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Houghton Mifflin Harcourt (NASDAQ:HMHC) made its public debut on Thursday, November 14. Shares of the provider of education solutions ended their first day with gains of 32.2%.

I remain on the sidelines even though shares have recovered from a lowered priced offering. The continued losses, selling interest from shareholders, and dependency on government budgets, are major red flags to me.

For the full year of 2012, Houghton reported negative revenue growth, driven by a squeeze on government budgets at all different levels. Furthermore the selling shareholders are not selling to raise some cash after founding the company, but in this case include sophisticated investors like John Paulson which only bought the company in bankruptcy less than 18 months from today.

And last, the continued losses even when striping out amortization and interest charges are meaningful which makes me believe the current valuation is too far ahead given the true earnings capacity of Houghton Mifflin.

The Public Offering

Houghton Mifflin Harcourt is a provider of education solutions to over 50 million students in over 150 countries. The company offers its solutions to both educational institutions and consumers across the world.

The company is a leading provider of kindergarten to twelfth grade content in the US. As most of these youthful students in the US have already utilized Houghton's solutions, the company believes it has a well-established brand name.

The strong intellectual property includes work of Nobel Prize winners, Pulitzer Prize winners and National Book Awards. Well-known characters include the Lord of the Rings, and Life of Pi, among others.

Houghton Mifflin sold 18.25 million shares for $12 apiece, thereby raising $219 million in gross proceeds. Note that all shares were being offered by selling shareholders, yielding in zero proceeds for the company itself.

Initially, bankers and the firm set an initial price range of $14-$16 per share. Shares were eventually sold just below the low end of the preliminary initial public price range. Some 13% of the total shares were offered in the public offering. At Wednesday's closing price of $17.66 per share, the firm is valued at $2.52 billion.

The major banks that brought the company public were Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), Citigroup (NYSE:C), Credit Suisse, Wells Fargo Securities (NYSE:WFC) and BMO Capital Markets, among others.

Valuation

Houghton Mifflin sells its products across multiple platforms and distribution channels. Its 300 sales professionals increasingly focus on individual consumers which are the target audience of life-long learners. The company furthermore creates digital content, apps, games and websites.

For 2012, Houghton Mifflin generated annual revenues of $1.29 billion, down 0.8% on the year before. The company reported a sharp increase in GAAP losses, increasing from $87.1 million to $2.18 billion. Losses were mostly driven by a $1.67 billion goodwill impairment charge. Even when excluding this charge and high interest payments, operating losses were very sizable.

Revenues for the first nine months of the year came in at $1.08 billion, up 7.6% on the year before. Net losses narrowed to $46.5 million on the back of lower impairment charges and lower interest expenses.

The company operates with $358.0 million in cash and equivalents. Total debt stands around $246.2 million, resulting in a net cash position of around $112 million.

Note that Houghton Mifflin will not receive any proceeds from the offering. With the equity in the business being valued around $2.52 billion, Houghton Mifflin is valued around 1.9 times 2012's annual revenues.

Investment Thesis

As noted above, the offering of Houghton Mifflin has not been a great success. The company priced the offering at $12 per share, some 20% below the midpoint of the preliminary offering range. Ever since, shares have seen a decent first day jump, trading some 17.7% above the midpoint of the preliminary offering range.

Houghton focuses on the US K-12 education segment as the firm likes to call it. This market is still very decentralized, as Houghton aims to grab a large piece of the estimated $30 billion in instructional supplies market.

According to the US department of Education, to be found in Houghton's S1-filing, the number of students is expected to increase from the current 55 million by another 8 million in 2021. On top of this, Houghton focuses on international markets as well as new sales channels.

Key risks include the fact that Houghton is still reporting losses after coming out of bankruptcy in 2012. Other risks include fierce competition and the possible negative impact of changing technology and competitive dynamics on the firm.

The fact that only selling investors offer shares in the public offering is a major red flag as well. Major selling shareholders include Paulson & Co, led by John Paulson. Other key risks are the reliance upon state and district funding, with many governmental budgets being stretched at all levels.

The fact that Paulson and affiliates try to flip their investment within one and a half year, is a major red flag. As such I remain on the sidelines given these risks and the poor operational performance.

Source: Houghton Mifflin Harcourt - Insider Selling Makes Me Cautious Of This Recent Offering