(Bloomberg Opinion) -- Back-to-school season can be something of a make-or-break moment for the largest publishers of U.S. college textbooks and other course materials.
This year, it looks more likely it’ll just be a breaking point.
Earlier this week, the University of North Carolina rattled the higher-education world by announcing it would shift to all-remote classes for undergraduates after coronavirus spread across its Chapel Hill campus, a serious blow given it was one of the biggest colleges to attempt in-person learning. On that same day, Moody’s Investors Service took an axe to the speculative-grade credit ratings of Cengage Learning Inc. and McGraw-Hill LLC, two of the largest producers of college course materials. It dropped both companies from B3 to Caa2, nearly the lowest rating possible without actually missing debt payments. The outlook for each of them is negative, a sign that Moody’s views some sort of default as likely. A week earlier, it cut market-leader Pearson Plc to the brink of junk.
RELATED: Covid-19 Shows That Scientific Journals Need to Open Up
The college textbook industry looks as if it may face a reckoning as the U.S. academic year begins, much like the rental-car business did in the early days of the pandemic. Almost six months into America’s coronavirus crisis, credit investors should see the common themes among companies that can’t outlast the virus’s reshaping of the U.S. economy.
Hertz Corp., for instance, had to file for bankruptcy because it had too much debt relative to its peers to withstand the sharp drop in rental-car demand. Similarly, Moody’s said its downgrade of McGraw-Hill “reflects the company’s persistently high financial leverage” and “its debt-heavy capital structure that Moody’s deems unsustainable.” Cengage, too, has “a heavy debt burden,” which, combined with an anticipated drop in earnings, raises “concerns about sustainability of the company’s capital structure.” Cengage and McGraw-Hill are both owned by private-equity firms.
By now, it’s clear that Covid-19 will shake up higher education unlike anything in recent memory, though whether the trends are fleeting or permanent remain to be seen. Most universities have benefited from decades of tuition price increases that vastly outpaced inflation and insatiable demand from students in the U.S. and abroad. That means all but the most strapped colleges will most likely survive what’s sure to be a peculiar school year.
College textbook publishers, on the other hand, have been reeling for years. My Bloomberg Opinion colleague Justin Fox did a deep dive on the industry in early February that showed the cost of educational books and supplies has flatlined since 2016, thanks to a combination of used-textbook sales and rentals and the proliferation of digital offerings, both from established publishers and non-profits. Not only was this pressure evident before the coronavirus pandemic struck in the U.S., but six months ago Cengage and McGraw-Hill were in the middle of a merger, which would have combined their respective 21.8% and 15.9% share of revenue in the U.S. market for new college course materials to rival Pearson’s 42.7%, presumably giving them more pricing power. Three months later, they terminated the agreement because of a prolonged regulatory review process and the failure to agree on divestitures with the Justice Department.
Put together, it’s an industry dominated by a few companies that had planned to shift their business models in the face of structural changes toward digital learning, the rise of free-textbook efforts and the outlook for a shrinking undergraduate population. To use the rental-car comparison, it’s similar to how Hertz, Avis Budget Group Inc. and Enterprise Holdings Inc. had to wrestle with the emergence of Uber Technologies Inc. and other ride-sharing services.
As low-rated as they may be, Cengage and McGraw-Hill both have digital offerings in place — in fact, Cengage Chief Executive Officer Michael Hansen was named one of the “most creative people in business” by Fast Company for “creating a revolutionary (and affordable) rental model for college textbooks.” While Moody’s says the companies are positioned favorably in the higher-education market as remote learning ramps up, it doesn’t mean they can avoid defaulting on their debt. Here’s a key passage from Moody’s:
As affordability of textbooks and learning materials are important to students and higher education institutions, less expensive alternatives to print textbooks emerged. This social trend resulted in a multi-year precipitous decline in average spend per student on learning materials. Publishers, including [Cengage/McGraw], are responding by growing digital offerings that provide extra value to students. The coronavirus outbreak is accelerating the transformational social changes impacting [Cengage/McGraw] and its peers.
That’s a powerful assessment. Since March, Moody’s analysts appear to have used the word “precipitous” only 10 other times across global credit markets, in reference to steep declines in the price of oil and aluminum, the drop-off in leisure and business travel, and the financial performance of a Pennsylvania health system. That’s it — those things, and spending on college learning materials.
The bond market is also taking a harsh stance. McGraw-Hill debt maturing in May 2024 traded this week at 58.5 cents on the dollar, the lowest since May and equivalent to a yield of almost 26%, while Cengage securities due a month later traded at about 67 cents to yield 22.8%. As bad as that seems, the bonds changed hands at less than 40 cents on the dollar in early May. As I wrote last month, investors have been digging through the riskiest corporate securities to separate distress from doom. It’s possible that some opportunistic credit buyers determined that Cengage and McGraw-Hill won’t have to cut their debt as much as previously feared.
A nationwide failure among colleges to bring back in-person learning could complicate that calculation. The University of Notre Dame said on Tuesday that it would shift to online instruction for at least two weeks after 147 people tested positive for the coronavirus just as the fall semester began, while Michigan State University sent a letter on the same day that urged undergraduates to stay home rather than live in campus housing. Whether it’s the right decision or not, as many as one out of five students may opt for a gap year in 2020-2021 because they can’t get the full college experience. A near-total loss of hard-copy textbook sales, combined with a plunge in enrollment, would seemingly leave Cengage and McGraw-Hill with a revenue hole too big to escape.
To borrow a line from my Bloomberg Opinion colleague Noah Smith, there are no good choices for the entire economic ecosystem tied to college life. Universities themselves are sure to take a financial hit, as will businesses in college towns across the country. I’m not convinced that Covid-19 will ignite the much-ballyhooed shift away from higher education, but the outlook for the coming school year is severe enough that it looks as if weak hands will have to fold.
That could mean distressed-debt exchanges from the likes of Cengage and McGraw-Hill, whose bonds were trading above 90 cents in February. It would be yet another painful lesson for investors about how highly leveraged companies can quickly falter in the face of a unforeseen shock.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
©2020 Bloomberg L.P.
