The big news in educational publishing last week was the announcement of the intended all-stock merger between Cengage and McGraw-Hill. The companies expect to achieve regulatory clearance by the end of Q1/2020 and the combined entity will operate under the name McGraw Hill. With pro forma revenues of $3.2bn, the new combined entity will be a strong challenger to market leader Pearson in the higher education space (total revenues of $5.4bn in 2018).
“Self-inflicted vicious cycle of decline in higher education”
Higher education publishing has been stuck in a self-inflicted vicious cycle of decline over the last decade, driven by lack of affordability. Higher prices have encouraged rental and re-use models, have promoted the growth of Open Educational Resources and have also driven growth in non-consumption of learning resources. Publishers have tried to compensate the market decline by further increasing prices. Apart from the poor service to students, this has also taken its toll on higher education publishers with Cengage losing $2m on sales of $1.5bn in the year to March 2018 and McGraw-Hill losing $160m on sales of $1.7bn in the last book year.
Tertiary education about the deal
In their announcement, management cites three main reasons for the deal:
- Revenue growth, due to higher sales coverage, rolling out of the “unlimited subscription” model, complementary offerings in K-12 and international sales growth (especially Australia, China, India and the Middle East)
- Cost synergies, estimated at $300m annualized
- Enhanced financial profile, with a better balance sheet supporting the adoption of recurring models and growth in adjacent markets.
Gains for shareholders and students
The biggest winners in this deal are likely to be the shareholders. Imagine the company might (eventually) be worth something like 13-17 times earnings (see Pearson), then with $300m of annualized savings, there’s arguably a potential cost synergy value of about $4-5bn, minus costs of maybe $300m to capture (my own unvalidated ballpark estimate).
Students should also be winners from this deal, as it enables the rolling out of the unlimited subscription model, alleviating the financial pressures of buying learning materials and at the same time increasing access and insights.
In the short term I think it’s likely that Pearson will be a winner from this deal too, as the people impact of the transaction rocks the boat at Cengage & McGraw-Hill, also opening up the talent pool to Pearson. Sales at Pearson are likely to benefit from portfolio rationalization at the combination as well.
Pains for employees and suppliers
Part of the pain from the deal is likely to be felt in the organization. Imagine a scenario whereby 1/3 of the $300m cost savings might be realized through reducing duplication in the organization through redundancies. This might be of the order of 1500 jobs on the line particularly in US Higher Education and International segments where duplication is likely to be the highest. There will of course also be anguish caused by the uncertainty the deal brings.
The second area where much of the pain is likely to be felt is with suppliers: authors, printers, tech providers, landlords and so on, maybe to the tune of $200m per year, as duplication is removed and the higher purchasing power is executed. (In some areas such as learning design skills or printing, this will likely have a knock-on benefit for Pearson, whose bargaining power in the market will also increase with this deal).
Watch this space closely
There are three areas I would track very carefully in the next few years if I were a shareholder in the new entity:
- Deliver on the cost savings. In my view the $300m of stated cost synergies should be eminently achievable. This should be a high value, low risk lever and management should be very well capable of making it happen. This should as management states be realizable within 3 years of closing the transaction and will underpin both earnings as well as the transformation in the business model.
- Roll out the unlimited subscription model. This is in my view the key reason to do this deal. The new entity can create a more attractive unlimited subscription package for students (superior content and platform) but will need the cost synergies to pay for the investment and model shift. Solving the problem of access and affordability to students in higher education is the critical path for this company. Making this happen is in my view going to be the key driver of the future prospects of the business, hence also the multiple that can be achieved on exit. I do think there will be revenue opportunities in the other areas stated in the announcement, but I believe this is by far the key initiative. Revenues in the next few years are going to be difficult to read, with portfolio realignment, new adoptions and the roll-out of new models. Short-term this might reflect negatively in the financials, hence the cost synergies will be required to financially enable this transformation. I estimate this to be a high value, medium risk lever.
- Critically evaluate investments in new areas. In the short term, in my view, the synergies and shift to the unlimited subscription model should be strongly prioritized, from a financial and management perspective. I would be wary of too many activities in new countries or new segments for this company at this time, bringing more complexity and cost and distracting from the core transformation. Where I would want to see full momentum on the savings and model shift, I would at this time want to see a critical approach to things that increase the complexity of the business.
Overall I think this deal makes a lot of sense and is being done for the right reasons. Good luck to the team in making it happen.
Footnote: I am not an investor in either entity nor the future entity, I am not a financial advisor, and I have not in any way been involved in this intended transaction.