Riverdeep, an Irish company that makes educational software, describes its agreement to buy textbook publisher Houghton Mifflin as a match made in heaven. Hmm. We think the deal may have been hatched elsewhere.
As often happens in acquisitions that count on synergies, Riverdeep seems to have overpaid‚ deeply, if you will. The company will likely find itself in over its head, up the river without a paddle, or. . . you get the idea.
Riverdeep’s chief executive‚ who has built an equity stake over the past seven years that he values at as much as $2 billion, while putting up little or none of his own money‚ also seems to be engaging in some dangerously aggressive financial engineering.
Riverdeep is paying $3.4 billion for Houghton Mifflin. That is more than 2.5 times Houghton Mifflin’s annual revenue, even though revenue grew just 5.2% in 2005 and even though the business is unprofitable‚ Houghton Mifflin had a loss from continuing operations of $56.3 million in 2005 and $67.2 million in 2004.
To look at the numbers another way: Riverdeep is paying almost three times what private-equity funds paid for Houghton Mifflin just four years ago (after adjusting the 2002 price to account for the $435 million of dividends the funds paid themselves in the intervening years). It’s true that the stock market has risen since the funds bought Houghton Mifflin‚ but by a third, as measured by the Dow Jones Industrial Average, not by 200%. It’s also true that private-equity firms sometimes make wrenching changes in businesses and improve their fortunes drastically, but, if that happened in this case, the firms never told anyone about it. A record of Houghton Mifflin press releases shows the appointment of a new chief executive and a few other management changes since the takeover, but offers nothing about any broad restructuring of the business. In the meantime, textbook makers have come under pressure because students and school systems have complained about rising prices.
How can a $3.4 billion purchase price possibly be justified?
Riverdeep sees synergies. Although it isn’t terribly specific, the idea seems to be that educational software and textbooks will merge, creating a new sort of entity that schools and students will love and will buy from the pioneer in the field: Riverdeep. In the meantime, Riverdeep expects to benefit from Houghton Mifflin’s sales force and its relationships with school systems. Riverdeep also says it can save money by moving profits from the U.S. to Ireland, where corporate taxes are lower.
The sales force may, in fact, help some, but the U.S. takes a dim view of companies that artificially move profits offshore, so it can be expected to limit any tax savings. More importantly, history is fraught with examples of media that were clearly destined to merge but that took their good old time about it. If you go back far enough, you see that early television broadcasts were really just video versions of radio shows. It took many, many years for television shows to develop into their own form. (Decide for yourself whether the result is a good thing or a bad thing.) In the 1990s, makers of videogames were disappointed to find that they couldn’t just sell their existing products to the large audience of personal-computer users. Game companies had to develop products that took particular advantage of PCs, such as the fact that they are just about all connected to each other over the Internet. Some companies have recently had huge successes with massively multi-player games, which let tens of thousands or even hundreds of thousands of people immerse themselves in fantasy online worlds that players help create, but the successes came much more slowly and at much greater cost than anticipated. Today, media companies are finding that they won’t generate a huge audience by simply taking existing movies and television shows and making them available on cellphone screens. Companies are starting to experiment with shows designed specifically for cellphone users.
A saying has developed in Silicon Valley: “People often confuse a clear view with a short distance.” And that’s exactly what Riverdeep seems to be doing. Just because textbooks and software can enhance each other doesn’t mean they’ll do so broadly enough and soon enough to justify anything like a $3.4 billion takeover of Houghton Mifflin.
Usually, one major strategic mistake is enough to doom a takeover, but the Riverdeep deal with Houghton Mifflin seems to make a second, as well‚ relying on the sort of financial smoke and mirrors that we call “taking a shortcut through the numbers.”
To understand what’s going on, it helps to look at Riverdeep’s history and that of its CEO, Barry O’Callaghan. The company was founded in 1995 by an entrepreneur who saw potential in the market for educational software. In 1999, he brought in O’Callaghan, who was a 31-year-old investment banker at the time. O’Callaghan declared that Riverdeep would put its software online, not just on CDs, and was really an Internet company. By March 2000, O’Callaghan had marshaled an initial public offering and raised $150 million. The company had only $8 million in annual sales and was losing lots of money, according to Irish newspapers, but, in the best traditions of the Internet bubble, Riverdeep briefly carried a market capitalization of $2 billion. As it happens, Riverdeep went public on the very day that the Nasdaq index peaked, and it was just about all downhill from there. But, before too much market cap melted away, the nimble O’Callaghan managed to use his stock to buy seven companies, including the respected and profitable educational-software makers Edmark, The Learning Company, and Broderbund.
By 2002, the stock had fallen so far and so many questions were being raised about Riverdeep’s business that O’Callaghan lined up a small group that offered to buy the company for $373 million. Investors complained bitterly because the price per share that he offered was more than a third lower than the price Riverdeep set when it sold stock shortly beforehand, but investors were nervous enough that they sold. O’Callaghan wound up with almost a third of the equity. He borrowed money to buy his share, then set up a new capital structure for the company, which involved borrowing money and declaring a special dividend. The dividend let O’Callaghan repay his personal loan, essentially transferring his personal debt obligation into a corporate obligation.
O’Callaghan and the entrepreneur who founded Riverdeep bought out their partners, then, early this year, O’Callaghan bought out the founder. O’Callaghan paid $120 million for the founder’s 32% stake, meaning the total valuation of Riverdeep was still about $375 million. O’Callaghan’s 65% was thus valued at $244 million.
Flash forward to the current deal.
After announcing that Riverdeep would buy Houghton Mifflin, O’Callaghan said that deal would be accomplished by setting up a new company that would actually buy both Riverdeep and Houghton Mifflin. The new company, to be called Houghton Mifflin Riverdeep Group, will again have a new capital structure, which we assume will let O’Callaghan get out from under any debt he borrowed to buy out the founder, by turning that debt into some sort of loan to the company.
Here’s the screwy part: The formation of the new company assigns Riverdeep a value of $1.2 billion, more than 3.5 times the value that O’Callaghan and the founder agreed to less than a year earlier. Riverdeep also says that management will own 50% of the new company, which is claiming a value of $5 billion. No one is saying just what stake O’Callaghan will personally hold, but he’ll be the CEO, he already owns 65% of Riverdeep, and he’s been aggressive about looking after his own interests, so it seems fair to say he’ll wind up with $1.5 billion to $2 billion of the value that is being set aside for management. In other words, if our guess is right, O’Callaghan will have increased his personal equity by a factor of six to eight in less than a year, while ending up with little or no personal debt.
The calculations assume, of course, that we accept O’Callaghan’s valuations at face value. Should we?
Whle Riverdeep doesn’t have to disclose numbers because it’s private, Irish newspapers report that Riverdeep had revenue of $330 million in the 12 months ended June 30. That means Riverdeep is assigning itself a valuation that is almost four times revenue‚ a steep valuation in any market that isn’t enjoying exceptional growth. The newspapers also report that Riverdeep earned $82 million in those same 12 months, which could easily justify a $1.2 billion valuation, or even higher, except that those earnings are EBITDA or, earnings before interest, taxes, depreciation, and amortization. While Riverdeep apparently wasn’t any more specific about net income, the newspapers said that for 2004, the company’s last year as a public entity, Riverdeep reported interest expense of $85 million and amortization costs of $67 million. Riverdeep remains heavily leveraged, so it seems likely that the company is losing money on a net basis, perhaps even quite a bit of money. In any case, earnings don’t seem to make the case for a valuation anywhere close to $1.2 billion.
As a result, it doesn’t seem possible that Riverdeep and Houghton Mifflin together would merit a valuation even approaching the claimed $5 billion.
Now, companies can sometimes push the envelope in their valuations of their businesses and yet grow their way out of any problems before they become apparent. Amazon comes to mind. Amazon used some accounting tricks to obfuscate certain costs early on, yet grew so rapidly that it could in a matter of years begin using more generally accepted accounting principles without losing too much of its stock-market following. But there are also plenty of companies that start down the path of financial engineering and find themselves so loaded with debt and with a structure so complicated that they can never straighten themselves out. Warnaco, for instance, cobbled together a series of brands‚ such as Calvin Klein and Speedo‚ through an involved series of transactions, then found itself so indebted that it had to file for bankruptcy protection in 2001. Holders of $2.5 billion of debt had to sit down with Warnaco and negotiate how much they would get back on each dollar.
So far, the new Houghton Mifflin Riverdeep Group is looking a lot more like Warnaco than like Amazon. The company is private, so it can assign itself any value it wants, for the moment. But the company now has to make the rounds of lenders and other potential investors to see if they’ll buy the numbers that O’Callaghan is selling. Our advice: If someone comes knocking on your door, hold onto your hats, your wallets, and anything else that matters to you.
