Initial Thoughts on McGraw-Hill Education Acquisition

Update (12/1): Added excerpts from NY Post article re. Apollo holding of Cengage debt

Earlier this week came the official news that McGraw-Hill Education (MHE) was being purchased by Apollo Global Management, a publicly-traded global alternative investment firm – roughly the equivalent of private equity in nature. Based on the PR Newswire report:

The McGraw-Hill Companies (NYSE:MHP) (“the Company”) today announced it has signed a definitive agreement to sell its McGraw-Hill Education business to investment funds affiliated with Apollo Global Management, LLC (NYSE: APO) (collectively with its subsidiaries, “Apollo”), for a purchase price of $2.5 billion, subject to certain closing adjustments.  As part of this transaction, McGraw-Hill will receive $250 million in senior unsecured notes issued by the purchaser at an annual interest rate of 8.5%.  The transaction, which is expected to close in late 2012 or early 2013, is subject to regulatory approval and customary closing conditions. [snip]

The McGraw-Hill Companies announced in September 2011 it would separate into two industry-leading companies following a year-long strategic portfolio review.

As noted in the article, this spinoff of the education division has been in the works for over a year, based on recommendations from a hedge fund investor in 2010 that led to a year-long strategic review. This review culminated in the Sep 2011 decision. It is clear from this review that MHE is a profitable, slow-growth (or no-growth) company.

McGraw-Hill said on Monday [Sep 12, 2011] that it would break itself up, spinning off its education division to focus on its business information unit in an effort to lift its stagnant share price.

The remaining business will concentrate on the higher-growth operations of Standard & Poor’s, along with the financial data provider Capital IQ and the energy and metals information service Platts. McGraw-Hill also said that it would cut costs and buy back $1 billion in stock this year. [snip]

Several [companies], like Kraft and now McGraw-Hill, are splitting their operations into a high-growth operations and a lower-growth one that nonetheless generates steady profits and could pay a big dividend [emphasis added].

For McGraw-Hill, its announcement was the culmination of a business review it had conducted for nearly a year in response to shareholder complaints about the company’s stock price. This summer, Jana Partners, an activist hedge fund, and the Ontario Teachers’ Pension Plan took a big stake in the company and added to the pressure for a major overhaul.

One interesting note is that McGraw-Hill Education recently hired a new CEO, as described by Education Week:

The sale comes just six months after McGraw-Hill named Lloyd Waterhouse CEO of McGraw-Hill Education. He will continue to lead the company under new ownership. Harold McGraw III, the CEO of the 103-year-old McGraw-Hill Companies, will lead McGraw-Hill Financial. Under Apollo’s ownership, McGraw-Hill Education will now be privately held, though some of Apollo’s funds are publicly traded. [snip]

In a phone interview, Waterhouse said he was fully aware of the sale plans at the time of his hiring, a contrast to a past stint at Houghton Mifflin Harcourt, when he was hired shortly before the company was sold. McGraw-Hill will be taking on a minimal amount of debt, which should allow the company to invest in products, Waterhouse said. Those products are likely to be increasingly digital, with a focus on curating content, technology platforms, and pedagogy.

“The mistakes some people have been making is they tend to think about portions of [the digital content] formula,” Waterhouse said. “We really want to put it all together in a focused way.”

I don’t have time for a full analysis, but here are some observations that I haven’t seen elsewhere.

• Josh Kim from Inside Higher Ed should claim his prize for this pre-EDUCAUSE prediction: “A Significant Merger or Acquisition in the EdTech Curricular Media Space Will Be Announced”. It’s true that his rationale was more based on a publishing company being on the other side of the acquisition, but the McGraw-Hill acquisition rumors coming less than 24 hours after the prediction justify his win.
• This acquisition has nothing to do with the University of Phoenix. The Apollo Group is the parent company of the University of Phoenix, and they have a subsidiary called Apollo Global, which is a joint venture with the Carlyle Group, another private equity firm. While the confusion is understandable, Apollo Global Management, shares nothing in common with the Apollo Group other than their admiration for the choir-directing sun-god.
• Despite the usual press releases touting great opportunities, this was a distress sale. Consider first the investment model of Apollo Global Management:

Apollo Global Management, LLC and its subsidiaries (“Apollo”) is a leading global alternative investment manager.  We are contrarian, value-oriented investors in private equity, credit and real estate, with significant distressed expertise. We operate our businesses in an integrated manner which we believe distinguishes us from other alternative investment managers.  We have applied this investment philosophy over our 22-year history, deploying capital across the balance sheet of industry leading businesses, and seeking to create value for our investors throughout economic cycles. [emphasis added]

• Consider next the sales price. McGraw-Hill Education was sold for $2.5B, including $250M in loans, and the net proceeds of the sale are approximately $1.9B. For the previous twelve months of operations, MHE had revenues of $2.121B and and operating profit of $284M. This leads to a sales price of ~1.2x revenue. For the first 9 months of 2012, revenues have dropped by 11% and operating profit by 15% compared to 2011. By way of comparison, when Thomson sold off their education companies to private equity in 2007, which became Cengage Learning. For revenues of $1.685B for FY2008, the company was acquired for $7.75B, leading to a sales price of ~4.6x revenue.
• This is the second recent case where Cengage Learning or their owner has tried but failed to acquire another company. The were outbid by Pearson to acquire EmbanetCompass, and now they were outbid by Apollo Global Management to acquire McGraw-Hill Education. This certainly raises questions about the Cengage long-term strategy – were these critical acquisitions or just targets of opportunity? Does the loss of both acquisition attempts require a change in strategy?

So what does this mean for the higher education market? While that question remains to be answered, I will point out that private equity firms, particularly ones specializing in distressed acquisitions, typically work at streamlining operations to maximize profits of the acquired company. It seldom occurs that the acquired company significantly invests in new product lines, but renewed focus on existing product lines and further acquisitions / combinations of companies could occur.

At the same time, Brian Kibby, president of the higher education portion of MHE has been quite vocal recently about their aggressive move to digital content. He responses to Josh Kim in October certainly gives some indications of the future (it’s worth reading the whole post).

Question 1: Can you talk about the business pros and the business risks for McGraw-Hill and other large educational publishers if this transition from paper to digital is complete by 2015?

Answer 1: I can only speak for McGraw-Hill Education here, but from our perspective, the transition from print to digital can’t happen quickly enough. The first reason for this is that we’re totally prepared for such a switch. One hundred percent of our content is available in a digital format – and has been for some time. On top of that, we have a number of digital learning systems that provide an experience that goes far beyond what’s offered by e-books. From a business perspective, there isn’t too much of a change – most of our digital products generate revenue, so for us, going from print to digital will just substitute one line of revenue for another.

The second reason, and the one I’d like to emphasize, is that the type of digital learning experiences we offer really have the potential to improve student performance in a way that print materials simply don’t. This is great for students, obviously, and it’s also great for our company. McGraw-Hill LearnSmart, our super-adaptive learning program, has been shown to help students improve their academic performance by one full letter grade. Combining these types of platforms with our content is allowing us to help improve results and experiences for students, faculty and institutions, and in truth, it’s changing the way colleges and universities think of us. We’re now much more of a partner than we are a publisher. Our recent announcement with Western Governors University is a great example of this.

The third reason we stand to benefit is that we’ve expanded our business model beyond products. We offer an array of services that solve real problems in the market and that can generate revenue for us.

Update: According to the NY Post, Apollo Global Management also owns debt from Cengage Learning, and this may give insight into their plans:

At the same time, Apollo also has a significant debt position in cash-strapped Cengage Learning, sources told The Post.

The second-largest college textbook publisher, which was bought by PE firms Apax Partners and OMERS Capital Partners for $7.7 billion in 2007, is expected to trip its loan covenants by 2013 or 2014, at the latest.

If that happens, Apollo’s plan is to repossess Cengage, combine it with McGraw-Hill Education and significantly cut costs, according to a source. [snip]

Pearson is the leader in the US higher learning market, and controls more than a third of the market. Cengage’s share is in the low 20s, while McGraw-Hill’s is in the high teens.

While Apollo may be interested in combining Cengage and McGraw-Hill, it is not essential to its business plan, according to a source close to the firm.

Apollo believes producing higher education materials in digital formats will ultimately increase profits as well as cut costs at McGraw-Hill Education.

Any thoughts on what this acquisition means for higher education? Feel free to comment here or at Google+.