then about half that. And I am comparing apples to apples. They actually give if you dig deeper, the tender doc gives you their free cash flow projections. It is not on the table but then it is later. And when you do the math, it is thirty-three or thirty-four percent incremental margins. What happened to the 65% margins that not only have you been guiding to, but they actually had been achieving thus far in the recovery since they had reduced the cost structure. So yeah, the revised forecast I think the other thing that was concerning a couple of other elements and just the process itself.

So February 17th, Veritas submitted the $20 bid. That was their revised bid based on the revised forecast. The board goes back on February 18th and says, "No, you got to submit $21 a share."

Andrew: Yep.

Chris: They agreed to twenty-one that day. If you read the tender doc, February 18th, and the board that does not say, "You have to agree today or this is going away." I mean, they had no other bidders at that point because it was based on this revised forecast. But I thought that was interesting but the board asked for one dollar more. Veritas said, "Sure, yeah that sounds great. Yeah, we'll do that." I think that was interesting. Also, a couple of other things I didn't like...

Andrew: ...I would just say to be a fair and balanced neutral part, I do not disagree. It is quick to turn it around but I do think Veritas is an experienced private equity bidder. I have seen in past docs where a board comes back and says, "Hey, 20 is enough. We need 21". And the bidders can respond pretty quickly because they know where their bottom line is. So, I had to 100% disagree with you but just to be kind of a little bit fair and balanced there.

Chris: Yeah. No, it does not surprise me. They responded right away and yeah, I hear you, but I do think it is just maybe a little nugget that wasn't how much more to ask order. And then, of course, the structure. When we talk about the process instead of a vote it is a tender. And that is crucial, that is a huge negative for us as shareholders. And I thought it was laughable that in the tender doc when they listed the reasons you should agree to this merger because they had, "Here are the positives", "Here's the negatives." Listed under positives was, "This is a tender". That is not a positive as a shareholder.

And I am going to have a quick public service announcement here. ISS and Glass Lewis need to start making recommendations on tenders because I think you are going to see more tenders happen. And in the world where passive shareholders, the Vanguards, the BlackRock, the World, own over 50% shares which is all you need in the tender. They ultimately base it on proxy recommendations. There is no proxy recommendation. And I think they have to change that, and provide a recommendation on this because it is effectively the same as a vote. You're just voting with the tender.

Andrew: That's really interesting because the classic merger over bank-driven thing is, tender offers are the best because they happen really fast, right? You get your money. There are less chances of a deal falling through. There are less chances of something going crazy. When the tender offer happens, all the financing is going to be super fast. But that is interesting. It is a way to, kind of, get around, "Hey, maybe this was a flawed process. Hey, maybe somebody" There's something in there that ISS and Glass Lewis wouldn't do, and you can do this really quickly before anybody really pays it. That's a really interesting comment.

Chris: Yeah. And the last thing, I'd say, just on the process, is conflicts of interest. So we saw this in Great Canadian, too. Actually, if I remember right, Evercore was the advisor to HMHC. They also provided the Fairness Opinion. I know we are seeing this and seeing it more often. I remember when I was in banking if I recall, you always had a different bank which makes sense to do the fairness opinion. There's a huge conflict there. Yes, we should certainly get this deal done so when we get our banker fee. In that fairness opinion, used first-quarter estimated net debt, 3 million. Their year-end net cash was, like, a hundred and twenty million. So, you are talking about a dollar per share value that leaks just by saying, "You know what, we are going to base this on an estimated March 31st, instead of using the actual balance sheet at twelve thirty-one. And my guess is that March 31st was based off again on a very low forecast. They do not give you the details to get there.

And the last thing on conflicts of interest is two other things, the fairness opinion...

Andrew: ...Can I add one thing on Evercore? One person, when they heard you were coming out to talk on HMHC, they said, "Hey, I am really pissed that Evercore worked with HMHC on this because Evercore, apparently, does a lot of banking for Veritas on the other side. And they said. not to accuse a banker of feeding, of working with but they said, they think Veritas has a lot of work with Evercore, and maybe that had Evercore put their thumb on the scale a little bit there, too. So I do not want to accuse them of everything. That's an unconjectured rumor. People are saying that type of stuff but...

Chris: ...Actually, on the conflict of interest on the Fairness Opinion, they didn't actually name the transaction comps. At least I didn't see it. That's fairly uncommon to not even list what transaction comps they are using. But, fine.

But the last thing I was going to say on conflicts of interest, and again, like you said, not accusing anyone of anything, these are just facts that the tender doc discloses that Veritas paid Evercore $75 million over the last 24 months.

Andrew: Well, that must be where my friend got it from. I didn't realize it was the source. But that is why people are saying it, right? Like Veritas clearly works with them. And it is strange to have the private equity firm pay them so much, and then have them advise the target, very strange stuff.

Chris: And the gain give a Fairness Opinion. So, those are just facts. They were banker, Fairness Opinion, received 75 million. Take those facts and form your own opinions, right? So, go ahead.

Andrew: Speaking of conflicts of interest, that is great. I do want to talk about it. So, bankers can be conflicted. Obviously, private equity would love to buy every business for a song, right? But I want to come back to the management team and the board of directors, right? Like it seems strange to me that a management team in November would put together a forecast that was so off on the EBITDA forecast.

And then in December, when the process started, if I was the board, I would be like, "Holy crap, our EBITDA's going to be that much higher? We're gushing cash for, maybe we need to pause and evaluate. Look, earnings are 40% percent higher. Our business is 40% more valuable. We need to rethink everything, right? It seems a very strange time to go and sell the company."

So, I want to talk about, maybe conflicts of interest from the management and board point. Why do you think that they are recommending a sale right now? Why do you think they did not? Obviously, a lot of shareholders piss at this. Why would they go with a quick sale and not re-evaluate, maybe think about staying public, maybe asking for a higher price, all that type of stuff?

Chris: Yeah, it is a great question and I do not have the answer to that. I think it is the question that we are all asking. What I can point to is the board owns, I believe .3%. If you remove Jack Lynch, they own .3% of the shares.

Andrew: Yep.

Chris: Now, part of our assessment when we look at a potential portfolio company is, what is the experience, which I touched on. Jack has great experience in the alignment of incentives. And Jack himself had good alignment. Now, I do not know. The tender doc says that there have been no employment contracts executed. I would find it very hard to believe that Jack is not staying on. And I think, unless you know what that employment contract looks like, it is kind of tough. I think it is just speculation. And I do not want to speculate on maybe, for all I know, Jack is retiring. But I suspect he is staying on. There's probably a nice incentive package there.

Andrew: I do not want to speculate. But I will say, as you said, insider ownership here is very low. Jack owns, I think it is 400,000 shares of stock and another 600,000 sort of stock options. So on a $20 stock, that is not "nothing". But it is not huge, right? So I could imagine a world Autozone[?], sorry, Academy Sports is a company I've been looking at a lot recently. And they have a fantastic CEO. And what happened was private equity bought a business. They were having trouble and they got a fantastic CEO by saying, "Hey, we are going to give you stock options to buy a ton of this company on the cheap. It is very levered. It is just a little bit stressed right now. If you can make this work, you are going to make tens of millions of dollars."

And I could imagine, yeah there is no agreement between Jack and Veritas, but he knows himself. "I am the best person to run this business. If this goes private, they put some leverage on it. I can get some stock options and if I keep executing, I can really juice this thing." So, that would be my conjecture. I do not know if you want to add anything to that.

Chris: Yeah, because we do not know if Jack is staying on an employment agreement. We're speculating, I think, when you ask any shareholder that. When you ask me, "Why would the board agree to this?", I can just turn to exclude Jack. That group of board members owns very little stock, number one. And then two, I would want to know what the post comp is. And I think one of the letters written out there suggested giving Jack more comp. And I would be on board with that as well. I think he is done a great job running the business.

If we need to pay him based on if you hit these targets, this stock gets to 30, 40 dollars, as long as it does not get to where the compensation, obviously, is not truly hurting the shareholders. I think you could create a nice alignment there. So, we can talk about the better path, and I think that should include going to Jack and saying, "Hey, not sure what you had with Veritas but here's a deal staying public where you can make a lot of money if you create shareholder value". And that was what one of the letters actually a friend of mine, Persad [?], wrote on his own. We've known each other for years, been in similar situations, own the same companies, think similarly. And that is what he put in his letter which I thought was a really good idea.

Andrew: This is the charter, even Tesla did it, right? You give the CEO and you say, "Hey, we are going to put some aggressive share price targets out there. But if you hit them, you are going to make multiples and multiples of money" Right? Give him, "Hey, a hundred thousand shares, stocks at twenty. Hundred thousand shares vested, thirty. Hundred fifty thousand shares vested, forty. Two hundred thousand shares vested, fifty, and you've got to hit those in 5 to 7 years. And if you hit them, you are going to get really rich but shareholders are going to be super happy, right? You doubled the company. And it really aligns interests well, and I am with you". Because he joined this company in 2017. I think, he is done a really solid job. And honestly, he is probably been underpaid for how good of a job he is done in selling the non-core divisions, getting this business on the right track.

Chris: Yeah. I agree with you. I think he is done a phenomenal job and would be happy to pay him much more and align it with a higher share price. And I think there is a scenario where he could be more attracted than, maybe, what he'd get as a private company.

Andrew: Well, All I ask you first. Is anything else on the process that you want to talk about here?

Chris: No, I think, there is little but no. I think that is the big piece.

Andrew: Let me ask you a qualitative question. One of the things I was surprised by, so again, I am not an expert on this company. I followed them tangentially for a while. I brush upon them for the podcast, obviously. But one thing I was surprised by was, the CEO says, "Hey, we have got a significant barrier to entry for new companies." Thirty percent market share, as you said, pretty sticky business, salesforce. You're not going to be a startup company and come, and be able to just sell to Grade K on reading or something, right? Like there are real benefits to scale and salesforce and everything. And if you can do that often the best thing is, just go sell yourself to HMHC and they'll plug you into their huge distribution port. So, there is a barrier to entry there.

I was a little surprised, they have not done much bolt-on M&A, and stuff. I do not think they bought a business in the past 5 years or something. So my 2 questions there were, "Am I missing something?", "Is it strange that they have not done them M&A, or there is just a lack of opportunity?". And then, part two of the question was, "Do you think Veritas is looking at this company and saying, 'Oh, great. This is a leopard roll-up story'". Right? Like we buy them, take them private and we accelerate their growth by going to do a bunch of accretive bolt-on acquisitions.

Chris: Yeah, great question. So, in the first part of that question, they have not done M&A, and I think it is because they have really been focused on transforming the core business itself. So often, non-consumer businesses get the cost structure low, transition to more digital, and they had started to, so, if you think about the K through 12 markets there is the core piece which there is basically 3 big players, them, McGraw-Hill, and Savvas, which was part of Pearson.

And then you have, what I would call an in-core. Think of your reading math, sciences, that everyone's got to take, K through 12. Then, they have the extensions and supplemental market. And the easy way to describe that is to think of materials for students that are either behind the curve are ahead of the curve. And that is a business where they have like 10% share.

Part of their strategy was growing that share, and that was going to come through two avenues. One was going to their schools, their customers, and saying, "Look, we already served this core material. Now, we have created our own products and extensions. We think we can offer more here", and try to get their share and extensions up to core which is why all of us keep referencing normalized billings. I think the reality is, it is going to be much higher than normalized billings, materially higher because I do think they'll gain share.

The other part of gaining shares, so there is an organic piece coming up with their own products, and selling based on they have the best platform because then, they can serve everything. The second piece and they have actually been pretty vocal recently about, is the opportunity to acquire smaller startups that have great products but do not have the scale to get into the doors of the schools and to go sell this thing nationwide. So that was a key part of this strategy going forward.

When you look at some of the materials out there, it was focused on making sure of organic growth and we got the business going in the right direction. Then, it is M&A and then it is a return of capital. So, I had not seen it yet because they had to get the transformation done, and obviously, COVID impacted that in some ways, accelerated the transformation but probably took some more work. That was a major, kind of, setback from a bonus[?] perspective but that was definitely for the opportunity. And if you think about Veritas, they bought Cambium Learning. I think it was in 2018 if I recall, which is in the space. I believe they also bought the K through 12 business from Lexus if I am remembering right. So, they bought Lexus, and then they are keeping the K through 12-piece of that. So, they are already starting a roll-up here.

Andrew: I had forgotten about that about Veritas. So, obviously, they have got expertise in the space. Do you know if Veritas, I do not think they said it in the press release or anything? Do you think they are planning to merge this with the other businesses they have, or are they going to run this as a standalone and just be like, "We have got lots of place on the ed-tech space?"

Chris: I do not know, of course. But I would suspect I do not see why they would not ultimately merge these entities. I mean, the cost-saving, the cost synergies, there has to be some. And then second, I think there should be probably some revenue synergies. That would be my guess. I think what HMHC has stated publicly as part of the tender they released is the materials that the employees get. And in those materials, they imply or directly state that it would be standalone. But I would suspect that down the road, they are going to merge these entities.

And is one letter pointed out, if you read these materials, they say, "Look, this merger is happening". They're just customary closing conditions. And that is one of the things I think that is been pressuring from a shareholder perspective. This is not a done deal. Ultimately, the board does not control the company. It is also being down to the shareholders. And I think the employees, they own shares, and so it is unfair to not make clear to them that, "Hey, you've got it right here. It is not a vote. We have a right to tender or not. And oh, by the way, we plan to stay as a standalone entity. But the company buying us has acquired 2 other companies in the space in the last thirty-six months".

Andrew: I am completely with you there though at the same time I feel for, like, It is a tender offer, right? What do you say other than it is subject to customary closing conditions and stuff? My shadows are getting crazier. But no, I am completely with you there.

Let me ask you. Okay, so we have got the $21-per-share offer on the table, right? And from here, there are 2 paths shareholders can... Hopefully, shareholders get together and if everyone agrees, if shareholders think this is undervalued, shareholders do not tender. And then either Veritas can bump their bid, or Veritas walks away and HMHC is a stand-alone, publicly-traded company and we can go from there.

So, I want to walk down both paths. Let us start with path number 2. Say, the tender offer fails and Veritas walks away, I think you argued $40 per share in value, what would you like to see for that values can realize. Engine proposed, "Do a big tender offer right now to buy back a ton of shares at twenty-one or twenty-two, move on from this, and then go forward as a standalone". Would you like to see that? Would you like to see them really lean into inorganic growth? What would you like to see as a standalone if this deal falls through?

Chris: Yeah, good question, and I think it is worth touching on, and valuation. If you take the low end of their normalized billings and imply like a dollar and seventy-five or free cash flow, put a market multiple which I call six and a half times. I think this is better than the average public business especially as its transformation continues. But I get you to like $29 a share. If you take the mid-cycle billings, that gets you to 2 over 250 per share, free cash flow, apply mark multiple, and that is how you get a $40 stock, which is what we were getting when you look out a few years. And I think you will see multiple expansions, SAS peers, trade for seven and a half times revenue, which implies is a $7 stock.

And again, I am not saying it should be seventy today but that just kind of shows you the potential upside and expansion plus you have an NOL that is
worth about two dollars per share and net cash, balance sheet, and those are things that, the NOL we are not getting paid for and that is a future upside. And of course, I think there are going to be big synergies.

We talked about but it is also worth noting when the CFO was hired back in. I think it was sixteen. It was a twenty-dollar stock back then so there hasn't been truly any shareholder value created since he joined. And that just shows you. This isn't like they bought some huge premium and it is never been here.

Let us say much better business today than it was not 2016 when I was a twenty-dollar stock and also cheaper on an Enterprise Value basis because of net cash versus a lot of debt but I think the better path. I agree with what some of the other shareholders have written on a high level. I think if it were totally my decision. What I honestly if they are tossed walks away who I hope they walk away if they are not willing to pay materially more than I would go lever. The company two times on last year's EBITDA which should end up being sub 2 times on this year's EBITDA. You could go buybacks 20% of the shares in today's share price.

Andrew: Yep.

Chris: And that would convert to a stock that is doing on low in a building over two hours for sure cash flow on bid cycle billings over three dollars a share, put a mark in multiple. You're talking about thirty-five to [inaudible], five-dollar stock and that should still give you. So you do 2 times the leverage on last year's EBITDA ultimately, less than that on the forward EBITDA and it is things generating cash. So you should be able to also have the capital to go do some MMA because I think that is an opportunity to expand their extensions and supplemental product portfolio, and really increase their market share there. So, I think it is both of those scenarios.

Andrew: And I think the only other thing I would add again when I was reading the conference from the beginning of January going to the decks and stuff. This is a business. The revenue retention is off the charts. It is going to print cash flow. There are tons of operating leverage like this is a business. This is why private equity loves these businesses. It is a business that can support a lot of debt because it should be non-cyclical with selling into schools, non-cyclical, very steady with that revenue retention like two times EBITDA, two times leverage is not crazy on that type of business especially the leverage is going to come down really quickly because of both the cash flow generation and the growth. So I am with you.

So as a standalone business, what you would like to see, is kind of what I'll call the engine model, right? Hopefully, Veritas walks, buys back a bunch of shares at the Veritas price. So the arbs and everyone who was in it for the arb[?], can get the heck out. It is going to be at a creative price and the remaining shareholders who believe are going to own more of the company and hopefully, the company grows and it is going to prove to be very cheap. So that is one route. I am with you there.

Let's talk about the second route, we get into, I think the tender expires at the beginning of April. We get to the tender offer date and Veritas sees, "Hey, we do not have the shares to close this deal. We need to bump to get some of the crest or the engines." Or the other shareholders to have said, "We are not tender into this price. It is way too cheap." So they are talking about a bump, you have said, I think you said on a market multiple this business would be about twenty-nine or thirty. I think engine throughout a forty dollar per share price of the company. What price do you start saying? All right, burn in the hand worth more than two in the bush. What price are you saying? All right. I am going to tender my shares into this.

Chris: Yeah, before I answer that I should clarify that first scenario. They stay public. I was talking about two times gross leverage. They would still have a hundred and right now, 135 million dollars of cash flow reports.

Andrew: Great one, great.

Chris: Yes, so net leverage we are talking like one and a half going much, much lower. So in that scenario, you have the ability to buy back stock plus plenty of cash to go. Do your roll-up of smaller companies and you made a great point that I should have stayed. And also, you could pay $22 to share. So the folks that want to tender twenty-one. Well, now you can get a dollar higher in those like me that want to stick around and see a longer-term opportunity. So it is a win-win for everybody but in the scenario where...

Andrew: ...I would just say, I am a little greedier than you. I would say you offer twenty-one, so the arbs get their twenty-one, and then everybody else saved the dollar and can get a little higher but I am with you there.

Chris: Yeah, so to your question of what price would I accept? We said in our letter that we thought it should be $29 of share. Honestly, our letter was a little more conservative because I told you our private letter said $30 a share.

Andrew: And it was before the projections and the tender docks, and everything came out. So you were writing as ice called in the fog of war. There is new information that is going on some time.

Chris: Yeah and if you take her twenty-nine plus $2 of NOL value. That's thirty-one said differently, take our twenty-nine plus the fact that there is going to be, I think some synergies. So think about that and secondly that scenario where I told you we buyback to 20% of the shares. Just levering, it gross two times that gets you easily to $35 stock. I think pretty quickly north of thirty. So I would like to see $30. That's where I am going to tender my shares. If they came out tomorrow and said twenty-eight, I would still not be tendering my shares which someone could say, "Well, that is crazy" but that only sounds crazy because you are anchoring it to this very low, $21.

If you look at their trailing EBITDA, apply a slight premium to McGraw-Hill's buyouts which to be clear, I think is a better business, McGraw-Hill has a lot of higher ed-tech exposure which is a much more competitive market and they have very little share in the K through 12 extensions and supplemental. So if you take McGraw-Hill, apply a one-term, one-half term premium on trailing EBITDA. You get to a low to mid-twenties and obviously, we are not near normalized billings from what the company is publicly stated that does not include the benefits of a tender and everything. So, $30 would be if I owned 100% of the company and you were Veritas and said, "What do I have to pay you?" It would be thirty dollars this year.

Andrew: Yeah. No, look. I do not disagree with you but I think if they bump this to twenty-six to twenty-eight dollars per share, I think ultimately they are able to get this done. There would be some shareholders who weren't crazy-happy. But again, it comes down to burden in the end.

Chris: I agree with you.

Andrew: Yeah, yeah.

Chris: I do agree with you. We have owned companies for over 5 years. So we are probably a little bit more of a longer-term holder than I think. Maybe a lot of public money...

Andrew: ...Then May[?] who started ramping up on this a week ago and he is over here opining[?] like he is an expert.

Chris: Yeah, but no, yeah. So I agree with you. I think if they, especially at the high-end of that, but I think twenty-one, you know, you have a bunch of passive investors and something I would say, obviously, every shareholder means to make their own decision. But I think for those that say, "Well this is going to pass" Because there are all these passive investors and ISS is not going to give a recommendation and I do not want to take the PNL hit. I will again point out that I think this could there will not be much. I could be wrong but you will see event-driven guys sell this deal ends and Veritas walks away. But on a valuation fundamental basis, I think twenty-one is cheap on today's numbers. And so I am willing to say, "Look, I am willing to take the risk, they walk away." I hope they do because I think there is a lot more upside.

Andrew: Yeah. Look, I mean, this is a business that is growing mid to high single digits, great revenue retention, huge operating leverage as we have talked about, a great cash flow, not economically sensitive. If I told you about that business and we just blanked it out. Nobody would think that is a nine times EBITDA, ten times free cash flow business, right? You'd be saying, "Oh, this is a 12, 13, 14 times EBITDA business", maybe higher as you said with the market multiples thing. So I do not want to people to anchor on that. I think the most important thing you can correct me wrong. I've talked to a lot of shareholders now, maybe because of the passive flows and our dynamics and everything, a little. But I think there are a lot of shareholders who are with you. Like, if this price is under twenty-five, I think there are a lot of shareholders you just say, "Hey, I'd rather the company lever up, buyback shares", to get the arms out, to shrink the share account, and then keep growing because I think it is going to spit off a lot of cash flow. And I think we could be looking at $40 in eighteen months, especially with the chair repurchase dynamic.

Chris: Yeah, I would say, I heard from a lot of shareholders after I wrote my letter. Obviously, since I am not forming a group to not engage with those shareholders. But I have got a lot of feedback. I do not know of one shareholder, active shareholder that thinks $21 is near fair value. I mean, how often do you see? Four separate managers come out and write public letters and we are not an activist. We've written some letters but that is not our strategy. So I think that is important. The thing I left off when shareholders consider, should they tender or not? I said, "I think we truly have downside protection based on the trailing earnings power." But probably arguably, more importantly, I do not want to speak for them. But engine publicly came out and said, "Look, we want to nominate directors and pursue this tender offer or buyback path as soon as possible." So, I do not think shareholders will be left with what do we do now. And although we are frustrated that CEO and board presumably have accepted this tender. We still you know, would love and are willing to give, Jack would love to give him a compensation package that pays him for that upside. I do not think there is anyway.

I think it is a little different Great Canadian where I think it is shareholders were done with the CEO who actually ended up that was kind of a funny story, ended up getting fired because of, did you ever kind of tangent here, but.

Andrew: I remember a little bit of why the CEO got fired. At this point, COVID time flies so I can't. But I do remember, was it right before or right after the deal closed? But yeah, I remember that be.

Chris: Yeah, I forget the specifics. But in this case...

Andrew: ...I do not think it was pretty, is how it would put a kind.

Chris: Yeah. Something about invading some vax like going to get vaccine somewhere, he should know.

Andrew: That was it. Yeah, he said he was a hospitality worker and he drove like a hundred miles from their headquarters and was like, "Oh, yeah. I am a frontline worker. I need to be boosted to the front of the line for the vaccine." Allegedly, he said all this and it came out in the board had to fire him because of that. That was it.

Chris: Yeah. Yeah, and that is an area. I think Cheryl's were frustrating were in this scenario. I think we are all economic piece and I think we look at and say, "Look, he is done a great job, Jack. We would happily love to have them continue to run the company, give them a bigger conversation package, and you've got this engine who's got a great track record." And again, I can't speak for them. I do not know what they would ultimately do, but they have at least publicly said, "Hey, we would like to nominate board members and execute this buyback plan."

Chris: What I would love to see here is, I love to see the tender offer fail or they can boost it to thirty. I'll take thirty, right? But the tender offer fails and then in the next proxy, it comes out. The engine has put someone on the board who has a 6% ownership stake in the company. So you've got it a big shareholder involved and then Jack gets, as I call it the charter treatment, right? If you can get the shares to 30, 40, 50, in the next 5 years, you are going to create huge value. We are going to give you so much money and
you are going to be a multi-multi-multi-multimillionaire based on that.

And then six months later, I would love to start seeing all of the compounder bros start talking about and putting tweets off, "Oh hey HMHC, it is a business that grows." Great operating leverage they are committed to 2x leverage targets that they keep buying back shares the CEOs really incentivize. There's a line board and it is a great business and you see Scuttleblurb come out with a piece talking about how good and sticky the HMHC businesses and stuff are.

And you know, just like all the people who I really respect that but this becomes the small-cap, compounder bro, ed-tech company. That is what I would love to see because I think this business could do that and would create a lot of value going that path.

Chris: Yeah, and I think there is, of course, there is always execution race operational risk and just macro. But this is a business that it has some lumpiness based on the adoptions calendar but that is becoming a less lumpy but generally less cyclical business. There are some ties you municipalities in their budgets but generally less cyclical. This is not a business that we were talking about before the podcast. You have to worry about, where is consumer spending going to end, right? This is a much more defensive business than that becoming obviously a better business as it goes the more sass. So, I agree with you. That's the hope and I think it is a realistic one if this tender does not happen which I think...

Chris: ...Let me ask one more question. I know a big thesis, not the core thesis [inaudible], but I like a cherry on top of the thesis for HMHC had been, Hey, in the wake of COVID. There's all this money that the bill back butter money or whatever that is just going to get flooded into the municipalities into improving education, all this sort of stuff. And HMHC 30% market share as you said, they are going to be a mammoth beneficiary of that. To my two questions, you are. Is that still playing out on the cars on the horizon? And now I am looking at the projections, it is fine growth, but I do not see a wave of federal money. Do you think they understood that in the projections?

Andrew: Yes, I think the projections undersold from a top-line perspective. Number one, because there is $200 billion of stimulus to K through 12. And, and to be clear. It is not 30% of 200 billion, obviously, because that is going to go to a lot of different pockets.

Chris: Improving the HVAC, it is nasty and sort of stuff.

Chris: Right, right. And I think if I remember right, laughing water actually did do some math on. Here's the potential from that and I do not have it on top of my head.

Andrew: I think I have seen it that from. Yeah.

Chris: Yeah, which if you think about it we go lever up two times gross which is one and a half or something that, and then we have the surge in billings and cash flow. We can quickly pay that down, right? It makes it even more attractive because you have the stimulus funds coming through the next few years. The other reason that I think the forecast is low, certainly on the bottom line is we talked about incremental margins but on the top line, the normalized billings of a one-two to one-four where they were, historically, that was based on a 10% extensions and supplemental share. And I do believe that Jack and his team will ultimately gain share through. If you think about really their pitches, they are the only ones that basically sell the full services. McGraw-Hill has very little extension supplemental platinum equity bar from Apollo. I think probably and they have already made an acquisition. I think they are going to try to do more of that and then Savas, as far as I know, the other big player does not have very little extensions supplemental smoke. So Hoften has the best kind of Playbook that can bring you the full menu. And so if they are able to gain share in that, that would imply that normalized billings is a higher number than what it is been, historically.

Andrew: Perfect. Well, Chris, I think we have covered most of the main points here, but I want to make sure is there anything we didn't touch on HMHC that you think we should have touched on? Anything we kind of glossed over that you wish we had hit harder.

Chris: Looking through, I do not think so. I think we touched on everything. I think he did a great job. As always, is asking questions. I think that this summary again is for the reason, I won't rehash. Well, we think the process is flawed, because of the forecast and the other things we talked about. We think the value is this bit extra tender, extremely undervalues the business looking at trailing earnings and comps and kind of the future. The other thing is it makes little sense to go sell this one. We are still recovering from COVID and early in that transformation. I think they are still future sources upside from it. And lastly, I think they are just a much better plan here with compensating the CEO doing the buyback and you've already got activist shareholders publicly saying that they would nominate directors to help kind of get the board more aligned. So there is a very clear, I think also different from Great Canadian is, there is a much more clear path on what the future looks like. The shareholder base and hopefully the management team and everything.

So the downside from my perspective is to not tendering is very low and I think some people would ask if you do not tender and it happens, you are still going to get the $21. So that if they ultimately get 50% but the downside is low and I think the upside is huge because non-tender scenario as we talked about. This is a thirty and really a forty-plus dollar stock and a few years, I think.

Andrew: Look, I wrap it up with neither of us is looking to form a group with anyone. We want to make that clear. But if you are a shareholder or potential shareholder, you know, you should do your own work. Come to your own conclusions. But if you think this deal is too low, you should send a letter to the board and let them know. "Hey, I think this deal is too low", and if Veritas wants it, they need space fair price. And if they do not, I am not going to tender my share and I would support buying back shares, doing tender offers to shrink the share account, get the arms out.

So I would just say, if you are a shareholder, potential shareholder, do your own work. We're not looking to form a group but let the board know that you do not support this deal and do not tend to your shares because then Veritas will have to bump or we can try to run the more shareholder-friendly playbook. Do you want to add anything to that?

Chris: No, I think that is well summarized so.

Andrew: Perfect. Well, Chris, I appreciate you coming on. I am hoping this one works out as well or better than Great Canadian. We are talking before I know you have got a lot of other great ideas and we have some overlap. So we are going to have to have you out back on, hopefully, quicker than it took from the last time, but I'll include a link to the breach and letter and the show notes. People can go ahead and read that to see more of the thought process here. Chris is on Twitter under a bridge and I will include a link to that if people want to slide on into his DMs. Chris thank you so much for coming on and looking forward to the next time.

Chris: Yeah, really appreciate it. Great job as always Andrew and look forward to hopefully a great outcome again here and talking to the future.

Andrew: Perfect.

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