Item 1. Business
General Development of Business
Houghton Mifflin Company was incorporated in 1908 in Massachusetts as the successor to a partnership formed in 1880. Antecedents of the partnership date back to 1832. The Company is a leading publisher in the pre-kindergarten through grade twelve (“K-12”) and college education, trade and reference, educational, and clinical testing markets in the United States. The K-12 education market focuses on core subjects such as reading, language arts, literature, mathematics, world languages, social studies, and science, which represents that market’s largest and highest priority funding areas. Houghton Mifflin also provides K-12 educational and clinical assessments and related services. The college education market primarily targets introductory courses with the largest enrollments. The trade and reference market publishes an extensive line of fiction and non-fiction books for adults and children, dictionaries, and other reference materials. Houghton Mifflin’s diverse product offerings are classified into three reporting segments:
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K-12 Publishing The K-12 Publishing segment develops comprehensive educational programs, comprised primarily of textbooks, workbooks, supplemental materials, teaching guides, technology-based components, and other resources. This segment also provides testing and assessment services to the K-12 market.
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College Publishing The College Publishing segment publishes textbooks, ancillary products, such as workbooks and study guides, technology-based instructional materials, teacher materials, and other materials, primarily for introductory college-level courses. This segment also sells college products in the high school advanced placement market.
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Trade and Reference Publishing The Trade and Reference Publishing segment publishes fiction and non-fiction books for adults and children, dictionaries, and other reference materials for the trade market worldwide.
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Other Other includes unallocated corporate related items.
Ownership Structure
Publishing was incorporated on September 12, 2003 and is the wholly owned subsidiary of Holdings. Holdings is a company beneficially owned by Thomas H. Lee Partners, L.P. and its affiliates (“THL”), Bain Capital, LLC and its affiliates (“Bain Capital”), and the Blackstone Group and its affiliates (“Blackstone”; collectively the “Sponsors”). Holdings contributed 100% of its interest in Houghton Mifflin to Publishing on September 17, 2003. Publishing and Houghton Mifflin are companies organized under the common control of Holdings. The historical consolidated financial statements of Houghton Mifflin have become the historical consolidated financial statements of Publishing. The historical results of operations for all periods prior to September 12, 2003 are of Houghton Mifflin and its subsidiaries. Publishing conducts all its business through Houghton Mifflin. The Company has elected to present dual consolidated financial statements for Publishing and Houghton Mifflin. The chart below illustrates in summary form the ownership and corporate structure.
Financial Information About Segments
Financial information about Houghton Mifflin’s reporting segments is in Part II, Item 6, Selected Financial Data beginning on page 11 and Part II, Item 8, Notes to Consolidated Financial Statements in Note 16 under the heading “Segment Information” beginning on page.
Description of Business
As a publisher, Houghton Mifflin shapes ideas, information, and instructional methods into various media that satisfy the lifelong need of people to learn, gain proficiency, and be entertained. Houghton Mifflin seeks out, selects, and generates worthwhile concepts and then enhances their value and accessibility through creative development, design, production, marketing, sales, and distribution. While Houghton Mifflin’s works have been published principally in printed form, programs or works are also published in other formats, including computer software, laser discs, CD-ROM, and Internet-based platforms.
Business Segments
K-12 Publishing
Overview
The K-12 Publishing segment develops and markets comprehensive educational programs and assessments targeted to the more than 54 million students in over 123,000 elementary and secondary schools in the United
States, principally in core academic subjects. Products and services include textbooks, workbooks, supplemental materials, technology-based products, teaching guides and other resources, and teacher training as part of a full-service offering to schools, educators, and students. With an in-house editorial staff supplemented by external specialists, Houghton Mifflin develops programs that can be aligned to state standards and customized for specific state requests. In addition, through our Assessment Division, the K-12 Publishing segment offers a wide range of educational, cognitive, and developmental standardized testing products in print, CD-ROM, and online formats, targeting the educational and clinical assessment markets.
In the educational publishing industry, materials are often described as “basal” or “supplemental.” Basal materials are comprehensive programs intended to provide a complete course of study in a subject, either at a single grade level or across grade levels, and are the primary source of classroom instruction. They typically include a student textbook and a variety of ancillary materials such as teacher’s editions, charts, classroom displays, classroom handouts, workbooks, tests, CD-ROMs, and online materials. Supplemental materials provide focused information about a topic or practice in a particular skill, but not the comprehensive system of materials offered in a basal program. These materials are used both as alternatives and as supplements to core basal textbooks, enabling local educators to cost-effectively tailor standard programs to the specific needs of their students. Supplementals are generally purchased irrespective of adoption schedules, creating net sales and earnings that do not vary greatly with the adoption cycle. In addition, the development of supplemental materials tends to require significantly less capital investment than the development of a basal program.
Adoption Process
Adoption is the process by which public elementary and secondary schools select and purchase new instructional materials. The terms “adopt” and “adoption” are often used to describe the overall process of a state governing body’s official approval of basal programs for selection and purchase by that state’s school districts, or an individual school or school district’s selection and purchase of basal programs.
Twenty states approve basal programs on a statewide basis for a particular subject (“adoption states”). These states represent approximately one-half of the U.S. elementary and secondary school-age population. The selections typically occur every five to seven years according to a schedule publicized years in advance. Historically, deviations from announced adoptions have been minimal. The funding for the purchase of the materials in an adoption state is approved at the state level and is appropriated by subject. Typically, a school or school district within an adoption state may use state funding to purchase instructional materials only from the list of programs that have been adopted by the particular state’s governing body. After the state entities have approved instructional materials, individual schools later decide the quantity and timing of their purchases.
In the other states, referred to as “open states” or “open territories,” each individual school or school district can purchase materials without restrictions. Schools and school districts in open territories often consider decisions made in large adoption states when making their own purchasing decisions.
In adoption states, the state school board’s decision to approve a certain program developed by an educational publisher depends on recommendations from textbook committees, which are often comprised of educators and curriculum specialists. To ensure the approval and subsequent success of a new textbook program, extensive market research is conducted, including: (i) discussions of the planned curriculum with the state level curriculum advisors to secure their support; (ii) development of prototype textbooks that are focus-tested with educators, often against competing programs, to gather feedback on the program’s content and design; and (iii) incorporation of qualitative input from existing customers in terms of classroom needs. A publisher’s ultimate market share in a given state will generally depend on the quality of its program and materials, the magnitude of its marketing and sales efforts, and the strength and nature of its relationships with key decision-makers at the district level. Historically, there has been a strong correlation between a publisher’s investment in product development and success in being listed in adoption states.
Generally, a national edition is developed for sale in open territories and smaller adoption states, while programs for states that represent large purchasing opportunities are customized. The sales organization presents to school boards and textbook selection committees, which in turn make recommendations to departments of education in adoption states and to district level school boards in open territories. It is the Company’s belief that documented success in adoption states, especially California, Texas, and Florida, which in the aggregate comprised almost 22% of the market in recent years, can often positively influence a publisher’s sales efforts in open territories.
Once an adoption schedule is set, Houghton Mifflin analyzes upcoming opportunities and begins to develop content for basal programs. The preparation for any new program includes an upfront investment in research and editorial costs, which generally begins up to three years before a major new adoption. Additional investment is required to tailor content to specific adoption states, with the amount of the investment depending upon the potential size of the opportunity, but generally being less than the initial investment. Because the adoption cycle is staggered by subject, positive cash flows from existing programs are used to finance spending for new program development.
Supplementary materials and assessments are generally not adopted through this process. Supplementary materials are sold as off-the-shelf materials to schools and districts. Assessment programs are either bought as custom programs for statewide assessment, following a request for proposal process, or as off-the-shelf products in schools and districts.
Operations
The K-12 Publishing segment operates through four primary divisions: School Division, McDougal Littell, Great Source Education Group (including Cognitive Concepts, Inc. (“CCI”)), and the Assessment Division (which includes Riverside and Edusoft). Each division benefits from strong relationships with its customers, most of which have been developed over many years through a service-based approach to designing, marketing, and implementing its programs.
School. The School Division develops and markets leading basal programs for the kindergarten through grade six market utilizing the Houghton Mifflin brand. The division focuses its publishing portfolio on the subjects that have consistently received the highest priority from educators and politicians, namely reading, language arts (including spelling and English), mathematics, science, and social studies. In each subject, comprehensive learning programs are designed and then marketed with a variety of proprietary products to maximize teaching effectiveness, including textbooks, workbooks, teachers’ guides and resources, audio/visual aids, and technology-based products.
McDougal Littell. The McDougal Littell Division develops and markets basal programs for the grades six through twelve market, utilizing the McDougal Littell brand. The division publishes products and provides services in five major educational subjects: literature/language arts, mathematics, social studies, world languages, and science. Vocational studies is the only major subject area in which McDougal Littell does not offer products and services. The editorial process, like that of the School Division, involves significant market research. McDougal Littell designs broad programs for middle school grades and course-specific products for high school.
Great Source Education Group. The Great Source Education Group Division develops and markets instructional, curriculum-based educational supplements for pre-kindergarten through grade twelve market utilizing various brands, including the Write Source and Earobics brands. The division offers such products as handbooks, instructional kits, summer school and after-school curricula, consumable student practice books, and test review books, as well as other resources. These materials supplement the core curriculum, allowing local educators to cost-effectively tailor standard programs for the specific needs of their students in the areas of intervention, special education, and early language learning. Many of Great Source Education Group’s product lines sell well outside the adoption cycle, creating a revenue stream that does not vary greatly with the adoption schedule.
Assessment. The Assessment Division develops and markets testing technology to the K-12 market, assessment products for the grades K-12 and clinical markets, and offers scoring and reporting services. Tests include: (i) norm-referenced tests, or NRTs, which compare students to national performance levels; (ii) criterion-referenced tests, or CRTs, which are standards-based educational assessments, frequently customized for state educational entities; and (iii) clinical tests, which assess intellectual, cognitive, and behavioral development. Additionally, the Assessment Division sells a paper-to-web-based assessment platform that helps school districts, administrators, teachers, and parents track student performance on state standards through three kinds of tests: state exams, district benchmarks, and in-class teacher tests. The division’s testing and reporting solution gives districts information to help improve instruction and student performance.
Sales and Marketing
Major regional sales offices for the K-12 Publishing segment are in California, Georgia, and Texas. Each division in the K-12 Publishing segment has its own dedicated sales force, comprised largely of former educators. The School and McDougal Littell Divisions employ a combined sales force in excess of 400 people. The Great Source Education Group and Assessment Division sales forces are smaller. The Great Source Education Group sales force works with the School and McDougal Littell Divisions to maximize customer relationships. McDougal Littell also markets the College Division’s texts for high school advanced placement courses.
The sales force focuses on maintaining strong relationships with decision-makers in the adoption states, including teachers, district administrators, and state policymakers. In open territory states the sales force uses canvassing to strengthen relationships with decision-makers. Marketing efforts begin at the conception of the development of a new program. In the case of states where programs are already established, marketing efforts are continuous. Formal market research efforts include educator focus groups, prototypes of student and ancillary materials, and comparisons against competing products. Additional informal market research includes ongoing feedback from the sales force in identifying teachers’ and students’ requirements. The marketing and editorial staffs work closely together to incorporate the results of research into products, developing the most updated, research- and needs-based curricula. Once product development is complete, the sales campaign involves product presentations and sampling along with presentations by key authors. Sending sample copies is an essential part of marketing instructional materials. In addition, once a program is purchased, various ancillary products are typically included with the program materials purchased by the customer. These additional materials, usually called “implementation” materials, are an integral part of the program. Training sessions are also conducted within a school district that has purchased the materials to help teachers learn to use the products effectively and to provide professional development services for which fees are charged.
College Publishing
Overview
The College Publishing segment publishes textbooks, ancillary products, such as workbooks and study guides, technology-based instructional materials, teacher materials, and other materials, primarily for introductory college-level courses. This segment targets more than 16 million students in approximately 4,200 institutions in the post-secondary higher education market. Concentration is on college courses in core disciplines, such as mathematics, chemistry, history, psychology, modern languages, accounting, business, and remedial studies, although some recent growth has come from new publications for high school advanced placement courses. The library of titles for introductory college courses enables the College Publishing segment to generate considerable sales in the high school advanced placement market.
In the post-secondary market, the faculty generally selects the textbooks and other materials to be used in class, acting either as a committee or individually. Affiliated college bookstores and large retail chains order post-secondary educational materials based on professors’ selections for purchase by college students.
In the private career school market, the institution generally purchases products directly from the publisher and requires students to purchase those products from the institution as part of the tuition. For high school advanced placement courses, which generate a considerable portion of the College Division’s net sales, the selection of college-level materials is made through the adoption or open-territory selection processes described above.
College textbooks generally are updated every three to four years by authors and publishers. Textbooks with a current-year copyright date are referred to in the industry as “frontlist,” textbooks with a subsequent year copyright date referred to as “early in-stock,” and textbooks with an older copyright date referred to as “backlist.” The success of each year’s frontlist and early in-stock titles significantly influences sales of backlist titles in subsequent years. Consequently, most of the selling and marketing activities of college publishers focus on promoting frontlist and early in-stock titles.
Operations
The College Division’s products are offered primarily to the post-secondary higher education market in traditional print, electronic, and Internet-based formats; virtually all major print textbooks now have an integrated technology component such as a website or multimedia CD-ROM. Many of the division’s products are sold to high school advanced placement courses and to certificate-granting, for-profit institutions that offer skill-based training and job placement.
The College Division’s portfolio consists of titles by highly regarded authors who are experts in their respective disciplines. The authors agree to certain non-compete provisions, as is common industry practice, that prevent them from authoring for other publishers’ books and technology-based products that directly compete with the products that they create for the Company. Authors who are experts in their field write the majority of a book while the in-house editorial staff focuses on pedagogical development, layout, graphics, and refinement.
A significant portion of the college content is digitally stored and indexed, which enables the efficient development of new electronic and print products, optimizes the customization process, and allows publication in concurrent multi-media formats. Additionally, with nearly all college students utilizing the Internet, the College Division supports more than 600 textbook-related websites for students and professors.
Sales and Marketing
The College Division employs a sales and marketing force of approximately 190 people that promotes products to college faculty through a combination of on-campus visits, shipments of sample products, and direct marketing. As professors have embraced e-mail and the Internet to a greater extent in recent years, the role of direct marketing, especially e-mail correspondence, has increased significantly. The sales force continually canvasses college faculty with products. In addition, a dedicated McDougall Littell sales force sells advanced placement products in the high school market.
Trade and Reference Publishing
Overview
Specializing in high-quality adult and children’s books that generate strong backlist sales, the Trade and Reference Publishing segment’s adult list includes fiction, non-fiction, field guides, and cookbooks. The children’s list includes board books, picture books, and young adult novels. The market for reference materials, including dictionaries and thesauruses, is characterized by stable spending patterns and significant concentration among a small number of well-recognized brands. Additionally, the growing accessibility and desirability of the Internet as an information source has created a market for web-based and other electronic reference materials. The Company has taken steps, including licensing content to online publishers, to digitize existing content in order to exploit these online opportunities.
Operations
The Trade and Reference Publishing segment publishes quality fiction and non-fiction books for adults and children, dictionaries, and other reference works under brands such as Houghton Mifflin, Mariner Books, Clarion Books, American Heritage dictionaries, and Kingfisher Publishing plc (“Kingfisher”), a U.K.-based publisher of children’s fiction and non-fiction titles and reference materials for the trade market worldwide. The Trade and Reference Publishing segment generates a majority of its sales from its backlist of more than 5,000 titles, thereby reducing its dependence on introducing bestsellers each year, which can be a volatile market.
Sales and Marketing
The Trade and Reference Publishing segment’s marketing and publicity strategies focus on both booksellers and end consumers and contribute significantly to the success of an author and/or title. The Trade and Reference Publishing segment employs a sales force that principally covers the reseller marketplace, including retail chains, independent bookstores, online booksellers, wholesalers, and a variety of non-traditional book outlets. The sales forces of the other divisions are used to sell trade and reference products into the K-12 and college markets. Reference materials, in particular, are sold to K-12 schools and colleges, as well as to office supply distributors and businesses. The Trade and Reference Publishing segment also licenses book rights and content to paperback publishers, book clubs, websites, and other publishers as well as electronic businesses in the United States and abroad.
Raw Materials, Printing and Binding
Paper is one of the principal raw materials used. The Company has not experienced and does not anticipate experiencing difficulty in obtaining adequate supplies of paper for operations. While prices fluctuate depending upon market conditions, average market paper prices increased moderately in 2005.
The Company outsources the print, bind, and cover of its products, with approximately 60% of printing currently handled by Quebecor Publishing, R.R. Donnelley & Sons, Banta Corporation, Von Hoffman Press, Webcrafters, and Lehigh Press. The Company has a longstanding relationship with each printer.
Customers and Seasonality
In the K-12 market, the Company typically receives payments for products and services from individual school districts, and to a lesser extent individual schools and states. In the college and trade and reference markets, payment is received for products and services from book distributors and retail booksellers. In the case of the testing and assessment products and services, payment is received from the individually contracted parties.
Approximately 90% of net sales are derived from educational publishing in the K-12 and College Publishing segments, which are markedly seasonal businesses. Schools make most of their purchases in the second and third quarters of the calendar year, in preparation for the beginning of the school year. Colleges typically make most of their purchases in the third and fourth quarters for the semesters starting classes in September and January. Thus, approximately 75% of consolidated net sales have historically been realized in the second and third quarters.
Sales of K-12 instructional materials and customized testing products are also cyclical, with some years offering more sales opportunities than others. The amount of funding available at the state level for educational materials also has a significant effect on year-to-year revenues. No single customer accounts for more than 10% of consolidated net sales. Although the loss of a single customer or a few customers would not have a material adverse effect on the Company’s business, schedules of school adoptions and market acceptance of the Company’s products can materially affect year-to-year revenue performance.
Distribution
The Company operates five distribution facilities from which the Company coordinates its own distribution process: two in Indianapolis, Indiana and one each in Geneva, Illinois; Kennesaw, Georgia; and Dallas, Texas. Additionally, some adoption states require the use of in-state textbook depositories for educational materials sold in that particular state. Riverside ships its products primarily from a distribution vendor located in Green Bay, Wisconsin. The Company utilizes delivery firms including United Parcel Service, Inc., FedEx Corporation, and DHL Worldwide Express, Inc. to facilitate the principally ground transportation of products.
Competition
The Company sells its products in highly competitive markets. In these markets, product quality and customer service are major factors in generating sales growth. Other factors affecting sales growth in the K-12 market include the level of student enrollment in subjects that are up for adoption and the level of spending per student in each state and/or school district. Profitability is affected by industry developments including: (i) increasingly competitive selling, sampling, and implementation costs; (ii) rising development costs due to customer requirements for more customized instructional materials and assessment programs; and (iii) higher technology costs due to the increased number of textbook program components being developed in digital formats.
The Company competes with large publishers, such as Reed Elsevier plc, Pearson plc, The Thomson Corporation, and The McGraw-Hill Companies, Inc. The Company has three primary competitors in the K-12 market, six in the college market, and multiple competitors in the trade and reference and assessment markets.
Employees
As of December 31, 2005, the Company employed 3,113 employees. Approximately 1,324 of the employees are located in Boston, Massachusetts; 1,204 in the Chicago, Illinois metro area; and 203 in Indianapolis, Indiana. The Company’s sales force makes up approximately 28% of all employees. None of the employees are subject to collective bargaining agreements. The Company believes that relations with employees are generally good.
Intellectual Property
The Company’s principal intellectual property assets consist of trademarks and copyrights in its content, as well as other rights in its brand names. Substantially all of the Company’s publications are protected by copyright, whether registered or unregistered, either in the Company’s name or in the name of the author of the work. Such copyrights protect the Company’s exclusive right to publish the work in the United States and in many countries abroad for specified periods. In most cases, protection extends for the author’s life plus 70 years, but in any event a minimum of 28 years for works published prior to 1978 and 95 years for works published thereafter.
The Company does not own any material patents, franchises, or concessions, but has registered certain trademarks and service marks in connection with its publishing businesses. The Company believes it has taken, and takes in the ordinary course of business, all appropriate available legal steps to protect its intellectual property in all relevant jurisdictions.
Environmental Matters
The Company generally contracts with independent printers and binders for their services, and operations are generally not otherwise affected by environmental laws and regulations. However, as the owner and lessee of real property, regardless of fault, it is possible that the Company could face liability if contamination were to be discovered on the properties it owns or leases. The Company is currently unaware of any material environmental liabilities or other material environmental issues relating to its properties or operations and anticipates no material expenditures for compliance with environmental laws or regulations.
Financial Information About Geographic Areas
Sales outside of the U.S. are not significant to Houghton Mifflin’s three segments.
Item 1A.
Item 1A. FACTORS AFFECTING FUTURE OPERATING RESULTS
The risks described below may not be the only risks facing the Company. Additional risks and uncertainties not currently known or those the Company currently views to be immaterial may also materially and adversely affect its business, financial condition or results of operations.
A significant portion of net sales is derived from sales of K-12 instructional materials pursuant to cyclical adoption schedules, and if the Company is unable to maintain residual sales and continue to generate new business net sales could be materially and adversely affected.
Due to the revolving and staggered nature of state adoption schedules, sales of K-12 instructional materials have traditionally been cyclical, with some years offering more sales opportunities than others. Furthermore, the Company cannot make assurances that states that have adopted its programs, or that schools and school districts that have purchased its products and services, will do so again in the future. A significant portion of net sales is therefore dependent upon the Company’s ability to maintain residual sales and to continue to generate new business. For example, from 2007 through 2009, adoptions are scheduled in the primary subjects of reading, language arts, and literature in, among others, the states of California, Texas, and Florida, the three largest adoption states, which have historically represented almost 22% of all state spending on K-12 programs. The inability to succeed in these three states, or reductions in their anticipated funding levels, could materially and adversely affect net sales for subsequent years.
A significant portion of net sales is derived from sales of K-12 instructional materials to school districts that are dependent on government funding. If the funding available for the Company’s products and services declines or does not continue to grow, net sales could be materially and adversely affected.
Most public school districts, the primary customers for K-12 products and services, are largely dependent on state and local funding to purchase materials. The amount of funding available to the school districts and the timing of funding opportunities are closely tied to numerous national and local political, economic and demographic factors that are beyond the Company’s control. These factors include the level of student enrollment in subjects that are up for adoption and the level of spending per student on instructional materials in each school district and/or state. In adoption states, the amount of funding available at the state level for K-12 educational materials has historically had a significant effect on year-to-year net sales.
Net sales may be negatively affected by reductions in local, state, and/or federal funding. In school districts in states that primarily rely on local tax proceeds, significant reductions in those proceeds for any reason can severely restrict district purchases of instructional materials. In districts and states that primarily rely on state funding for instructional materials, a reduction in state allocations or additional restrictions on the use of those funds may reduce net sales.
A number of factors related to federal funding may negatively affect school spending on instructional materials, including reductions in federal education spending and increases in regulations or requirements that may make certain materials ineligible for federal funding and thus less attractive to local schools. In addition, the actual implementation of the No Child Left Behind Act may affect the acceptability and availability of funding for materials. New requirements for “research-based” programs could result in additional costs for development of materials beyond what is currently anticipated and thus reduce expected profit margins and/or reduce sales opportunities. The Company could be materially and adversely affected if the federal government institutes a mandatory national assessment program.
The Company’s operating results fluctuate on a seasonal and quarterly basis and in the event it does not generate sufficient net sales in the third quarter, it may not be able to meet the debt service and other obligations.
The Company’s business is seasonal. For the year ended December 31, 2005, the Company derived approximately 90% of net sales from educational publishing in the K-12 and College Publishing segments in the
aggregate. In the K-12 Publishing segment, purchases typically are made primarily in the second and third quarters of the calendar year, in preparation for the beginning of the school year, though testing net sales are primarily generated in the second and fourth quarters. In the College Publishing segment, purchases are typically made in the third and fourth quarters for the semesters starting classes in September and January. The Company typically realizes approximately 50% of net sales during the third quarter, making third-quarter results material to full-year performance. This sales seasonality affects operating cash flow from quarter to quarter. The Company normally incurs a net cash deficit from all of its activities through the middle of the third quarter of the year. The Company cannot make assurances that its third quarter net sales will continue to be sufficient to meet its obligations or that they will be higher than net sales for its other quarters. In the event it does not derive sufficient net sales in the third quarter, the Company may not be able to meet its debt service requirements and other obligations.
The Company is a party to at-will contracts with significant customers and the termination of these contracts could harm its business.
The Company currently provides or has agreements to provide products and services to governmental agencies, school districts and educational facilities under contracts that are terminable at-will. The fact that these customers have at-will contracts with the Company gives rise to the possibility that it may have no recourse in the event of customer cancellation of a contract. In addition, contracts awarded by states pursuant to a procurement process are subject to challenge by competitors and other parties during and after that process. The Company anticipates that it will continue to rely upon customers under such at-will contractual arrangements. As a result of this reliance, the election by these customers to terminate any or all of their at-will contracts with the Company, or the loss of or decrease in business from several of its large customers, could materially and adversely affect its business, prospects, financial condition, and results of operations.
The Company is subject to contingent liabilities that may affect liquidity and its ability to meet its obligations.
In the ordinary course of business, the Company issues performance bonds, surety bonds, and letters of credit posted as security for its operating activities, some of which obligates the Company to make payments if it fails to perform under certain contracts in connection with the sale of textbooks and criterion-referenced tests (“CRTs”). As of December 31, 2005, the Company’s contingent liability for such performance and surety bonds and letters of credit was $24.7 million, including $18.2 million letters of credit. The gross amount of letters of credit is deducted from the amount of credit available to Houghton Mifflin under the Revolver. As a result, letters of credit reduce Houghton Mifflin’s ability to borrow funds under the Revolver, which could affect liquidity and, therefore, its ability to meet its obligations. Houghton Mifflin may increase the number and amount of contracts that require the use of letters of credit, which may further restrict liquidity and, therefore, its ability to meet its obligations in the future.
If the Company cannot successfully implement its business strategy, then its business, results of operations, and growth potential could be materially and adversely affected.
The Company’s ability to achieve its business and financial objectives is subject to a variety of factors, many of which are beyond its control, and the Company may not be successful in implementing its strategy. In addition, the implementation of its strategy may not improve its operating results. The Company may decide to alter or discontinue aspects of its business strategy and may adopt alternative or additional strategies due to business or competitive factors or factors not currently expected, such as unforeseen costs and expenses or events beyond its control. Any failure to successfully implement its business strategy could materially and adversely affect its results of operations and growth opportunities.
The Company operates in a highly competitive environment that is subject to rapid change and increasing costs of development, and if it is unable to compete effectively, profitability could be harmed.
The Company’s businesses operate in highly competitive markets. These markets continue to change in response to technological innovations and other factors. Profitability is affected by developments in the Company’s markets beyond its control, including:
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changing federal and state standards for educational materials;
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rising development costs due to customers’ requirements for more customized instructional materials and assessment programs;
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changes in prevailing educational and testing methods and philosophies;
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higher technology costs due to the trend toward delivering more educational content in both traditional print and electronic formats;
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market acceptance of new technology products, including online or computer-based testing;
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an increase in the amount of materials given away in the K-12 and college publishing markets;
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the effect of the used book market, course packs, and student resistance to textbook price increases on sales of college textbooks;
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college enrollment trends;
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changing demographics and preferences of college students and professors that may affect product offerings and net sales;
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the impact of the expected increase in turnover of K-12 teachers and instructors on the market acceptance of the Company’s products;
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customer consolidation in the retail and wholesale book market and the increased dependence on fewer but stronger customers;
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rising advances for popular authors and market pressures to maintain competitive retail pricing;
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dependence on third parties to provide scoring services for the Company’s testing businesses;
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a material increase in product returns or in certain costs such as paper; and
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overall uncertain economic issues that affect all markets.
The Company cannot predict with certainty the changes that may occur and the effect of those changes on the competitiveness of its businesses. The Company will continue to monitor and evaluate these and any other emerging developments, but acceleration of any of these developments may materially and adversely affect its profitability.
The means of delivering the Company’s products may be subject to rapid technological change. Although the Company has undertaken several initiatives and invested significant amounts of capital to adapt to and benefit from these changes, it cannot predict whether technological innovations will, in the future, make some of the Company’s products, particularly those printed in traditional formats, wholly or partially obsolete. If this were to occur, the Company might be required to invest significant resources to further adapt to the changing competitive environment. In addition, the Company cannot predict whether its end customers will have sufficient funding to purchase the equipment needed to use its new technology products.
Failure to achieve and maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act could result in a loss of investor confidence regarding the Company’s financial reports or may have a material adverse effect on the business.
During the course of the evaluation, attestation, and compliance process required by Section 404, deficiencies may be identified which the Company may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act. The Company is required to comply with the reporting requirements of Section 404 in its annual report for the year ending December 31, 2007. If the Company fails to maintain adequate internal controls, as such standards are modified, supplemented, or amended from time to time, or to
remediate any identified weaknesses, management may not be able to conclude on an ongoing basis that effective internal controls over financial reporting are in accordance with Section 404 of the Sarbanes-Oxley Act. Failure to achieve and maintain an effective internal control environment could result in a loss of investor confidence regarding the accuracy and completeness of the Company’s financial reports or may have a material adverse effect on the business.
In connection with the financial statement audit, the Company’s independent registered accounting firm advised the Company that the control deficiency described below constitutes a material weakness in its internal controls. A material weakness, as defined by the Public Company Accounting Oversight Board, is a control deficiency that by itself, or in combination with other control deficiencies, results in more than a remote likelihood that a material misstatement of the annual or interim financial statements could result that would not be prevented or detected.
The Company cannot reconcile its royalty accrual balance to an underlying trial balance. Although the Company has existing controls over payments to authors, the input of data into the royalty system, and the posting of entries from the royalty system to the general ledger, the reconciliation of the balance sheet accrual is considered an important control. This control deficiency did not result in a restatement or adjustment of the Company’s interim or annual consolidated financial statements, but it represents a material weakness. The Company is currently reviewing its royalty system and royalty processes to determine appropriate remedial measures to address the general ledger reconciliation matter.
Consolidation in the markets in which the Company operates could place it at a competitive disadvantage.
Some of the markets in which the Company operates have experienced significant consolidation. In particular, the combinations of traditional media content companies and new media distribution companies have resulted in new business models and strategies. Similarly, the consolidation of book retailers has increased the Company’s reliance on certain customers. The Company cannot predict with certainty the extent to which these types of business combinations may occur or the impact that they may have. These combinations could potentially place the Company at a competitive disadvantage with respect to negotiations, scale, resources, and its ability to develop and exploit new media technologies.
The Company’s reliance on intellectual property and proprietary rights that may not be adequately protected under current laws may harm its competitive position and materially and adversely affect its business and results of operations.
The Company’s products are largely comprised of intellectual property content delivered through a variety of media, including books and the Internet. The Company relies on copyright, trademark, and other intellectual property laws to establish and protect its proprietary rights in these products. However, the Company cannot make assurances that its proprietary rights will not be challenged, invalidated or circumvented. The Company conducts business in other countries where the extent of effective legal protection for intellectual property rights is uncertain, and this uncertainty could affect future growth. Moreover, despite copyright and trademark protection, third parties may be able to copy, infringe, or otherwise profit from the Company’s proprietary rights without its authorization. The Internet may more easily facilitate these unauthorized activities. In addition, the lack of Internet-specific legislation relating to intellectual property protection creates an additional challenge for the Company in protecting its proprietary rights relating to its online business processes and other digital technology rights. If the Company is unable to adequately protect its intellectual property and proprietary rights, its competitive position may be harmed and its business and financial results could be materially and adversely affected.
The Company may not be able to identify successful business models for generating sales of technology-based programs. Furthermore, customers’ expectations for the number and sophistication of technology-based programs that are given to them at no additional charge may increase, as may development costs.
The basal elementary school, basal secondary school, educational testing, and college customers have become accustomed to being given technology-based products at no additional charge from publishers, such as the Company, as incentives to adopt programs and other products. The sophistication and expense of technology-based products continues to grow. Thus far, no business model generating material sales has proven to be effective.
The Company’s profitability may decrease materially if:
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the Company is unable to realize sales of these products;
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customers continue to rely on an increasing number of technology-based materials of increasing quality being given to them; or
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costs of these products continue to rise.
The Company may not be able to complete, or achieve the expected benefits from, any future acquisitions, which could materially and adversely affect its growth.
The Company has at times used acquisitions as a means of expanding its business and expects that it will continue to do so. If the Company does not successfully integrate acquisitions, anticipated operating advantages and cost savings may not be realized. The acquisition and integration of companies involve a number of risks, including:
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use of available cash, new borrowings or borrowings under the Company’s Revolver to consummate the acquisition;
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demands on management related to the increase in the Company’s size after an acquisition;
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diversion of management’s attention from existing operations to the integration of acquired companies;
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integration of companies existing systems into the Company’s systems;
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difficulties in the assimilation and retention of employees; and
•
potential adverse affects on the Company’s operating results.
The Company may not be able to maintain the levels of operating efficiency that acquired companies achieved separately. Successful integration of acquired operations will depend upon the Company’s ability to manage those operations and to eliminate redundant and excess costs. The Company may not be able to achieve the cost savings and other benefits that it would hope to achieve from acquisitions, which could materially and adversely affect the Company’s financial condition and results.
The Company may not be able to retain or attract the key management, creative, editorial, and sales personnel that it needs to remain competitive and grow.
The Company operates in a number of highly visible industry segments where there is intense competition for experienced and highly effective individuals, including authors. The Company’s successful operations in these segments may increase the market visibility of members of key management, creative, and editorial teams and result in their recruitment by other businesses. The loss of certain of the Company’s high-profile authors could harm business.
In addition, the Company’s sales personnel make up about 28% of its employees, and its business results depend largely upon the experience, knowledge of local market dynamics, and long-standing customer relationships of such personnel. The Company’s inability to retain or hire effective sales people at economically reasonable compensation levels could materially and adversely affect its ability to operate profitably and grow its business.
The Sponsors control the Company and their interests as equity holders may conflict with those of the Company’s creditors.
The Sponsors currently control nearly 100% of the Company’s outstanding capital stock on a fully-diluted basis. The Sponsors have the ability to control the Company’s policies and operations including the appointment of management and the entering into of mergers, acquisitions, sales of assets, divestitures and other extraordinary transactions. For instance, the Sponsors could cause the Company to enter into contracts or make acquisitions that increase the Company’s indebtedness or to sell revenue-generating assets, thereby impairing its ability to make payments under the Notes. Additionally, the Sponsors are in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with the Company. The Sponsors may also pursue acquisition opportunities that may be complimentary to the Company’s business, and as a result, those acquisition opportunities may not be available to the Company. Further, the Sponsors may receive payments from the Company in connection with certain of these transactions, such as structuring or financial advisory fees.
Item 1B.
Item 1B. Unresolved Staff Comments
Not Applicable.
Item 2.
Item 2. Properties
The principal executive office is located at 222 Berkeley Street, Boston, Massachusetts.
The following table describes the approximate building areas in square feet, principal uses, and the years of expiration on leased premises of the Company’s significant operating properties as of February 16, 2006. The Company believes that these properties are suitable and adequate for its present and anticipated business needs, satisfactory for the uses to which each is put, and, in general, fully utilized.
In addition, the Company leases 12 smaller sales offices.
(a) Upon lease expiration in 2006, the offices and print and scoring manufacturing center at Itasca, Illinois and the offices at Addison, Illinois will consolidate and relocate to a facility in Rolling Meadows, Illinois. The Rolling Meadows lease will cover approximately 117,000 square feet and commences on January 1, 2007 and continues through 2015.
Item 3.
Item 3. Legal Proceedings
From time to time the Company is involved in litigation incidental to the conduct of business. The Company believes that no litigation currently pending against it, if adversely determined, would have a material adverse effect on its consolidated financial position or results of operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to the sole stockholder in the fourth quarter of 2005.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Neither Publishing nor Houghton Mifflin has any publicly traded common stock.
Item 6.
Item 6. Selected Financial Data
The selected historical consolidated statement of operations data and consolidated statement of cash flow data for the years ended December 31, 2005, 2004, and 2003, and the selected historical consolidated balance sheet data as of December 31, 2005 and December 31, 2004 have been derived from the historical financial statements of Publishing, appearing elsewhere in this annual report on Form 10-K. The selected historical consolidated statement of operations data and consolidated statement of cash flow data for the year ended December 31, 2002 and the periods of July 7, 2001 through December 31, 2001 and January 1, 2001 through July 6, 2001 and the selected historical consolidated balance sheet data as of December 31, 2003, 2002, and 2001, have been derived from the historical financial statements of Publishing, which are not included in this Form 10-K.
In January 2006, the Company signed a definitive stock purchase agreement to sell its subsidiary, Promissor, Inc. This sale was completed and all activities of Promissor have ceased during January 2006. The selected historical financial data has been reclassified to reflect this business as a discontinued operation for all periods presented.
The selected historical consolidated financial data set forth below should be read in conjunction with, and the data is qualified by reference to “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the audited consolidated financial statements and accompanying notes included elsewhere in this filing.
(a) Excludes results of certain smaller business units previously owned by Vivendi Universal, S.A. (“Vivendi”) that were contributed to Houghton Mifflin concurrent with Vivendi’s acquisition of Houghton Mifflin in 2001 (the “Vivendi Purchase”).
(b) Reflects the non-recurring, non-cash effect for the impairment write-down of goodwill as of December 31, 2002, resulting from the reduction in Houghton Mifflin’s fair value.
(c) Pre-publication capital investments include art, prepress, and other costs incurred in the creation of a master copy of a book or other media. These investments are capitalized and then amortized over the subsequent three to five years. The costs to write manuscripts are expensed as incurred.
(d) For purposes of calculating the ratio of earnings to combined fixed charges and preferred dividends, earnings represent income (loss) from continuing operations before income taxes plus fixed charges. Fixed charges consist of discount and interest costs, one-third of operating rental expense which management believes is representative of the interest component of rent expense and preferred dividends and associated redemption costs. Due to the loss from operations for the years ended December 31, 2005, 2004, and 2003 and 2002 and for the period prior to the Vivendi Purchase there were insufficient earnings of $73.0 million, $105.9 million, $115.6 million, $748.4 million, and $123.1 million, respectively, to cover fixed charges.
(e) Represents total current assets minus total current liabilities excluding discontinued operations.
(f) Excludes intercompany promissory notes owed to Vivendi in 2001.
The selected historical consolidated statement of operations data and consolidated statement of cash flow data for the years ended December 31, 2005, 2004, and 2003, and the selected historical consolidated balance sheet data as of December 31, 2005, and 2004 have been derived from the historical financial statements of Houghton Mifflin, appearing elsewhere in this annual report on Form 10-K. The selected historical consolidated statement of operations data and consolidated statement of cash flow data for the year ended December 31, 2002 and the periods of July 7, 2001 through December 31, 2001 and January 1, 2001 through July 6, 2001 and the selected historical consolidated balance sheet data as of December 31, 2003, 2002, and 2001, have been derived from the historical financial statements of Houghton Mifflin, which are not included in this Form 10-K.
In January 2006, the Company signed a definitive stock purchase agreement to sell its subsidiary, Promissor. This sale was completed and all activities of Promissor have ceased during January 2006. The selected historical financial data has been reclassified to reflect this business as a discontinued operation for all periods presented.
The selected historical consolidated financial data set forth below should be read in conjunction with, and the data is qualified by reference to “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the audited consolidated financial statements and accompanying notes included elsewhere in this filing.
(a) Excludes results of certain smaller business units previously owned by Vivendi that were contributed to Houghton Mifflin concurrent with the Vivendi Purchase.
(b) Reflects the non-recurring, non-cash effect for the impairment write-down of goodwill as of December 31, 2002, resulting from the reduction in Houghton Mifflin’s fair value.
(c) Pre-publication capital investments include art, prepress, and other costs incurred in the creation of a master copy of a book or other media. These investments are capitalized and then amortized over the subsequent three to five years. The costs to write manuscripts are expensed as incurred.
(d) For purposes of calculating the ratio of earnings to combined fixed charges and preferred dividends, earnings represent income (loss) from continuing operations before income taxes plus fixed charges. Fixed charges consist of discount and interest costs, one-third of operating rental expense which management believes is representative of the interest component of rent expense and preferred dividends and associated redemption costs. Due to the loss from operations for the years ended December 31, 2005, 2004, 2003, and 2002 and for the period prior to the Vivendi Purchase there were insufficient earnings of $51.9 million, $87.0 million, $111.2 million, $748.4 million, and $123.1 million, respectively, to cover fixed charges.
(e) Represents total current assets minus total current liabilities excluding discontinued operations.
(f) Excludes intercompany promissory notes owed to Vivendi in 2001.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
General
On December 30, 2002, Holdings acquired (the “Acquisition”) all of the outstanding shares of Houghton Mifflin from Vivendi Communications North America, Inc. (“Vivendi Communications”), a wholly owned subsidiary of Vivendi Universal S.A. (“Vivendi”). In accordance with the requirements of purchase accounting, the assets and liabilities of Houghton Mifflin were adjusted to their estimated fair values and the resulting goodwill computed as of the Acquisition date.
Overview
Houghton Mifflin is a leading publisher in the K-12 and college education, trade and reference, and educational, and clinical testing markets in the United States. A diverse portfolio of products and services is offered within each of these markets, including textbooks, workbooks, supplemental materials, technology-based products, teaching guides, various types of standardized and customized tests, professional assessment products, and a range of trade and reference titles. The Company’s geographic area of operation is predominantly the United States. Export or foreign sales to locations outside the United States are not significant.
The Company has seven divisions that offer products and services. These divisions are grouped in three reporting segments:
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K-12 Publishing This segment consists of four divisions: School Division, McDougal Littell, Great Source Education Group (which includes CCI), and Assessment (which includes Riverside and Edusoft). This reporting segment sells textbooks, instructional materials and services, tests for measuring achievement and aptitude, clinical and special needs testing products, multimedia instructional programs, and career guidance products and services. The principal markets for these products are elementary and secondary schools.
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College Publishing The College Division is the sole business unit reported in this segment. This reporting segment sells textbooks, ancillary products such as workbooks and study guides, technology-based instructional materials, and services for introductory and upper level courses in the post-secondary education market. Products may be in print or electronic form. The principal markets for these products are two and four year colleges and universities. These products are also sold to high schools for advanced placement courses and to for-profit, certificate-granting institutions that offer skill-based training and job placement.
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Trade and Reference Publishing This segment consists of the Trade and Reference Division and Kingfisher. Kingfisher management reports functionally to the Trade and Reference Division. This reporting segment publishes fiction and nonfiction for adults and children, dictionaries, and other reference works. The segment also licenses book rights to paperback publishers, book clubs, web sites, and other publishers and electronic businesses in the United States and abroad. The principal markets for these products are retail stores, including Internet bookstore sites and wholesalers. Reference materials are also sold to schools, colleges, libraries, office supply distributors, and businesses.
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Other This consists of unallocated corporate items.
In January 2006, the Company signed a definitive stock purchase agreement to sell its subsidiary, Promissor, a developer and provider of testing services and products for professional certification and licensure. The sale was completed and all activities of Promissor have ceased during January 2006. Effective December 2005, the Company’s consolidated financial statements and notes have been reclassified to reflect this business as a discontinued operation in accordance with Financial Accounting Standards Board Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”
The Company derives approximately 90% of its net sales from educational publishing in the K-12 and College Publishing segments, which are markedly seasonal businesses. Schools make most of their purchases in
the second and third quarters of the calendar year, in preparation for the beginning of the school year. Colleges typically make most of their purchases in the third and fourth quarters for the semesters starting classes in September and January. The Company has historically realized approximately 75% of consolidated net sales in the second and third quarters.
Sales of K-12 instructional materials and customized testing products are also cyclical, with some years offering more sales opportunities than others. The amount of funding available at the state level for educational materials also has a significant effect on the Company’s year-to-year revenues. No single customer accounts for more than 10% of consolidated net sales. The Company’s largest single customer is Barnes & Noble, which purchases both Trade and Reference and College products. In management’s opinion, a loss of a single customer, including Barnes & Noble, would not have a material adverse effect on the Company. Although the loss of a single customer or a few customers would not have a material adverse effect on the Company’s business, schedules of school adoptions and market acceptance of its products can materially affect year-to-year revenue performance. The impact of inflation and changing prices has not had a material impact on the Company’s consolidated financial statements and results of operations.
Critical Accounting Policies and Estimates
The discussion and analysis of the Company’s financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with Generally Accepted Accounting Principles (“GAAP”). The preparation of these financial statements requires estimates, assumptions, and judgments to be made that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates and assumptions including, but not limited to, book returns, allowance for bad debts, recoverability of advances to authors, valuation and recoverability of inventory, depreciation and amortization periods, recoverability of long-term assets such as property, plant, and equipment, capitalized pre-publication costs, intangible assets, and goodwill, as well as deferred revenue, income taxes, restructurings, pensions and other postretirement benefits, contingencies, and litigation. The Company bases its estimates on historical experience and on various other assumptions that the Company believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Revenue Recognition
The Company derives revenue primarily from the sale of textbooks and instructional materials, trade books, reference materials, assessment materials, and multimedia instructional programs, license fees for book rights, content and software, and services that include test development, test scoring, and training.
The Company recognizes revenue from textbooks and instructional materials, trade books, reference materials, assessment materials, and multimedia instructional programs in the period when persuasive evidence of an arrangement with a customer exists, the products are shipped, title and risk of loss have transferred to the customer, all significant obligations have been performed, and collection is reasonably assured.
Effective July 1, 2003, Houghton Mifflin adopted Financial Accounting Standards Board (“FASB”) Emerging Issues Task Force (“EITF”) Issue No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” The EITF applies to certain contracts having multiple elements or deliverables, some of which will be delivered at dates subsequent to the initial sale. The relative fair value of revenue for the undelivered items is deferred until such time as the products are delivered to the customer, however, payment from the customer is typically due at the time of the initial sale. The anticipated growth in the adoption cycle may have a material impact on the level of deferred revenue in future years.
License fees for software products without future obligations are recognized upon delivery. Certain contracts include software and ongoing fees for maintenance and other support. If vendor specific objective evidence of the fair value of each element of the arrangement exists, the elements of the contract are unbundled and the revenue for each element is recognized as appropriate.
Revenue for test delivery, test scoring, and training is recognized when the services have been completed, the fee is fixed and determinable, and collection is reasonably assured. Revenue for fixed-priced contracts that require significant test development is recognized as the services are provided. Differences between what has been billed and what has been recognized as revenue are recorded as deferred revenue. Losses on such contracts are recognized when they become known.
The Company enters into agreements to license certain book publishing rights and content. Revenue is recognized on those arrangements in accordance with the license agreements, when all materials have been delivered to the customer, and collection is reasonably assured.
As products are shipped with a right of return, a provision for estimated returns on these sales is made at the time of sale, based on historical experience. The Company records revenue for textbooks shipped from depository locations one month in arrears based on information received from the depository. Shipping and handling fees billed to customers are included in net sales. The cost of shipping and handling is included in cost of sales.
Cash, Cash Equivalents, and Short-term Investments
Cash and cash equivalents consist primarily of cash in banks and highly liquid investment securities that have maturities of three months or less when purchased. The carrying amount approximates fair market value due to the short-term maturity of these instruments. Auction rate securities for which interest rates reset in less than three months, but for which the maturity date is greater than three months, are classified as short-term investments. Despite the long-term nature of the auction rate securities contractual maturities, the Company has the ability to liquidate without delay, if necessary.
Accounts Receivable
Accounts receivable are recorded net of allowances for doubtful accounts and reserves for book returns. In the normal course of business, the Company extends credit to customers that satisfy predefined criteria. The Company estimates the collectibility of its receivables. Allowances for doubtful accounts are established through the evaluation of accounts receivable agings, credit worthiness of the customer, prior collection experience, and any other information that is relevant to estimate the ultimate collectibility of these receivables. Reserves for book returns are based on historical return rates and sales patterns. Approximately 80% of the reserves for book returns as of December 31, 2005 and 2004 are related to the College and the Trade and Reference divisions.
Inventory
The Company uses the lower of weighted average cost or market method to value inventory and determine cost of inventories included in cost of sales in the statement of operations. The level of obsolete and excess inventory is calculated on a program or title level by comparing the number of units in stock with the expected future demand. The estimate of expected future demand of a program or title is determined by the copyright year, the previous year’s sales history, the subsequent year’s sales forecast, known forward-looking trends including the development cycle to replace the title or program, and competing titles or programs. Based on this review, any excess stock is reserved as appropriate.
Pre-Publication Costs
The Company capitalizes the art, prepress, and other costs incurred in the creation of the master copy of a book or other media (the “pre-publication costs”). The costs to write manuscripts are expensed as incurred. Pre-publication costs are amortized from the year of copyright, or sale if earlier, over three to five years using the sum-of-the-years-digits method. This policy is used by all divisions, except for the Trade and Reference Division’s non-reference publications, which are expensed as incurred, and the Assessment Division, which uses the
straight-line amortization method. The amortization methods and periods chosen best reflect the expected sales generated from individual titles or programs. The Company evaluates the remaining lives and recoverability of capitalized pre-publication costs, which are often dependent upon program acceptance by state adoption authorities.
Royalty Advances
Royalty advances to authors are capitalized and represent amounts paid in advance of the sale of an author’s product and are recovered as earned. As advances are recorded, a partial reserve may be immediately recognized based primarily upon historical sales experience. Advances are evaluated periodically to determine if they are expected to be recovered. Any portion of a royalty advance that is not expected to be recovered is reserved. Approximately 70% of total royalty advances are related to the Trade and Reference Division.
Goodwill, Publishing Rights, and Other Intangible Assets
Goodwill is the excess of the purchase price paid over the fair value of the net assets of the business acquired. Other intangibles consist of branded trademarks, acquired publishing rights, customer-related intangibles, and non-compete agreements. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, goodwill and indefinite-lived intangible assets are not amortized but are reviewed at least annually for impairment or earlier, if an indication of impairment exists. With regard to goodwill, the Company tests for impairment annually on an implied residual basis by deducting the fair value of all assets and liabilities from the total estimated fair value of each reporting unit to determine the implied fair value of goodwill. Impairment recognized is measured by the amount by which the carrying amount of goodwill exceeds the implied fair value of goodwill. The Company estimates total fair value of reporting units using discounted cash flow analysis, and makes assumptions regarding future revenues, gross margins, working capital levels, investments in new products, capital spending, tax cash flows, and the terminal value of the reporting unit. With regard to other intangibles with indefinite lives, the Company determines the fair value by asset, which is then compared to its carrying value. The Company completed its annual goodwill and indefinite lived intangible asset impairment test as of October 1, 2005 and determined that no impairment existed.
A publishing right allows the Company to publish and republish existing and future works as well as create new works based on previously published works. The Company determines the fair market value of the publishing rights arising from business combinations by discounting the after-tax cash flows projected to be derived from the publishing rights and titles to their net present value using a rate of return that accounts for the time value of money and the appropriate degree of risk. The useful life of the publishing rights is based on the lives of the various copyrights involved. The Company calculates amortization using the percentage of the projected operating income before taxes derived from the titles in the current year as a percentage of the total estimated operating income before taxes over the useful life. Acquired publishing rights, as well as customer related intangibles with definite lives are amortized on an accelerated basis over their estimated useful lives between two and eighteen years.
Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of
The Company accounts for long-lived assets in accordance with the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the assets to future undiscounted net cash flows expected to be generated by the assets. If the assets are considered to be impaired, the impairment to be recognized is the amount by which the carrying amount of the assets exceeds the fair value of the assets. Fair value is normally assessed by using a discounted cash flow model. Assets to be disposed of are recorded at the lower of carrying value or estimated net realizable value. In the fourth quarter of 2005, as a result of receiving a preliminary offer from a third party to purchase Promissor and subsequent sale in January 2006, the Company determined that the carrying value of the Promissor business exceeded its fair value and recorded an impairment charge of $5.4 million to discontinued operations.
Taxes
The Company has incurred losses subsequent to the Acquisition primarily as a result of significantly increased interest expense related to debt financing. The Company recorded significant deferred tax liabilities as a result of purchase accounting for the Acquisition with respect to book-tax differences for identifiable intangible assets. There was no step-up in tax basis for these assets and, accordingly, there is no expected future tax deductibility for them.
The Company has recorded a tax benefit for the losses incurred in 2005, 2004, and 2003. SFAS No. 109, “Accounting for Income Taxes,” requires that deferred tax assets be reduced by a valuation allowance if, based on all available evidence, it is considered more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods. This assessment requires significant judgment, and in making this evaluation, the Company considers all available positive and negative evidence, including past results, the existence of cumulative losses in recent periods, and the forecast of taxable income for the current year and future years. During the fourth quarter of 2005, which marked the Company’s third consecutive year of taxable losses, management concluded, in light of this negative evidence, it was no longer more likely than not that future taxable income would be available in order to utilize deferred tax assets. Based on that judgment, management evaluated all deferred tax assets based only on whether the reversing of existing deferred tax liabilities would be sufficient in the specific future periods necessary to utilize the deferred tax assets. As a result of this analysis, the Company recorded a non-cash charge of $10.4 million to establish a valuation allowance against deferred tax assets relating to the long-term nature of the payments of future postretirement benefit obligations.
Retirement Plans
The Company maintains a qualified defined benefit pension plan that covers substantially all domestic employees, a defined benefit plan for Kingfisher, and an unfunded nonqualified defined benefit plan that covers domestic employees who earn over the qualified pay limit (together the “pension plans”).
The Company’s pension expense for all pension plans was $14.4 million in 2005, and is calculated based upon a number of actuarial assumptions, including a weighted average expected long-term rate of return on the assets of the pension plans of 8.0%. The overall expected long-term rate of return on U.S. plan assets is 8.0% and 7.0% for non-U.S. plan assets. The U.S. plan assets represent approximately 95% of total plan assets. In determining the expected return on plan assets, Houghton Mifflin considers the relative weighting of plan assets, the historical performance of plan assets and individual asset classes, and economic and other indicators of future performance.
The discount rate used for the Company’s U.S. pension plans is selected based on highly-rated long-term corporate bond indices and yield curves that match the duration of the plans’ benefit obligations. The bond indices and yield curve analyses include only bonds rated Aa or higher from a reputable rating agency. The selected rate reflects the rate at which the pension benefits could be effectively settled. The discount rates for non-U.S. plans were selected based on indices of high-quality bonds using criteria applicable to the respective country.
The Company regularly reviews the actual asset allocation and periodically rebalances its investments to its targeted allocation when appropriate. For 2005 and 2004, the Company has used a weighted average expected long-term rate of return of 8.0%, and asset allocation assumptions of approximately 60% equities and 40% fixed income investments. The Company will continue to evaluate its actuarial assumptions, including the weighted average expected rate of return, at least annually, and will adjust as necessary.
The Company estimates that its pension expense for all plans will be approximately $13.4 million in 2006. This estimate is based on a weighted average expected rate of return on the assets of the pension plans of 8.0%,
a weighted average discount rate of 5.6% and various other assumptions. Future actual pension expense will depend on future investment performance, changes in future discount rates, and various other factors related to the populations participating in the plans.
Postretirement Benefit Plan
The Company provides postretirement medical benefits to retired full-time, non-union employees hired before April 1, 1992, who have provided a minimum of five years of service, and attained age 55. For retirements on or after January 1, 1993, the Company’s commitment to provide postretirement medical benefits is capped ($10,000 per year for coverage before age 65 and $5,000 per year for coverage at age 65 and over).
The postretirement medical expense was approximately $4.0 million in 2005, and was calculated based upon a discount rate of 5.8%, medical inflation rate range grading down from 11.0% to 5.0% per annum over time, and a number of other actuarial assumptions. The discount rates utilized for determining future benefit obligations are based on the yields on high quality fixed income investments. The weighted average discount rate determined on this basis has remained constant at 5.8% for 2005 and 2004.
The Company estimates that its postretirement medical expense will be approximately $3.7 million in 2006. This estimate is based on a discount rate of 5.6% and medical inflation range grading down from 11.0% to 5.0% per annum over time. Future actual postretirement medical expense will depend on changes in future discount rates and assumed health care cost trend rates, as well as other factors related to the populations participating in the plan.
Results of Operations
The following tables set forth information regarding net sales, operating income, and other information from the Company’s consolidated statements of operations.
Results of Operations (Continued)
Results of Operations-Consolidated
Net Sales
The Company’s net sales for the year ended December 31, 2005 increased $63.2 million, or 5.2%, to $1,282.1 million from $1,218.9 million in the same period for 2004. The increase in 2005 was primarily due to strong results in the K-12 Publishing segment from state adoptions at both the elementary and middle and high school levels, offset by the expected decline in the Trade and Reference Division’s sales from 2004. Significant sales in 2005 included elementary reading, social studies and math programs, and secondary social studies and science programs.
The Company’s net sales for the year ended December 31, 2004 increased $19.3 million, or 1.6%, to $1,218.9 million from $1,199.6 million in the same period for 2003. The increase was most notably the result of the Trade and Reference Division’s higher sales of adult, cookbook, and children’s titles in 2004.
Cost of Sales Excluding Pre-publication and Publishing Rights Amortization
The Company’s cost of sales excluding pre-publication and publishing rights amortization for the year ended December 31, 2005 increased $2.4 million, or 0.5%, to $516.0 million from $513.6 million for the same period in 2004. The higher cost of sales was the result of increased investments in editorial costs of $3.9 million, and $10.1 million of increased implementation costs, substantially offset by lower manufacturing costs. As a percentage of net sales, cost of sales decreased to 40.2% in 2005, from 42.1% in 2004 due to better management of paper, printing, and binding costs in 2005.
The Company’s cost of sales excluding pre-publication and publishing rights amortization for the year ended December 31, 2004 increased $23.7 million, or 4.8%, to $513.6 million from $489.9 million for the same period in 2003. The higher cost of sales was the result of increases in editorial and production costs of $27.4 million, partially offset by decreased implementation costs of $6.5 million. The increases in editorial and production costs related to new product development for adoption years 2005 through 2009 and resulted in a higher cost of sales as a percentage of net sales of 42.1% in 2004, compared to 40.8% in 2003.
Pre-publication and Publishing Rights Amortization
The Company’s pre-publication and publishing rights amortization for the year ended December 31, 2005 increased $6.7 million, or 3.8%, to $185.3 million from $178.6 million during the same period for 2004. The change is attributable to investments in pre-publication cost that resulted in an increase in pre-publication amortization of $36.1 million, partially offset by lower publishing rights amortization of $28.8 million. As a percentage of net sales, pre-publication and publishing rights amortization decreased to 14.5% in 2005 from 14.7% in 2004.
The Company’s pre-publication and publishing rights amortization for the year ended December 31, 2004 increased $17.3 million, or 10.7%, to $178.6 million from $161.3 million during the same period for 2003. The change was attributable to investments in pre-publication cost that resulted in an increase in pre-publication amortization of $36.5 million, partially offset by lower publishing rights amortization of $17.5 million. As a percentage of net sales, pre-publication and publishing rights amortization increased to 14.7% in 2004 from 13.4% in 2003. This increase was a result of investing in new product development and resulted in the amortization of such costs being greater than the increase in net sales in 2004.
Selling and Administrative Expenses
The Company’s selling and administrative expenses for the year ended December 31, 2005 increased $16.1 million, or 3.2%, to $517.1 million from $501.0 million during the same period for 2004. The increase is primarily a result of higher selling and marketing costs of $21.4 million, and increased fulfillment expenses of $4.8 million, offset by decreased administrative expenses. As a percentage of net sales, selling and administrative expenses decreased to 40.3% in 2005 from 41.1% in 2004.
The Company’s selling and administrative expenses for the year ended December 31, 2004 increased $2.9 million, or 0.6%, to $501.0 million from $498.1 million during the same period for 2003. The change was primarily the result of $19.5 million of incremental costs for businesses acquired in the fourth quarter of 2003 and increased selling and marketing costs. These increases were partially offset by a reduction in retention expense of $24.7 million for 2004 as compared to 2003. As a percentage of net sales, selling and administrative expenses decreased to 41.1% in 2004 from 41.5% in 2003.
Intangible Asset Amortization
The Company’s intangible asset amortization for the year ended December 31, 2005 increased $0.6 million, or 16.2%, to $4.3 million from $3.7 million during the same period for 2004. The increase was primarily due to the amortization of publication rights acquired in the third quarter of 2005.
The Company’s intangible asset amortization for the year ended December 31, 2004 increased $3.3 million to $3.7 million from $0.4 million during the same period for 2003. The increase was primarily due to incremental amortization related to the acquisitions in the fourth quarter of 2003 and the accelerated amortization of these intangible assets.
Net Interest Expense
Publishing’s consolidated net interest expense for the year ended December 31, 2005 increased $4.3 million, or 3.4%, to $132.3 million from $128.0 million in 2004. The increase is primarily due to a decrease in interest income from swap agreements of $3.6 million in 2005, as well as incremental interest expense in 2005 from the $265 million senior discount notes, and higher interest rates on the revolving line of credit, partially offset by interest income related to short-term investments in 2005.
Publishing’s consolidated net interest expense for the year ended December 31, 2004 increased $10.9 million, or 9.3%, to $128.0 million from $117.1 million in 2003. The increase was primarily the result of the accretion of debt issued by Publishing in October 2003 offset slightly by mark-to-market adjustments for, as well as settlements of, a portion of the interest rate swaps.
Houghton Mifflin’s net interest expense for the year ended December 31, 2005 increased $2.0 million, or 1.8% to $111.2 million from $109.2 million in the same period for 2004. The increase compared to the prior year is primarily due to the $3.6 million of incremental interest income recognized from swap agreements in 2004, offset by interest income related to short-term investments in 2005.
Houghton Mifflin’s net interest expense for the year ended December 31, 2004 decreased $3.4 million, or 3.0% to $109.2 million from $112.6 million in the same period for 2003. The marginal decrease for 2004 was the result of mark-to-market adjustments for, as well as settlements of, a portion of the interest rate swaps.
Debt Extinguishment Charge
In the first quarter of 2003, Houghton Mifflin recorded a $48.4 million debt extinguishment charge related to the tendering of the 7.125% senior secured notes due April 1, 2004 (the “2004 Senior Notes”) and 7.0% senior secured notes due March 1, 2006 and the repayment of the $500.0 million senior subordinated bridge loan facility and the $275.0 million senior term loan under the senior credit facility that were used to finance the Acquisition.
Income Taxes
The Company has incurred losses subsequent to the Acquisition primarily as a result of significantly increased interest expense related to debt financing. The Company recorded significant deferred tax liabilities as a result of purchase accounting for the Acquisition with respect to book-tax differences for identifiable intangible assets. There was no step-up in tax basis for these assets and, accordingly, there is no expected future tax deductibility for them.
The Company has recorded a tax benefit for the losses incurred in 2005, 2004, and 2003. SFAS No. 109, “Accounting for Income Taxes,” requires that deferred tax assets be reduced by a valuation allowance if, based on all available evidence, it is considered more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods. This assessment requires significant judgment, and in making this evaluation, the Company considers all available positive and negative evidence, including past results, the existence of cumulative losses in recent periods, and the forecast of taxable income for the current year and future years. During the fourth quarter of 2005, which marked the Company’s third consecutive year of taxable losses, management concluded, in light of this negative evidence, it was no longer more likely than not that future taxable income would be available in order to utilize deferred tax assets. Based on that judgment, management evaluated all deferred tax assets based only on whether the reversing of existing deferred tax liabilities would be sufficient in the specific future periods necessary to utilize the deferred tax assets. As a result of this analysis, the Company recorded a non-cash charge of $10.4 million to establish a valuation allowance against deferred tax assets relating to the long-term nature of the payments of future postretirement benefit obligations.
Discontinued Operations
The operating results of Promissor, which was sold in January 2006, are included in discontinued operations for all periods presented. For the year ended December 31, 2005, discontinued operations incurred a loss of $5.8 million, net of tax, compared to a loss of $3.2 million, net of tax, for the comparable period in 2004. Net loss from discontinued operations before taxes was $6.0 million in 2005 and $5.3 million in 2004. The increase in net loss from discontinued operations in 2005 as compared to 2004 is a result of an impairment charge of $5.4 million recorded in 2005 to adjust the carrying value of the Promissor business to its fair value, partially offset by higher net sales in 2005.
For the year ended December 31, 2004, discontinued operations incurred a loss of $3.2 million compared to a loss of $1.4 million for the comparable period in 2003. The loss from discontinued operations in 2003 includes the results of Promissor and Curriculum Advantage, Inc., which was sold on April 1, 2003. Promissor’s net loss in 2004 was $5.3 million before taxes, as compared to $0.2 million in 2003. Curriculum Advantage had a loss before taxes of $2.0 million for the year ended December 31, 2003.
Results of Operations-Segments
K-12 Publishing
The K-12 Publishing segment’s net sales for the year ended December 31, 2005 increased $75.7 million, or 8.9%, to $925.5 million from $849.8 million in the same period for 2004. The School Division had sales from its new social studies program of approximately $29.7 million and higher math sales than in 2004 of approximately $9.6 million. McDougal Littell’s sales increased approximately $33.0 million from 2004, primarily as a result of incremental revenue from adoptions of science and social studies of $8.2 million and $30.2 million, respectively, partially offset by lower math sales. Additionally, Edusoft had increased sales from new bookings in 2005, and Great Source revenue increased due to growth in science and math. These stronger performances were partially offset by decreased sales from Riverside’s state contracts.
The K-12 Publishing segment’s net sales for the year ended December 31, 2004 increased $1.4 million, or 0.2%, to $849.8 million from $848.4 million in the same period for 2003. The School Division’s success with higher math sales of approximately $17 million, Riverside’s success with new state contracts of approximately $12 million, and Edusoft’s incremental net sales of $9.3 million were partially offset by the School Division’s reduced sales opportunities in the California market of approximately $31 million and other marginal decreases in net sales associated with McDougal Littell. McDougal Littell’s success with increased mathematics sales of approximately $41 million was more than offset by significantly reduced sales for social studies of approximately $43 million, all associated with the timing of major adoptions.
The K-12 Publishing segment’s operating income for the year ended December 31, 2005 increased $30.9 million to $71.2 million from $40.3 million for the same period in 2004. The increase was due to higher net sales of $75.7 million, more favorable manufacturing rates, and lower administrative costs, partially offset by higher pre-publication amortization of $27.0 million and higher selling costs of $16.8 million.
The K-12 Publishing segment’s operating income for the year ended December 31, 2004 decreased $25.3 million to $40.3 million from $65.6 million for the same period in 2003. The decrease was primarily due to higher pre-publication amortization of $31.0 million, increased editorial and production costs of $22.3 million, and higher selling costs of $13.7 million, respectively, partially offset by lower implementation costs of $6.5 million, reduced manufacturing costs of $5.9 million, lower employee retention expense of $15.5 million, and the $5.5 million amortization of inventory step-up charge in 2003 as a result of the Acquisition.
College Publishing
The College Publishing segment’s net sales for the year ended December 31, 2005 increased $7.4 million, or 3.3%, to $228.3 million from $220.9 million in the same period for 2004. The increase is primarily due to higher sales of advanced placement products and frontlist titles, including history, modern languages, and Student Success programs, as well as modest pricing increases during the year, partially offset by lower revenues from backlist titles.
The College Publishing segment’s net sales for the year ended December 31, 2004 decreased $5.2 million, or 2.3%, to $220.9 million from $226.1 million in the same period for 2003. The decrease was a result of lower revenue in the domestic higher education market due to lower sales of backlist titles as a result of the used book market. In addition, sales of copyright 2005 product generated less than expected sales volume in 2004.
The College Publishing segment’s operating income for the year ended December 31, 2005 increased $5.7 million to $6.1 million from $0.4 million in 2004. The increase is due to higher gross margin on sales, decreased production costs, and decreased administrative costs, offset by increased selling expenses.
The College Publishing segment’s operating income for the year ended December 31, 2004 decreased $4.6 million to $0.4 million from $5.0 million in 2003. The decrease was primarily due to higher pre-publication amortization of $7.9 million and the lower net sales partially offset by lower employee retention expense of $5.3 million.
Trade and Reference Publishing
The Trade and Reference Publishing segment’s net sales for the year ended December 31, 2005 decreased $19.9 million, or 13.4%, to $128.3 million from $148.2 million in the same period for 2004. The decrease was primarily due to lower sales of titles tied to movie releases, which tend to normalize after the film and media publicity, and lower income from licensing rights in 2005.
The Trade and Reference Publishing segment’s net sales for the year ended December 31, 2004 increased $23.1 million, or 18.5%, to $148.2 million from $125.1 million in the same period for 2003. The increase was primarily due to higher sales of adult books, including The Heart is a Lonely Hunter, The Plot Against America, The Gourmet Cookbook, and children’s titles, including The Polar Express, which had higher sales due to the release of a movie in 2004 based on this children’s classic.
The Trade and Reference Publishing segment’s operating loss increased by $5.1 million to $5.9 million from $0.8 million for the year ended December 31, 2004. The increased loss was mainly due to lower net sales partially offset by lower royalty and selling related costs of $4.1 million and $6.6 million, respectively.
The Trade and Reference Publishing segment’s operating loss decreased by $4.5 million to $0.8 million from $5.3 million for the year ended December 31, 2003. The decreased loss was mainly due to higher net sales partially offset by higher manufacturing, royalty, and marketing costs of $8.4 million, $2.5 million, and $2.6 million, respectively.
Liquidity and Capital Resources
Sources and Uses of Cash
As sales seasonality affects operating cash flow, the Company normally incurs a net cash deficit from all of its activities through the middle of the third quarter of the year. The Company currently funds such seasonal deficits through the drawdown of cash and marketable securities, supplemented by borrowings under its revolving senior credit facility. On a consolidated basis, the Company’s primary source of liquidity is cash flow generated from operations while its primary liquidity requirements are for debt service, pre-publication costs, capital investments, and working capital. The Company believes that based on current and anticipated levels of operating performance, conditions in its industries and markets, cash flow from operations, and availability under the senior secured revolving credit facility, the Company will be able in the foreseeable future to make required payments of interest on debt and fund its working capital and capital expenditure requirements. Any future acquisitions, partnerships, or similar transactions may require additional capital, and there can be no assurance that this capital will be available.
The Company manages cash on a daily basis and maintains a minimum balance bank account for accounts payable disbursements. As checks are presented for payment, funds are made available. The outstanding checks in excess of funds on deposit in this account are classified on the balance sheet in accounts payable. As of December 31, 2005 and 2004 the outstanding checks totaled $17.4 million and $39.2 million, respectively.
Operating Activities
Net cash provided by continuing operating activities was $190.3 million for the year ended December 31, 2005, a $22.9 million increase, compared to $167.4 million in 2004. The increase in cash provided is impacted by the decrease in loss from continuing operations of $10.9 million and an increase in noncash adjustments to operating cash flow of approximately $8.3 million, which was primarily driven by the increase in depreciation
and amortization expense from 2004. In 2005, the decrease in accounts receivable resulted in additional operating cash flow of $10.0 million, due to higher net sales and improved collections. These increases in operating cash flow were offset by a decrease of $18.8 million from accounts payable in part due to the timing of inventory purchases in 2005, and higher royalty payments of $6.6 million in 2005, resulting from the Trade Division’s 2004 sales. Changes in the remaining operating assets and liabilities provided $3.8 million more cash during the year ended December 31, 2005 in comparison to 2004.
Net cash provided by continuing operating activities was $167.4 million for the year ended December 31, 2004, a $13.0 million decrease, compared to $180.4 million in 2003. The 2004 loss includes higher operating costs specific to new product development of $39.4 million for pre-publication amortization and $30.1 million for editorial and production costs, partially offset by an increase in net sales. The net loss in 2003 included debt extinguishment costs of $48.4 million. Changes in deferred and income taxes payable for Publishing and Houghton Mifflin used $3.1 million and $7.9 million less cash, respectively, during the year ended December 31, 2004 in comparison to 2003. The difference between Publishing and Houghton Mifflin is associated with the effective tax rates utilized. Changes in the remaining operating assets and liabilities provided $34.4 million less cash during the year ended December 31, 2004 in comparison to 2003. In 2004, the increase in accounts payable of $19.8 million was partially offset by an inventory increase of $5.4 million.
Investing Activities
Cash used for continuing investing activities was $117.7 million in 2005, a decrease of $50.7 million from the $168.4 million used in 2004. Activity related to the sale of auction rate securities in 2005 generated $54.2 million in cash, compared to a use of cash of $54.2 million in 2004 for purchases of these investments. This increase was partially offset by higher capital spending, including pre-publication costs, of $34.3 million in 2005 and $4.0 million of cash used for the acquisition of publication rights. The increase in capital spending is due to $17.4 million of increased pre-publication expenditures for new product development and $16.9 million of increased property, plant, and equipment expenditures in 2005, primarily due to continued investments in back-office systems, online initiatives, and a new data center. The comparison with 2004 is also impacted by the $19.5 million purchase price adjustment received from Vivendi during 2004.
Cash used for continuing investing activities was $168.4 million in 2004, a decrease of $2.1 million from the $166.3 million used in 2003. Lower acquisition activity of $49.8 million, including restricted cash of $11.4 million, and receipt of a purchase price settlement of $19.5 million from Vivendi related to the Acquisition were partially offset by increased property, plant, and equipment of $18.8 million due to investments in back office functions and new system implementation. Additionally, during 2004, activity related to auction rate securities resulted in the net use of $54.2 million in cash. Year-over-year, the Company invested at approximately the same levels with regard to pre-publication costs.
Financing Activities
For the year ended December 31, 2005 net cash used in financing activities was $0.3 million. During 2005, Houghton Mifflin borrowed and repaid $99.5 million on the senior secured revolving credit facility and repaid short term financing of $0.3 million.
For the year ended December 31, 2004 net cash used in financing activities was $1.0 million. During 2004, Houghton Mifflin borrowed and repaid $62 million on the senior secured revolving credit facility and repaid the balance of the $100.0 million 7.125% senior note due April 1, 2004.
Debt
On October 3, 2003, Publishing sold 11.5% senior discount notes due on October 15, 2013 (the “Senior Discount Notes”), generating initial gross proceeds of $150.9 million, in a private placement. The net proceeds of $145.2 million from this offering were distributed to the equity holders of Holdings as a return of capital. The Senior Discount Notes will not pay cash interest until after October 15, 2008, at which time the accreted value of
these notes will be $265.0 million. At December 31, 2005, the accreted value of these notes was $194.0 million. Publishing is the sole obligor of these notes. Publishing’s notes are structurally subordinated to Houghton Mifflin’s notes.
Publishing conducts all of its business through Houghton Mifflin, its wholly owned subsidiary. Houghton Mifflin is not obligated to make funds available to Publishing for payment on the Senior Discount Notes. In addition, the terms of certain of the indentures governing the existing notes of Houghton Mifflin significantly restrict Houghton Mifflin and Publishing’s other subsidiaries from paying dividends, making distributions, and otherwise transferring assets to Publishing.
On November 22, 2005, Houghton Mifflin entered into the Second Amendment to the Credit and Guaranty Agreement, which decreased the aggregate amount available for borrowings under the senior secured revolving credit facility (the “Revolver”) to $250 million from $325 million and amended certain financial covenants. The Revolver, for which Houghton Mifflin pays annual commitment fees, expires on December 30, 2008. The Revolver requires Houghton Mifflin to maintain certain interest coverage, leverage, and senior leverage ratios, as defined under the terms of the facility. As of December 31, 2005, Houghton Mifflin had no borrowings under the Revolver and, subject to certain covenants and borrowing base capacity limitations for outstanding letters of credit, had $225.3 million available to borrow.
The Revolver includes various financial covenants such as certain leverage and coverage ratios. The ratios are calculated quarterly using EBITDA, which is defined as earnings before interest, taxes, depreciation, and amortization and other adjustments allowed under the terms of the agreement, on a rolling twelve months basis. It also contains customary covenants, including limitations on Houghton Mifflin’s ability to incur debt, and events of default as defined by the agreement. The Revolver also limits Houghton Mifflin’s ability to pay dividends, to make advances, and otherwise engage in intercompany transactions. The primary covenants under the Revolver are the total leverage ratio, senior leverage ratio, interest coverage ratio, and consolidated capital investments. For 2006, the Revolver requires the total leverage ratio to be no greater than 4.5:1; the senior leverage ratio to be no greater than 3.25:1; the interest coverage ratio to be not less than 2.5:1; and the consolidated capital investments to not exceed $190.0 million.
In connection with the Acquisition, Houghton Mifflin incurred a substantial amount of debt. Interest payments on this indebtedness have significantly increased its funding requirements. On January 30, 2003, Houghton Mifflin issued $600.0 million of 8.25% senior notes that mature on February 1, 2011 (the “Senior Notes”) and $400.0 million of 9.875% senior subordinated notes due February 1, 2013 (the “Senior Subordinated Notes”). The Senior Subordinated Notes were priced at 99.22% of the principal amount to yield an effective interest rate of 10.0%. The net proceeds from these notes were $974.6 million. The net proceeds from these two financings were used to repay Houghton Mifflin’s $500.0 million senior subordinated bridge loan facility in full, the $275.0 million senior term loan under the Revolver, and repurchase $125.0 million of its 7.0% notes due March 1, 2006.
The Senior Notes and the Senior Subordinated Notes include various financial and customary covenants that limit Houghton Mifflin’s ability to pay dividends, make investments or sell assets, and dispose of substantially all its assets by sale or merger. Some covenants include the calculation of EBITDA, defined as earnings before interest, taxes, depreciation and amortization, and other adjustments under the indenture. These covenants are tied to the calculation of a fixed charge coverage ratio based on EBITDA, including Houghton Mifflin’s ability to incur additional debt or make restricted payments subject to qualifications and limitations as defined in the indenture. The fixed charge coverage ratio is required to be at least 2.0:1. Other covenants restrict Houghton Mifflin’s ability to enter into certain transactions with affiliates.
Houghton Mifflin was in compliance with the financial covenants for both the Revolver and the Senior and Senior Subordinated Notes, respectively, as of and for the year ended December 31, 2005.
Contractual Obligations
The following table sets forth consolidated long-term cash contractual obligations as of December 31, 2005:
(a) Represents minimum lease payments under non-cancelable operating leases.
(b) Represents a management fee that Houghton Mifflin pays annually to the Sponsors. Under the terms of the arrangement, the management fee expires in 2012.
(c) Purchase obligations are agreements to purchase goods or services that are enforceable and legally binding. These goods and services consist primarily of author advances, subcontractor expenses, information technology licenses, and outsourcing arrangements.
In addition to the payments described above, Houghton Mifflin has employee benefit obligations that require future payments. For example, Houghton Mifflin expects to make a $20.0 million cash contribution to its qualified defined pension plans in 2006, although it is not obligated to do so. Houghton Mifflin expects to make payments of $0.8 million in 2006 related to its restructuring plans. Based on current expectations of the formula and exceptions under the indentures, the Company believes that Houghton Mifflin will be able to distribute cash to Publishing to meet its cash interest obligations on the notes when they are due and payable commencing in 2009.
Off-Balance Sheet Transactions
The Company does not have any off-balance-sheet financial instruments and is not party to any off-balance sheet transactions.
Restructuring
The following table sets forth the activity in restructuring reserves for the year ended December 31, 2005.
In 2001, at the time of Vivendi’s acquisition of Houghton Mifflin, Vivendi developed and approved a plan to restructure the Company’s operations. As of the date of the Acquisition, management of Holdings validated certain of the restructuring plans formulated during the predecessor ownership and identified additional plans, the benefits of which were considered in the pre-acquisition business case. The new plans included further consolidation of the K-12 business operations and corresponding workforce reductions. During 2004, the adjustment to goodwill was the result of a re-evaluation of the restructuring reserve established at the Acquisition date.
As of December 31, 2005, severance costs of approximately $0.8 million remain accrued under this plan and are classified as other current liabilities. These payments are expected to be completed in 2006.
Recent Accounting Pronouncements
In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.” In annual periods beginning after June 15, 2005, SFAS No. 123R eliminates the ability to account for equity-based compensation using the intrinsic value-based method under Accounting Principles Board Opinion (“APB”) No. 25. SFAS No. 123R requires companies to record in their Statement of Operations equity-based compensation expense for stock compensation awards based on the fair value of the equity instrument at the time of grant. The Company adopted SFAS No. 123R beginning in the first quarter of 2006, as required, using the “Modified Prospective” method, and will not restate prior periods for the adoption of SFAS No. 123R. Prior to 2006, the Company disclosed pro-forma net loss in accordance with SFAS No. 123 and SFAS No. 148. Under SFAS No. 123R, equity-based compensation expense is required to be recognized in companies’ financial statements. Based on options outstanding as of December 31, 2005, the Company expects to record expense of approximately $1.0 million in 2006 as a result of adopting this pronouncement. This estimate will change if additional options are granted in 2006.
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs an Amendment of Accounting Research Bulletin (“ARB”) No. 43, Chapter 4” to improve financial reporting and global comparability of inventory accounting. The amendment clarifies that inventory related expenses, such as idle facility expense, excessive spoilage, double freight, and rehandling cost should be recognized as current period charges. The guidance is effective for inventory costs incurred beginning in fiscal year 2006. The adoption of SFAS No. 151 is not expected to have a material impact on the Company’s financial condition or result of operations.
“Safe Harbor” Statement under Private Securities Litigation Reform Act of 1995
This Form 10-K includes forward-looking statements that reflect the Company’s current views about future events and financial performance. Words such as “estimates,” “expects,” “anticipates,” “projects,” “plans,” “intends,” “believes,” “forecasts,” and variations of such words or similar expressions that predict or indicate future events or trends, or that do not relate to historical matters, identify forward-looking statements. The Company’s expectations, beliefs, and projections are expressed in good faith, and it is believed there is a reasonable basis for them. However, there can be no assurance that management’s expectations, beliefs, and projections will result or be achieved. Investors should not rely on forward-looking statements because they are subject to a variety of risks, uncertainties, and other factors that could cause actual results to differ materially from the Company’s expectations, and the Company expressly does not undertake any duty to update forward-looking statements, which speak only as of the date of this report. These factors include, but are not limited to: (i) market acceptance of new educational and testing products and services, particularly reading, literature, language arts, mathematics, science, and social studies programs, and norm-referenced and criterion-referenced testing; (ii) the seasonal and cyclical nature of educational sales; (iii) changes in funding in school systems throughout the nation, which may result in cancellation of planned purchases of educational and testing products and/or services and shifts in timing of purchases; (iv) changes in educational spending in key states such as California, Texas, and Florida, and the Company’s share of that spending; (v) changes in purchasing patterns in elementary and secondary schools and, particularly in college markets, the effect of textbook prices, technology, and the used book market on sales; (vi) changes in the competitive environment, including those which could adversely affect revenue and cost of sales, such as the increased amount of materials given away in the elementary and secondary school markets and increased demand for customized products; (vii) changes in the relative profitability of products sold; (viii) regulatory changes that could affect the purchase of educational and testing products and services; (ix) changes in the strength of the retail market for general interest publications and market acceptance of newly published titles and new electronic products; (x) the effect of fluctuations in raw material prices, particularly paper; (xi) the ability of the Assessment Division to enter into new agreements for testing services and generate net sales growth; (xii) delays and unanticipated expenses in developing new programs and other products; (xiii) delays and unanticipated expenses in developing new technology products,
and market acceptance and use of online instruction and assessment materials; (xiv) the potential for damages and fines resulting from errors in scoring high-stakes tests; (xv) the potential effect of a continued weak economy on sales of K-12, college, and general interest publications; (xvi) the risk that the Company’s well-known authors will depart and write for competitors; (xvii) the effect of changes in accounting, regulatory, and/or tax policies and practices; and (xviii) other factors detailed from time to time in the Company’s filings with the Securities and Exchange Commission.
Outlook
The Company expects the education marketplace to undergo a substantial shift, beginning in 2007, as the adoption market begins to expand through 2009. Several states are expected to buy education materials in Houghton Mifflin’s core disciplines in 2006, and the overall market is expected to increase slightly from 2005. With an estimated addressable market of approximately $600 million, the Company expects net sales to increase in the low single digit percent range over 2005.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosure About Market Risk
The Company is exposed to certain market risks as part of its on-going business operations. The Company’s primary exposure following consummation of the Acquisition include changes in interest rates as borrowings under its Revolver bear interest at floating rates based on the London InterBank Offered Rate or prime rate, in each case plus an applicable borrowing margin. The Company manages its interest rate risk by balancing the amount of fixed rate and floating-rate debt. For fixed rate debt, interest rate changes affect the fair market value but do not affect earnings or cash flows. Conversely, for floating-rate debt, interest rate changes generally do not affect the fair market value but do impact earnings and cash flows, assuming other factors are held constant. Up to $250.0 million of floating-rate borrowings are available under the Revolver subject to borrowing base limitations. At December 31, 2005, there were no borrowings outstanding under the Revolver. Interest paid on borrowings under the Revolver, subsequently repaid, in the year ended December 31, 2005, totaled $1.4 million. Consequently, a 10% change in market interest rate percentages would have no material impact on the results of operations.
During December 2003, Houghton Mifflin entered into interest rate swap agreements in conjunction with a notional $200.0 million of its Senior Notes. The interest rate swap agreements converted $200.0 million of Houghton Mifflin’s debt from a fixed rate to a floating rate. Changes in the fair value of these swaps are recorded as interest income or expense in the consolidated statement of operations on a monthly basis. During 2004, $1.8 million was recorded as interest income for the net change in fair value of these agreements. In 2004, Houghton Mifflin terminated portions of these swap agreements during periods of favorable interest rate movement, receiving $3.5 million at settlement on swaps with total recorded fair values of $2.1 million, resulting in $1.4 million of interest income in conjunction with these settlements. Total swap activity for 2004 yielded interest income of $3.2 million that was recorded in the results of operations. In February 2005, Houghton Mifflin terminated the remaining swap agreements and paid $1.8 million, of which $0.2 million was recorded as interest expense. The recorded fair value of the swaps at settlement was $1.6 million.
The fair value of the Company’s debt instruments at December 31, 2005 was as follows:
Most of the Company’s sales are denominated in U.S. dollars; thus its financial results are not subject to any material foreign currency exchange risks. A 10% change in the exchange rate of the U.S. dollar against other major currencies would not have a material impact on the Company’s results of operations.
Item 8.
Item 8. Financial Statements
HM Publishing Corp. and
Houghton Mifflin Company
Index to Consolidated Financial Statements
Page
Reports of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm
Consolidated Statements of Operations for the years ended December 31, 2005, 2004, and 2003
Consolidated Balance Sheets at December 31, 2005 and 2004
Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004, and 2003
Consolidated Statements of Stockholder’s Equity for the years ended December 31, 2005, 2004, and 2003
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholder
of HM Publishing Corp.:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, stockholder’s equity and cash flows present fairly, in all material respects, the financial position of HM Publishing Corp. and its subsidiaries at December 31, 2005 and 2004, and the results of operations and cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits of these financial statements provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
Boston, Massachusetts
March 30, 2006
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholder
of Houghton Mifflin Company:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, stockholder’s equity and cash flows present fairly, in all material respects, the financial position of Houghton Mifflin Company and its subsidiaries at December 31, 2005 and 2004, and the results of operations and cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits of these financial statements provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
Boston, Massachusetts
March 30, 2006
HM PUBLISHING CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands of dollars)
See accompanying Notes to Consolidated Financial Statements
HOUGHTON MIFFLIN COMPANY
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands of dollars)
See accompanying Notes to Consolidated Financial Statements
CONSOLIDATED BALANCE SHEETS
(In thousands of dollars, except per share amounts)
See accompanying Notes to Consolidated Financial Statements
HM PUBLISHING CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands of dollars)
HM PUBLISHING CORP.
CONSOLIDATED STATEMENT OF CASH FLOWS (Continued)
(In thousands of dollars)
See accompanying Notes to Consolidated Financial Statements
HOUGHTON MIFFLIN COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands of dollars)
HOUGHTON MIFFLIN COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(In thousands of dollars)
See accompanying Notes to Consolidated Financial Statements
HM PUBLISHING CORP.
CONSOLIDATED STATEMENT OF STOCKHOLDER’S EQUITY
(In thousands of dollars, except per share amounts)
See accompanying Notes to Consolidated Financial Statements
HOUGHTON MIFFLIN COMPANY
CONSOLIDATED STATEMENT OF STOCKHOLDER’S EQUITY
(In thousands of dollars, except per share amounts)
See accompanying Notes to Consolidated Financial Statements
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Tabular data in thousands, except per share data)
(1) Basis of Presentation
The consolidated financial statements of HM Publishing Corp. (“Publishing”) include the accounts of its wholly owned subsidiary, Houghton Mifflin Company (“Houghton Mifflin,” a separate public reporting company, together with Publishing, the “Company”). The Company’s principal business is publishing.
On December 30, 2002, Houghton Mifflin Holdings, Inc. (“Holdings”), through its wholly owned subsidiary, Versailles Acquisition Corporation, acquired (the “Acquisition”) all of the outstanding shares of Houghton Mifflin from Vivendi Communications North America, Inc., a wholly owned subsidiary of Vivendi Universal, S.A. (“Vivendi”).
Publishing, a wholly owned subsidiary of Holdings, was incorporated on September 12, 2003. Holdings is a company beneficially owned by Thomas H. Lee Partners, L.P. and its affiliates (“THL”), Bain Capital, LLC and its affiliates (“Bain Capital”), and the Blackstone Group and its affiliates (“Blackstone”; collectively the “Sponsors”). Holdings contributed its 100% equity interest in Houghton Mifflin to Publishing on September 17, 2003. At the time of this transaction, Publishing had no other assets. As Houghton Mifflin and Publishing were entities organized under the common control of Holdings, the historical consolidated statements of Houghton Mifflin, the predecessor company, became the historical consolidated financial statements of Publishing. No goodwill or other intangible assets arose from this transaction.
In October 2003, Publishing issued $265.0 million of 11.5% senior discount notes generating proceeds of $145.2 million, net of issuance costs. Publishing is the sole obligor of these notes. Other than this debt obligation, related deferred issuance costs, accrued liabilities, and interest expenses, net of taxes, all other assets, liabilities, income, expenses, and cash flows presented for all periods represent those of its wholly owned subsidiary Houghton Mifflin.
In January 2006, the Company signed a definitive stock purchase agreement to sell its subsidiary, Promissor, Inc. This sale was completed and all activities of Promissor have ceased during January 2006. Effective December 2005, the Company’s consolidated financial statements and notes have been reclassified to reflect this business as a discontinued operation in accordance with Financial Accounting Standards Board Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”
The Company has elected to present dual consolidated financial statements. Publishing conducts all of its operating activities through Houghton Mifflin. The financial statements of Publishing include the financial position and results of operations of Houghton Mifflin, as well as incremental senior discount notes issued by Publishing, and related interest expense. Unless otherwise noted, the information provided pertains to both Publishing and Houghton Mifflin.
(2) Significant Accounting Policies
Principles of Consolidation:
The consolidated financial statements of Publishing include the accounts of Publishing, its wholly owned subsidiary Houghton Mifflin, and Houghton Mifflin’s subsidiaries. The consolidated financial statements of Houghton Mifflin include the accounts of Houghton Mifflin and its wholly owned subsidiaries. All material intercompany accounts and transactions are eliminated in consolidation.
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Use of Estimates:
The preparation of financial statements in conformity with Generally Accepted Accounting Principles (“GAAP”) requires the use of estimates, assumptions and judgments by management that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosure of contingent assets and liabilities in the amounts reported in the financial statements and accompanying notes. On an on-going basis, the Company evaluates its estimates and assumptions including, but not limited to, book returns, allowance for bad debts, recoverability of advances to authors, valuation and recoverability of inventory, depreciation and amortization periods, recoverability of long-term assets such as property, plant, and equipment, capitalized pre-publication costs, other identified intangibles, and goodwill, as well as deferred revenue, income taxes, restructurings, pensions and other postretirement benefits, contingencies, and litigation. The Company bases its estimates on historical experience and on various other assumptions that the Company believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from those estimates.
Reclassifications:
Certain prior year amounts have been reclassified to conform to the current period presentation for comparability purposes. The Company revised its consolidated statements of cash flows for the year ended December 31, 2003 to reconcile Net loss to Net cash provided by operating activities. Previously, the Company reconciled Net loss from continuing operations to Net cash provided by operating activities. This matter did not change any of the account balances on the accompanying consolidated balance sheets, consolidated statements of operations, or the net increase in cash and cash equivalents included in our consolidated statements of cash flows for the year ended December 31, 2003.
Revenue Recognition:
The Company derives revenue primarily from the sale of textbooks and instructional materials, trade books, reference materials, multimedia instructional programs, license fees for book rights, content, and software, and services that include test development, test scoring, and training.
Revenues from textbooks and instructional materials, trade books, reference materials, assessment materials, and multimedia instructional programs are recognized in the period when persuasive evidence of an arrangement with the customer exists, the products are shipped, title and risk of loss have transferred to the customer, all significant obligations have been performed, and collection is reasonably assured. The Company enters into certain contractual arrangements that have multiple elements, one or more of which may be delivered subsequent to the initial sale. For these arrangements, fair value is determined for all elements and the relative fair value of revenue for items to be delivered after the initial sale is deferred until such time as the items are delivered. As products are shipped with right of return, a provision for estimated returns on these sales is made at the time of sale, based on historical experience. Textbooks shipped from depository locations are recorded one month in arrears based on information received from the depositories. Shipping and handling fees are included in net sales. Costs incurred for shipping and handling are included in cost of sales.
License fees for software products without future obligations are recognized upon delivery. Certain contracts include software and ongoing fees for maintenance and other support. If vendor specific objective evidence of the fair value of each element of the arrangement exists, the elements of the contract are unbundled and the revenue for each element is recognized as appropriate.
Revenues for test delivery, test scoring, and training are recognized when the services have been completed, the fee is fixed and determinable, and collection is reasonably assured. Revenues for fixed-priced contracts that
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
require significant test development are recognized as the services are provided. Differences between what has been billed and what has been recognized as revenue is recorded as deferred revenue. Losses on such contracts are recognized when they become known.
The Company enters into agreements to license certain book publishing rights and content. The Company recognizes revenue on such arrangements in accordance with the license agreements, when all materials have been delivered to the customer, and collection is reasonably assured.
Advertising Costs:
Advertising costs are charged to selling and administrative expenses as incurred. Advertising costs were $6.3 million, $9.8 million, and $7.1 million, for the years ended December 31, 2005, 2004, and 2003, respectively.
Cash, Cash Equivalents, and Short-term Investments:
Cash and cash equivalents consist primarily of cash in banks and highly liquid investment securities that have maturities of three months or less when purchased. The carrying amount approximates fair market value due to the short-term maturity of these instruments. Auction rates securities for which interest rates reset in less than three months, but for which the maturity date is greater than three months, are classified as short-term investments. Despite the long-term nature of the auction rate securities contractual maturities, the Company has the ability to liquidate without delay, if necessary.
Accounts Receivable:
Accounts receivable are recorded net of allowances for doubtful accounts and reserves for book returns. In the normal course of business, the Company extends credit to customers that satisfy predefined criteria. The Company estimates the collectibility of its receivables. Allowances for doubtful accounts are established through the evaluation of accounts receivable agings and prior collection experience to estimate the ultimate collectibility of these receivables. Reserves for book returns are based on historical return rates and sales patterns.
Inventories:
Inventories are stated at the lower of weighted average cost or market. The level of obsolete and excess inventory is calculated on a program or title level by comparing the number of units in stock with the expected future demand. Based on this review, any excess stock is reserved as appropriate.
Property, Plant, and Equipment:
Property, plant, and equipment are stated at cost, or in the case of assets acquired in business combinations at fair value as of the acquisition date, less accumulated depreciation. Equipment under capital lease is stated at fair value at inception of the lease, less accumulated depreciation. Maintenance and repair costs are charged to expense as incurred, and renewals and improvements that extend the useful life of the assets are capitalized.
Depreciation on property, plant, and equipment is calculated on the straight-line method over the estimated useful lives of the assets. Equipment held under capital leases and leasehold improvements are amortized using the straight-line method over the shorter of the lease term or estimated useful life of the asset. Estimated useful lives of property, plant, and equipment are as follows:
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Capitalized Internal Use Software:
Capitalized internal use software is included in property, plant, and equipment on the consolidated balance sheet. The Company capitalizes certain costs related to obtaining or developing computer software for internal use. Costs incurred during the application development stage, including external direct costs of materials and services, and payroll and payroll related costs for employees who are directly associated with the internal-use software project, are capitalized and amortized on a straight-line basis over the expected useful life of the related software. The application development stage includes design, software configuration and integration, coding, hardware installation, and testing. Costs incurred during the preliminary stage, as well as maintenance, training, and upgrades that do not result in additional functionality are expensed as incurred.
Pre-Publication Costs:
The Company capitalizes the art, prepress, and other costs incurred in the creation of the master copy of a book or other media (the “pre-publication costs”). The costs to write manuscripts are expensed as incurred. Pre-publication costs are amortized from the year of copyright, or sale if earlier, over three to five years using the sum-of-the-years-digits method. This policy is used by all divisions, except for the Trade and Reference Division’s non-reference publications, which are expensed as incurred, and the Assessment Division, which uses the straight-line amortization method. The amortization methods and periods chosen best reflect the expected sales generated from individual titles or programs. The Company evaluates the remaining lives and recoverability of capitalized pre-publication costs, which are often dependent upon program acceptance by state adoption authorities.
Amortization expense related to pre-publication costs was $87.0 million, $50.9 million, and $14.4 million, for the years ended December 31, 2005, 2004, and 2003, respectively.
Goodwill, Publishing Rights, and Other Intangible Assets:
Goodwill is the excess of the purchase price paid over the fair value of the net assets of the business acquired. Other intangible assets principally consist of branded trademarks, acquired publishing rights, and non-compete agreements. Goodwill and indefinite-lived intangible assets are not amortized but are reviewed at least annually for impairment or earlier, if an indication of impairment exists. With regard to goodwill, the Company tests for impairment annually on an implied residual basis by deducting the fair value of all assets and liabilities from the total estimated fair value of each reporting unit to determine the implied fair value of goodwill. Impairment recognized is measured by the amount by which the carrying amount of goodwill exceeds the implied fair value of goodwill. The Company estimates total fair value of reporting units using discounted cash flow analysis, and makes assumptions regarding future revenues, gross margins, working capital levels, investments in new products, capital spending, tax, cash flows, and the terminal value of the reporting unit. With regard to other intangibles with indefinite lives, the Company determines the fair value by asset, which is then compared to its carrying value. The Company completed its annual goodwill and indefinite-lived intangible asset impairment tests as of October 1, 2005 and determined that no impairments existed.
A publishing right allows the Company to publish and republish existing and future works as well as create new works based on previously published materials. The Company determines the fair market value of the publishing rights arising from business combinations by discounting the after-tax cash flows projected to be derived from the publishing rights and titles to their net present value using a rate of return that accounts for the time value of money and the appropriate degree of risk. The useful life of the publishing rights is based on the lives of the various copyrights involved. The Company calculates amortization using the percentage of the
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
projected operating income before taxes derived from the titles in the current year as a percentage of the total estimated operating income before taxes over the remaining useful life. Acquired publication rights, as well as customer-related intangibles with definitive lives are amortized on an accelerated basis over periods ranging from 2-18 years.
Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of:
The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. If the future undiscounted cash flows are less than their book value, an impairment exists. The impairment is measured as the difference between the book value and the fair value of the underlying asset. Fair value is normally assessed using a discounted cash flow model.
Royalty Advances:
Royalty advances to authors are capitalized and represent amounts paid in advance of the sale of an author’s product and are recovered as earned. As advances are recorded, a partial reserve may be immediately recognized based primarily upon historical sales experience. Advances are evaluated periodically to determine if they are expected to be recovered. Any portion of a royalty advance that is not expected to be recovered is fully reserved.
Income Taxes:
The Company has incurred losses subsequent to the Acquisition as a result of the financings having significantly increased interest expense and the Acquisition having increased certain other costs. The Company recorded significant deferred tax liabilities as a result of purchase accounting for the Acquisition with respect to book-tax differences for identifiable intangible assets. There was no step-up in tax basis for these assets and, accordingly, there is no expected future tax deductibility for them.
The Company has recorded a tax benefit for the losses incurred in 2005 and 2004. The recoverability of Houghton Mifflin’s taxable losses is adequately covered by existing taxable temporary differences that reverse before the expiration of the loss carry forward period allowed by law. Based on management’s assessment of historical pre-tax losses and the fact that it does not anticipate sufficient taxable income in the near term to assure utilization of certain deferred tax assets, the Company has recorded a valuation allowance at December 31, 2005 of $10.4 million. This valuation allowance was recorded against deferred tax assets relating to the long-term nature of the payment of future post-retirement benefit obligations.
Stock-Based Compensation:
As permitted by Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,” the Company uses the intrinsic value-based method of accounting prescribed by Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations to account for its employee stock-based compensation. Under this method, compensation expense for employee rewards is recorded only if the fair value of the underlying stock exceeds the exercise price of the option granted on the date of grant. To date, there has been no compensation costs for any stock-based awards.
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
The following table illustrates the effect on net loss as if Publishing had determined compensation cost based on the fair value at the grant date for stock options under SFAS No. 123:
The following table illustrates the effect on net loss as if Houghton Mifflin had determined compensation cost based on the fair value at the grant date for stock options under SFAS No. 123:
Comprehensive Income:
Comprehensive income is defined as changes in the equity of an enterprise except those resulting from shareholder transactions. The amounts shown on the consolidated statement of stockholder’s equity relate to the cumulative effect of minimum pension liabilities and translation adjustments.
Foreign Currency Translation:
The Company’s non-United States dollar denominated assets and liabilities are translated into United States dollars at current rates as of the balance sheet date and the revenues, costs and expenses are translated at the average rates established during each reporting period. Net gains or losses resulting from the translation of the foreign financial statements and the effect of exchange rate changes on intercompany balances are accumulated and recorded directly to the foreign currency translation adjustment component of stockholder’s equity.
Financial Instruments:
The Company may use swap contracts to manage its interest expense. The use of these financial instruments is intended to reduce the interest cost to the Company. The Company assesses at inception, and quarterly thereafter, whether the financial instruments that are used in hedged transactions are highly effective in offsetting changes in the fair value or cash flows of the hedged item. The swaps are recorded in the consolidated balance sheet at fair value as other assets or liabilities. Changes in the fair value of these swaps are recorded as interest income or expense in the consolidated statement of operations. As of December 31, 2005, the Company has no outstanding swap agreements. The Company does not use derivatives for trading purposes and is not a party to leveraged derivatives.
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Recent Accounting Pronouncements:
In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.” In annual periods beginning after June 15, 2005, SFAS No. 123R eliminates the ability to account for equity-based compensation using the intrinsic value-based method under Accounting Principles Board Opinion (“APB”) No. 25. SFAS No. 123R requires companies to record in their Statement of Operations equity-based compensation expense for stock compensation awards based on the fair value of the equity instrument at the time of grant. The Company adopted SFAS No. 123R beginning in the first quarter of 2006, as required, using the “Modified Prospective” method, and will not restate prior periods for the adoption of SFAS No. 123R. Prior to 2006, the Company disclosed pro-forma net loss in accordance with SFAS No. 123 and SFAS No. 148. Under SFAS No. 123R, equity-based compensation expense is required to be recognized in companies’ financial statements. Based on options outstanding as of December 31, 2005, the Company expects to record expense of approximately $1.0 million in 2006 as a result of adopting this pronouncement. This estimate will change if additional options are granted in 2006.
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs an Amendment of Accounting Research Bulletin (“ARB”) No. 43, Chapter 4,” to improve financial reporting and global comparability of inventory accounting. The amendment clarifies that inventory related expenses, such as idle facility expense, excessive spoilage, double freight, and rehandling cost should be recognized as current period charges. The guidance is effective for inventory costs incurred beginning in fiscal year 2006. The adoption of SFAS No. 151 is not expected to have a material impact on the Company’s financial condition or result of operations.
(3) Acquisitions
Acquisition of Edusoft:
On December 5, 2003, Houghton Mifflin acquired Edusoft, a San Francisco, California-based assessment platform provider, for $37.0 million in cash, including certain contractual post-closing adjustments. The acquisition was accounted for as a purchase transaction in accordance with SFAS No. 141, “Business Combinations.” The purchase price was allocated among tangible and intangible assets acquired and liabilities assumed based on fair values at the transaction date. The excess of the purchase price over the acquired tangible and intangible assets and liabilities was recorded as goodwill. Houghton Mifflin acquired the stock of Edusoft, and therefore, the goodwill arising from this transaction is not tax deductible. The following represents the allocation of the purchase price:
The other identified intangible assets consist of customer-related and other intangibles. The estimated useful lives of these intangibles are between two and three years.
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Acquisition of Cognitive Concepts, Inc.:
On October 14, 2003, Houghton Mifflin acquired Cognitive Concepts, Inc. (“CCI”), a provider of research-based supplemental education tools, for $12.8 million in cash. The acquisition was accounted for as a purchase transaction in accordance with SFAS No. 141, “Business Combinations.” The purchase price was allocated among tangible and intangible assets acquired and liabilities assumed based on fair values at the transaction date. The excess of the purchase price over the acquired tangible and intangible assets and liabilities was recorded as goodwill. The Company acquired the stock of CCI and, therefore, the goodwill resulting from this transaction is not expected to be tax deductible. The following represents the allocation of the purchase price:
(4) Restructuring
The following analysis sets forth the significant components of the restructuring reserves and the related activity:
In 2001, at the time of Vivendi’s acquisition of Houghton Mifflin (the “Vivendi Purchase”), Vivendi developed and approved a plan to restructure the Company’s operations. As of the date of the Acquisition, management of Holdings validated certain of the restructuring plans formulated during the predecessor ownership and identified additional plans, the benefits of which were considered in the pre-acquisition business case. The new plans included further consolidation of the K-12 business operations and corresponding workforce reductions. During 2004, the adjustment to goodwill was the result of a re-evaluation of the restructuring reserve established at the Acquisition date.
As of December 31, 2005, severance costs of approximately $0.8 million remain accrued under this plan and are classified as other current liabilities. These payments are expected to be completed in 2006.
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
(5) Discontinued Operations
On January 23, 2006, Houghton Mifflin sold Promissor, Inc. for cash proceeds of $42.0 million. The results from operations and cash flows of Promissor, Inc. have been segregated and classified as discontinued operations in the accompanying financial statements. As a result of the sale, the Company recorded an impairment charge of $5.4 million in 2005 to adjust the carrying value of the Promissor business to its fair value. This charge has been reflected in the net loss from discontinued operations for the year ended December 31, 2005. Promissor, Inc. had net sales of $68.0 million, $64.0 million and $64.0 million and loss before taxes of $6.0 million, $5.3 million and $0.2 million in the years ended December 31, 2005, 2004 and 2003, respectively.
On April 1, 2003, Houghton Mifflin disposed of Curriculum Advantage, Inc. The results from operations and cash flows of Curriculum Advantage, Inc. have been segregated and classified as discontinued operations in the accompanying financial statements, through closing on April 1, 2003, and reflect the cash proceeds received at closing as net cash provided by discontinued investing activities for the year ended December 31, 2003.
(6) Balance Sheet Information
Inventories:
Inventories, net of applicable reserves, at December 31, 2005 and 2004 consist of the following:
Property, Plant, and Equipment:
Balances of major classes of assets and accumulated depreciation and amortization at December 31, 2005 and 2004 are as follows:
Depreciation and amortization expense for the year ended December 31, 2005 was $36.1 million. Depreciation and amortization expense was $36.1 million for the year ended December 31, 2004, including amortization of equipment under capital lease of $0.2 million. Depreciation and amortization expense for the
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
year ended December 31, 2003 was $28.4 million, including amortization of equipment under capital lease of $0.5 million. Machinery and equipment includes equipment under capital lease in the amount of $0.3 million at December 31, 2004. There was no machinery and equipment under capital lease at December 31, 2005.
Rabbi Trust:
The Company maintains a Rabbi Trust for the purposes of funding certain compensation and benefit plan obligations made available to its senior executives and former directors in connection with the following plans: directors retirement, deferred compensation, supplemental executive retirement, and supplemental savings. As of December 31, 2005 and 2004, the Company’s balance in the Rabbi Trust was $11.2 million and $13.3 million, respectively, consisting of cash or cash equivalents and is included in other assets on the consolidated balance sheet. The liabilities associated with these plans are $14.0 million and $13.2 million at December 31, 2005 and 2004, respectively, and are included in other long-term liabilities on the consolidated balance sheet.
Accounts Payable:
The Company maintains a minimum balance bank account for accounts payable disbursements. As checks are presented for payment, funds are made available. The outstanding checks in excess of funds on deposit in this account are classified on the balance sheet in accounts payable. As of December 31, 2005 and 2004 the outstanding checks totaled $17.4 million and $39.2 million, respectively.
Deferred Revenue:
Deferred revenue, classified in other liabilities at December 31, 2005 and 2004, consists of the following:
The non-current deferred revenue is a result of certain contracts having multiple elements or deliverables, some of which will be delivered at dates subsequent to the initial sale. The relative fair value of revenue for the undelivered items has been deferred until such time as the products are delivered to the customer.
(7) Goodwill and Other Intangible Assets
Goodwill and other intangible assets at December 31, 2005 and 2004 consist of the following:
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Changes in the net carrying amount of goodwill for the year ended December 31, 2005 were as follows:
In accordance with the provisions of SFAS No. 142, goodwill and indefinite-lived trademarks and tradenames are not amortized. Amortization expense for publishing rights and customer related and other intangibles was $103.1 million in 2005, $131.4 million in 2004, and $145.4 million in 2003.
Estimated aggregate amortization expense expected for each of the next five years related to intangibles subject to amortization is as follows:
(8) Long-Term Debt
Long-term debt at December 31, 2005 and 2004 consists of the following:
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Long-term debt due in each of the next five years and thereafter is as follows:
Deferred financing costs are capitalized in other assets, net of accumulated amortization, and are amortized over the life of the related debt. Capitalized deferred financing costs at December 31, 2005 and 2004 were $43.6 million and $52.2 million for Publishing and $38.8 million and $46.7 million for Houghton Mifflin, respectively.
On October 3, 2003, Publishing sold 11.5% senior discount notes due on October 15, 2013 (the “Senior Discount Notes”), generating initial gross proceeds of $150.9 million, in a private placement. The net proceeds from this offering of $145.2 million were distributed to the equity holders of Holdings as a return of capital. The Senior Discount Notes will not pay cash interest until after October 15, 2008, at which time the accreted value of these notes will be $265.0 million. At December 31, 2005, the accreted value of these notes was $194.0 million. Publishing is the sole obligor of these notes, which are structurally subordinated to Houghton Mifflin’s notes.
Publishing conducts all of its business through Houghton Mifflin, its wholly owned subsidiary. Houghton Mifflin is not obligated to make funds available to Publishing for payment on the Senior Discount Notes. In addition, the terms of certain of the indentures governing the existing notes of Houghton Mifflin significantly restrict Houghton Mifflin and Publishing’s other subsidiaries from paying dividends, making distributions, and otherwise transferring assets to Publishing.
On November 22, 2005, Houghton Mifflin entered into the Second Amendment to the Credit and Guaranty Agreement, which decreased the aggregate amount available for borrowings under the senior secured revolving credit facility (the “Revolver”) to $250 million from $325 million and amended certain financial covenants. The Revolver, for which Houghton Mifflin pays annual commitment fees, expires on December 30, 2008. The Revolver requires Houghton Mifflin to maintain certain interest coverage, leverage, and senior leverage ratios, as defined under the terms of the facility. As of December 31, 2005, Houghton Mifflin had no borrowings under the Revolver and, subject to certain covenants and borrowing base capacity limitations for outstanding letters of credit, had $225.3 million available to borrow.
The Revolver includes various financial covenants such as certain leverage and coverage ratios. The ratios are calculated quarterly using EBITDA, which is defined as earnings before interest, taxes, depreciation and amortization, and other adjustments allowed under the terms of the agreement, on a rolling twelve months basis. It also contains customary covenants, including limitations on Houghton Mifflin’s ability to incur debt, and events of default as defined by the agreement. The Revolver also limits Houghton Mifflin’s ability to pay dividends, to make advances, and otherwise engage in intercompany transactions. The primary covenants under the Revolver are the total leverage ratio, senior leverage ratio, interest coverage ratio, and consolidated capital investments. For 2006, the Revolver requires the total leverage ratio to be no greater than 4.5:1; the senior leverage ratio to be no greater than 3.25:1; the interest coverage ratio to be not less than 2.5:1 and that consolidated capital investments not exceed $190.0 million.
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
On February 13, 2003, Houghton Mifflin repurchased substantially all of its $125.0 million of 7.0% notes due March 1, 2006. The premiums paid and consent fees for this purchase was $12.5 million. A charge of $16.4 million on this repurchase was recognized in 2003.
On January 30, 2003, Houghton Mifflin issued $600.0 million of 8.25% senior notes that mature on February 1, 2011 (the “Senior Notes”). The Senior Notes are general unsecured obligations of Houghton Mifflin effectively subordinated to secured obligations of Houghton Mifflin to the extent of the value of the assets securing such obligations ranking equally in right of payment to all existing unsecured obligations of Houghton Mifflin. On January 30, 2003 Houghton Mifflin also issued $400.0 million of 9.875% senior subordinated notes that mature on February 1, 2013 (the “Senior Subordinated Notes”). The Senior Subordinated Notes are general unsecured obligations of Houghton Mifflin, subordinated in right of payment to all existing senior debt of Houghton Mifflin. The Senior Subordinated Notes were priced at 99.22% of principal amount to yield an effective interest rate of 10.0%. The net proceeds from these notes were $974.6 million after deducting original issue discounts on Senior Subordinated Notes and estimated fees and expenses related to this offering. The net proceeds from these two notes were used to repay the then existing $125.0 million 7.0% notes due March 1, 2006, the $500.0 million senior subordinated bridge loan, and the $275.0 million Term Loan B (as defined below) plus accrued interest. The then existing Senior Secured Credit Facility, comprised of a $325.0 million revolving credit agreement and a $400 million Term Loan B agreement was terminated and Houghton Mifflin entered into the aforementioned Revolver. As a result of this refinancing, a charge of $30.0 million was recognized in 2003 for the deferred financing fees related to these debt instruments.
The Senior Notes and Senior Subordinated Notes include various financial and customary covenants that limit Houghton Mifflin’s ability to pay dividends, make investments or sell assets, and dispose of substantially all its assets by sale or merger. Some covenants include the calculation of EBITDA, defined as earnings before interest, taxes, depreciation, and amortization, and other adjustments under the indenture. These covenants are tied to the calculation of a fixed charge coverage ratio based on EBITDA, including Houghton Mifflin’s ability to incur additional debt or make restricted payments subject to qualifications and limitations as defined in the indenture. The fixed charge coverage ratio is required to be at least 2.0:1. Other covenants restrict Houghton Mifflin’s ability to enter into certain transactions with affiliates.
As of and for the year ended December 31, 2005, Houghton Mifflin was in compliance with the covenants for both the Revolver and the Senior and Senior Subordinated Notes, respectively.
On January 3, 2003, Houghton Mifflin purchased $99.2 million of its $100.0 million 7.125% notes due April 1, 2004 through a tender offer. Houghton Mifflin borrowed $100.0 million under its then existing Term Loan B agreement to finance this purchase. This borrowing was repaid on January 30, 2003. Consent fees for this repurchase totaled $2.0 million and a charge for this amount was recognized in 2003.
On December 30, 2002, Houghton Mifflin entered into a $725.0 million Senior Secured Credit Facility with several banks, including a revolving credit agreement and a term loan agreement (“Term Loan B”) for which Houghton Mifflin incurred fees of $32.4 million. Houghton Mifflin borrowed $175.0 million under the Term Loan B agreement at December 31, 2002. These agreements were amended on March 5, 2003, canceling the Term Loan B and Houghton Mifflin entered into the Amended and Restated Credit and Guaranty Agreement governing the Revolver.
On December 30, 2002, Houghton Mifflin entered into a $500.0 million Senior Subordinated Bridge Loan Agreement with several banks for which Houghton Mifflin incurred fees of $22.3 million. This loan was repaid on January 30, 2003.
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
On March 19, 2001, Houghton Mifflin issued $150.0 million of 10-year 7.2% notes through a public offering. The notes mature on March 15, 2011 and were priced at 99.847% to yield an effective annual interest rate of 7.22%. The notes are secured obligations, ranking equally with all of the other unsecured and unsubordinated indebtedness of Houghton Mifflin.
(9) Financial Instruments
During December 2003, Houghton Mifflin entered into interest rate swap agreements in conjunction with a notional $200.0 million of its Senior Notes. The interest rate swap agreements converted $200.0 million of Houghton Mifflin’s debt from a fixed rate to a floating rate. Changes in the fair value of these swaps are recorded as interest income or expense in the consolidated statement of operations on a monthly basis. During 2004, $1.8 million was recorded as interest income for the net change in fair value of these agreements. In 2004, Houghton Mifflin terminated portions of these swap agreements during periods of favorable interest rate movement, receiving $3.5 million at settlement on swaps with total recorded fair values of $2.1 million, resulting in $1.4 million of interest income in conjunction with these settlements. Total swap activity for 2004 yielded interest income of $3.2 million that was recorded in the results of operations. In February 2005, Houghton Mifflin terminated the remaining swap agreements and paid $1.8 million, of which $0.2 million was recorded as interest expense. The recorded fair value of the swaps at settlement was $1.6 million.
(10) Income Taxes
Total income taxes for the years ended December 31, 2005, 2004, and 2003 are as follows:
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Significant components of the benefit for income taxes attributable to loss from continuing operations before taxes consist of the following:
The reconciliation of the income tax rate computed at the U.S. federal statutory tax rate to the reported income tax benefit attributable to continuing operations before taxes is as follows:
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
The significant components of the net deferred tax assets and liabilities are shown in the following table:
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HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
The net deferred tax asset balance is stated at prevailing statutory income tax rates. Deferred tax assets and liabilities are reflected on the Company’s consolidated balance sheet at December 31, 2005 and 2004 as follows:
As of December 31, 2005, the Company had consolidated net operating loss carryforwards for federal, state, local and foreign jurisdictions of $57.7 million, which expire in various years from 2006 through 2025. The utilization of net operating loss carryforwards may be limited in the event of a change in ownership as defined by the Internal Revenue Code Section 382.
Publishing’s deferred tax assets at December 31, 2005 and 2004, were reduced by a valuation allowance of $26.9 million and $13.8 million, respectively. Houghton Mifflin’s deferred tax assets at December 31, 2005 and 2004, were reduced by a valuation allowance of $23.7 million and $12.2 million, respectively. The 2004 amounts principally related to state tax benefits of net operating losses that are not expected to be realized. The increase in 2005 for both Publishing and Houghton Mifflin relates primarily to an additional $10.4 million valuation allowance recorded against deferred tax assets relating to future postretirement benefit obligations.
Tax Indemnification:
Pursuant to the Acquisition, Vivendi agreed to indemnify Holdings for all income taxes of Houghton Mifflin and its subsidiaries due with respect to tax periods, or any portion of a tax period, ending on or before September 30, 2002.
(11) Retirement and Postretirement Benefit Plans
Retirement Plan
Houghton Mifflin has a noncontributory, qualified defined benefit pension plan (the “Retirement Plan”), which covers substantially all employees. The Retirement Plan is a cash balance plan, which accrues benefits based on pay, length of service, and interest. The funding policy is to contribute amounts subject to minimum funding standards set forth by the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code. The Retirement Plan’s assets consist principally of common stocks, fixed income securities, investments in registered investment companies, and cash and cash equivalents. Houghton Mifflin also has a nonqualified defined benefit plan, or nonqualified plan, that covers employees who earn over the qualified pay limit as determined by the Internal Revenue Service. The nonqualified plan accrues benefits for the executive officers based on service and pay. Benefits for all other employees accrue based on the cash balance plan calculation. The nonqualified plan is not funded. The Company uses a September 30 date to measure the accrued pension and postretirement liabilities.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Kingfisher has a contributory, defined benefit pension plan, The Grisewood and Dempsey Pension Scheme, which has been approved by the Inland Revenue (the “Kingfisher Pension Plan”). All permanent employees between ages 21 and 64 are eligible to join the plan. The assets of the plan are held in a trust fund and invested in stocks and fixed income securities of the UK and other countries. Kingfisher’s Pension Plan is included in the accompanying table for all years presented. Kingfisher’s Pension Plan had benefit obligations of $11.7 million, $11.4 million, and $9.1 million, plan assets of $6.6 million, $6.1 million, and $4.8 million, and accrued pension benefit liability of $4.0 million, $4.2 million, and $3.8 million, respectively, as of December 31, 2005, 2004, and 2003.
The following table summarizes the Accumulated Benefit Obligations (“ABO”), the change in Projected Benefit Obligation (“PBO”), and the funded status of Houghton Mifflin’s plans as of and for the financial statement periods presented:
HM PUBLISHING CORP. AND
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Weighted average assumptions used to determine the benefit obligations (both PBO and ABO) at year-end are:
Net periodic pension cost for the twelve months ended December 31, 2005, 2004, and 2003 include the following components:
Significant actuarial assumptions used to determine net periodic pension cost are:
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HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Assumptions on Expected Long-Term Rate of Return as Investment Strategies:
Houghton Mifflin employs a building block approach in determining the long-term rate of return for plan assets. Historical markets are studied and long-term relationships between equities and fixed income are preserved congruent with the widely accepted capital market principle that assets with higher volatility generate a greater return over the long run. Current market factors such as inflation and interest rates are evaluated before long-term capital market assumptions are determined. The long-term portfolio return is established via a building block approach and proper consideration of diversification and rebalancing. Peer data and historical returns are reviewed for reasonability and appropriateness. Houghton Mifflin regularly reviews the actual asset allocation and periodically rebalances investments to a targeted allocation when appropriate. The current targeted asset allocation is 60% with equity managers and 40% with fixed income managers. For 2006, Houghton Mifflin will continue to use an 8.0% long-term rate of return for the Retirement Plan and a 7.0% long-term rate of return for the Kingfisher Pension Plan. Houghton Mifflin will continue to evaluate the expected rate of return assumption, at least annually, and will adjust as necessary.
Plan Assets:
Plan assets for the U.S. and U.K. tax qualified plans consist of a diversified portfolio of fixed income securities, equity securities, real estate, and cash equivalents. Plan assets do not include any Houghton Mifflin securities. The U.K. plan assets are included in the asset information table.
Investment Policy and Investment Targets:
The tax qualified plans consist of the U.S. pension plan and the U.K. pension scheme. It is Houghton Mifflin’s practice to fund amounts for its qualified pension plans at least sufficient to meet minimum requirements of local benefit and tax laws. The nonqualified noncontributory defined benefit pension plan is generally not funded. Assets were invested amongst several asset classes.
The percentage of assets invested in each asset class is shown below.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Estimated Future Benefit Payments:
The following benefit payments, which reflect expected future service, are expected to be paid.
Expected Contributions:
Houghton Mifflin expects to contribute $20.0 million to its pension plans in 2006. However, the actual funding decision will be made after the 2006 actuarial valuation is completed.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Postretirement Benefit Plan
Houghton Mifflin also provides postretirement medical benefits to retired full-time, non-union employees hired before April 1, 1992, who have provided a minimum of five years of service and attained age 55.
The following table summarizes the Accumulated Postretirement Benefit Obligation (“APBO”), the changes in plan assets, and the funded status of Houghton Mifflin’s plan as of and for the financial statement periods presented.
Significant actuarial assumptions used to determine APBO at year-end were:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Net periodic postretirement benefit cost included the following components for the twelve months ended December 31, 2005, 2004, and 2003:
Significant actuarial assumptions used to determine postretirement benefit cost are:
Assumed health care trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects on the expense recorded in 2005 for the postretirement medical plan:
Estimated Future Benefit Payments:
The following benefit payments, which reflect expected future service, are expected to be paid:
Expected Contribution:
Houghton Mifflin expects to contribute $3.0 million to its postretirement plan in 2006.
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Medicare Reform Information for the Retiree Welfare Plan:
The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “Act”) was reflected in the second quarter of 2004 and assumes that Houghton Mifflin will continue to provide a prescription drug benefit for participants who retired prior to January 1, 1993 that is at least actuarially equivalent to Medicare Part D and that Houghton Mifflin will receive the federal subsidy. The prescription drug benefit for all other retirees is assumed to not meet the actuarial equivalence test and therefore no subsidy savings is reflected.
As a result of reflecting the effects of the Act, the liabilities were remeasured at the beginning of the third quarter of 2004. The APBO increased by $0.6 million from $54.4 million to $55.0 million due to the remeasurement of the Plan’s liability midway through the measurement year. The APBO decreased by $1.8 million from $55.0 million to $53.2 million due to the effect of the Act. The remeasurement and the Act had immaterial effects on the net periodic postretirement benefit cost.
Defined Contribution Retirement Plan
Houghton Mifflin maintains a defined contribution retirement plan, the Houghton Mifflin 401(k) Savings Plan, which conforms to Section 401(k) of the Internal Revenue Code, and covers substantially all of Houghton Mifflin’s eligible employees. Participants may elect to contribute up to 50.0% of their compensation subject to an annual limit. Houghton Mifflin provides a matching contribution in amounts up to 4.5% of employee compensation. The 401(k) contribution expense amounted to $7.7 million in 2005, $6.7 million in 2004, and $6.4 million in 2003.
(12) Stock-Based Compensation
Years Ended December 31, 2005 and 2004
Stock Option Plan of Holdings:
The Houghton Mifflin Holdings, Inc. 2003 Stock Option Plan (“Option Plan”) was adopted on December 3, 2003 to provide for the grant of options to purchase Holding’s Class A Common Stock. The board of directors of Holdings administers the Option Plan and may, from time to time, grant option awards to directors and employees of the Company and its subsidiaries who, in the opinion of the board, are in a position to make a significant contribution to the success of the Company and its subsidiaries. The board of directors of Holdings may grant options that are time-vested and options that vest based on the attainment of performance goals specified by the board of directors. The number of shares reserved for issuance under the Option Plan is 101,611, subject to adjustment based on any dilution of Holding’s Common Stock. The Option Plan became effective July 1, 2003 and options may be granted under the Option Plan until June 30, 2013.
Participants in the Option Plan have been granted stock options to purchase shares of Holdings Class A Common Stock in three parts, or tranches-Tranche 1, Tranche 2, and Tranche 3. One-third of each participant’s options are in Tranche 1, one-third are in Tranche 2, and one-third are in Tranche 3. Each tranche has its own vesting provisions.
Tranche 1 options vest in equal annual installments over four or five years, based on the terms of the grant. The Tranche 1 options vest ratably and become exercisable on each of the anniversaries of the date of the option grant. The Tranche 2 and Tranche 3 options fully vest and become exercisable on the seventh anniversary of the date they were granted. However, if certain events occur as noted in the Option Plan, the vesting of the Tranche 2 and/or Tranche 3 options will be accelerated so that the Tranche 2 and Tranche 3 options also vest and become exercisable, consistent with Tranche 1, on each of the anniversaries of the Option Plan’s effective date.
HM PUBLISHING CORP. AND
HOUGHTON MIFFLIN COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
The Company uses the Black Scholes option-pricing model to calculate the fair value of stock options on the date of grant with the following assumptions used for grants in 2005 and 2004, respectively:
Stock option activity during 2005 and 2004 is as follows:
The weighted-average fair value of options granted in 2005 and 2004 was $192.65 per share and $36.03 per share, respectively. The weighted average remaining contractual life of options outstanding at December 31, 2005 was 8.2 years.
Deferred Compensation Plan of Holdings:
In January 2003, Holdings established a Deferred Compensation Plan. The Deferred Compensation Plan was offered to certain executives and key employees of Houghton Mifflin, allowing the employees to defer receipt of all or a portion of their retention agreement payments in exchange for an interest in the common stock of Holdings. In January 2003, thirty-four of Houghton Mifflin’s employees elected to participate in the Deferred Compensation Plan and deferred an aggregate $4.6 million of payments due pursuant to their respective retention agreements in exchange for common stock ownership in Holdings. As of December 31, 2005 the deferred compensation liability had a balance of $4.4 million. The deferred compensation liability is included on the consolidated balance sheet of Houghton Mifflin within the “Due to parent” classification.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
(13) Disclosures About Fair Value of Financial Instruments
The following table presents the carrying amounts and estimated fair market values of the Company’s financial instruments at December 31, 2005 and 2004. The fair value of a financial instrument is deemed to be the amount at which the instrument could be exchanged in a current transaction between willing parties.
The fair market values of financial instruments were estimated based on market conditions and perceived risks at December 31, 2005 and 2004 and require varying degrees of management judgment. The factors used to estimate these values may not be valid on any subsequent date. Accordingly, the fair market value of the financial instruments presented may not be indicative of their future values.
(14) Commitments and Contingencies
Operating Lease Obligations:
The Company has operating leases for various real property, office facilities, and warehouse equipment that expire at various dates through 2017. Certain leases contain renewal and escalation clauses for a proportionate share of operating expenses.
The future minimum rental commitments under all noncancelable leases (with initial or remaining lease terms in excess of one year) for real estate and equipment are payable as follows:
Rent expense, net of sublease income, was $27.0 million, $24.4 million, and $26.1 million, in 2005, 2004, and 2003, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Contingencies:
The Company is involved in ordinary and routine litigation and matters incidental to its business. There are no such matters pending that the Company expects to be material in relation to its financial condition, results of operations, or cash flows.
Houghton Mifflin is contingently liable for $32.6 million of performance bonds, surety bonds, and letters of credit, posted as security for its operating activities. An aggregate of $24.7 million of letters of credit existed at December 31, 2005, $18.2 of which backed performance and surety bonds. Under the terms of Houghton Mifflin’s Revolver, outstanding letters of credit are deducted from the unused borrowing capacity under this facility.
The Company routinely enters into standard indemnification provisions as part of license agreements involving use of its intellectual property. These provisions typically require the Company to indemnify and hold harmless licensees in connection with any infringement claim by a third party relating to the intellectual property covered by the license agreement. The Assessment Division routinely enters into contracts with customers that contain provisions requiring the Company to indemnify the customer against a broad array of potential liabilities resulting from any breach of the contract or the invalidity of the test. Although the term of these provisions and the maximum potential amounts of future payments the Company could be required to make is not limited, the Company has never incurred any costs to defend or settle claims related to these types of indemnification provisions. The Company therefore believes the estimated fair value of these provisions is minimal, and has no liabilities recorded for them as of December 31, 2005.
(15) Contributed Capital and Related Party Transactions
The Sponsors:
Houghton Mifflin entered into a management services agreement with THL, Bain Capital, and Blackstone on December 30, 2002. Under the terms of the agreement, the Sponsors provided Houghton Mifflin the following services: (i) advice in connection with the negotiation of agreements, contracts, documents, and instruments necessary to provide Houghton Mifflin with financing from banks on terms and conditions satisfactory to Houghton Mifflin; and (ii) financial, managerial, and operational advice in connection with its day-to-day operations, including, without limitation, advice with respect to the development and implementation of strategies for improving the operating, marketing, and financial performance of Houghton Mifflin. Houghton Mifflin has agreed to pay the Sponsors a management fee in an aggregate amount not to exceed $5.0 million, plus out of pocket expenses, annually, payable quarterly in advance, in exchange for these services. The terms of this arrangement shall continue, unless terminated by agreement of two of the three Sponsors. If terminated, Houghton Mifflin is obligated to pay all unpaid fees through the date of termination plus the net present value of all annual fees that would be due through December 31, 2012. The net present value of this contingent liability at December 31, 2005 is estimated to be $18.4 million.
(16) Segment Information
The Company’s geographic area of operation is predominantly the United States. Export or foreign sales to locations outside the United States are not significant to the Company’s business segments. No single customer accounts for more than 10% of consolidated net sales. The Company’s largest single customer is Barnes & Noble, which purchases both College and Trade and Reference products and accounted for 11% of accounts receivable as of December 31, 2005. Although the loss of a single customer, including Barnes & Noble, or a few
HM PUBLISHING CORP. AND
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
customers would not have a material adverse effect on the Company’s business, schedules of school adoptions and market acceptance of the Company’s products can materially affect year-to-year revenue performance. The Company evaluates the performance of its operating segments based on the profit and loss from operations before interest income and expense, income taxes, and nonrecurring and extraordinary items. The significant accounting policies of the reportable segments are the same as those for the Company.
The Company has seven operating divisions with separate management teams and infrastructures that offer various products and services. These divisions have been aggregated into three reportable segments based on similar economic characteristics, products and services, production process, class of customers, and distribution method, as follows:
K-12 Publishing:
This segment consists of four divisions: School Division, McDougal Littell, Great Source Education Group (which includes CCI), and the Assessment Division (which includes Riverside and Edusoft). This operating segment includes textbooks, instructional materials and services, tests for measuring achievement and aptitude, clinical and special needs testing products, multimedia instructional programs, and career guidance products and services. The principal markets for these products are elementary and secondary schools.
College Publishing:
The College Division is the sole business unit reported in this segment. This operating segment includes textbooks, ancillary products such as workbooks and study guides, technology-based instructional materials, and services for introductory and upper level courses in the post-secondary education market. Products may be in print or electronic form. The principal markets for these products are two and four year colleges and universities. These products are also sold to high schools for advanced placement courses and to for-profit, certificate-granting institutions that offer skill-based training and job placement.
Trade and Reference Publishing:
This segment consists of the Trade and Reference Division and Kingfisher. Kingfisher management reports functionally to the Trade and Reference Division. This operating segment publishes fiction and nonfiction for adults and children, dictionaries, and other reference works. This segment also licenses book rights to paperback publishers, book clubs, web sites, and other publishers and electronic businesses in the United States and abroad. Its principal markets are retail stores, including Internet bookstore sites and wholesalers. It also sells reference materials to schools, colleges, libraries, office supply distributors, and businesses.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Other:
This consists of unallocated corporate related items. In January 2006, the Company sold the Promissor business, which had historically been included in Other. The consolidated financial information reported below has been adjusted to remove the results of Promissor from Other for all periods presented. In 2005, the Company also changed its method of allocating certain corporate expenses. The financial information reported below reflects the impact of these changes on all years presented.
The reconciliation of segment operating income to consolidated statements of operations is as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Tabular data in thousands, except per share data)
Summarized financial information concerning the Company’s reportable segments is shown in the following tables, except as disclosed below. The “Other” column includes unallocated corporate-related items and non-recurring items. In 2005, the Company changed its method of allocating certain corporate expenses. The financial information reported in the following tables reflects the impact of these changes on all years presented.
Deferred issuance costs in 2005 and 2004 of $4.9 million and $5.4 million and a deferred tax asset valuation allowance of $0.4 million in both years resulted in total assets from continuing operations of $2,247.6 million and $2,291.4 million for Publishing as of December 31, 2005 and 2004, respectively. Except as noted, all remaining reportable segment information relates to both Houghton Mifflin and Publishing.
HM PUBLISHING CORP. AND
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Financial Statement Schedules
(Tabular data in thousands, except per share data)
SUMMARY OF OPERATIONS BY QUARTER (UNAUDITED)
The above quarterly information reflects the seasonal fluctuations of the Company’s educational publishing business.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
Not applicable.
Item 9A.
Item 9A. Controls and Procedures
The Company’s Chief Executive Officer and Chief Financial Officer, with the participation of other members of management, conducted an evaluation of the effectiveness of the design and operation of the disclosure controls and procedures pursuant to Rules 13a-15(b) and 15d - 15(b) under the Securities and Exchange Act of 1934. Based upon the evaluation and because of the material weakness described below, such officers concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were not effective to provide reasonable assurance that information required to be disclosed in the reports it files or submits under such Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. Notwithstanding the material weakness discussed below, the Company’s management has concluded that the financial statements included in this Form 10-K fairly present in all material respects the Company’s financial position, results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles.
Effective as of December 31, 2007, Section 404 of the Sarbanes-Oxley Act of 2002 and rules and regulations of the SEC thereunder requires the Company to, among other things, annually assess and report on the effectiveness of its internal controls over financial reporting, and evaluate and disclose changes in its internal controls over financial reporting quarterly. The Company is currently performing the system and process evaluation and testing required (and any necessary remediation) in an effort to prepare for compliance with the management certification and auditor attestation requirements of Section 404.
In connection with the financial statement audit, the Company’s independent registered accounting firm advised the Company that the control deficiency described below constitutes a material weakness in its internal controls. A material weakness, as defined by the Public Company Accounting Oversight Board, is a control deficiency that by itself, or in combination with other control deficiencies, results in more than a remote likelihood that a material misstatement of the annual or interim financial statements could result that would not be prevented or detected.
The Company cannot reconcile its royalty accrual balance to an underlying trial balance. Although the Company has existing controls over payments to authors, the input of data into the royalty system, and the posting of entries from the royalty system to the general ledger, the reconciliation of the balance sheet accrual is considered an important control. This control deficiency did not result in a restatement or adjustment of the Company’s interim or annual consolidated financial statements, but it represents a material weakness. The Company is currently reviewing its royalty system and royalty processes to determine appropriate remedial measures to address the general ledger reconciliation matter.
Except as otherwise discussed herein, there have been no changes in the Company’s internal control over financial reporting during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrants
The current directors and executive officers of Publishing and Houghton Mifflin are as follows:
The following information provides a brief description of the business experience of each executive officer and director during the past five years.
Anthony Lucki has served as President, Chief Executive Officer, and a Director of Houghton Mifflin and Publishing since October 2003. In addition, he had been acting President, School and Supplemental Division of Houghton Mifflin from January 2004 through March 2005. He also currently serves as Chairman of the Association of American Publishers. From July 2001 through August 2003, he served as President and Chief Executive Officer of Harcourt, Inc., a division of Reed Elsevier plc. From November 1999 through August 2003, he served as President and Chief Executive Officer of Harcourt Education, a division of Harcourt General prior to the acquisition by Reed Elsevier. Previously he served as President and Chief Executive Officer of Harcourt School Publishers since November 1997.
Stephen Richards has served as Executive Vice President, Chief Operating Officer, and Chief Financial Officer of Houghton Mifflin and Publishing since April 2004. From 1998 until 2002, he had been Senior Vice President and Chief Financial Officer of Harcourt Education, a division of Harcourt General prior to the
acquisition by Reed Elsevier. In 2003, he also served as Global Chief Financial Officer for Harcourt Education. He had been Vice President and Controller at Harcourt Education from 1993 through 1998. Previously, he was a partner at Deloitte & Touche.
Lee Jones has served as President, The Riverside Publishing Company, since October, 2004, when he joined Houghton Mifflin. From 2001 to 2004, he had been Vice President of K-12 Development and Operations at The College Board, which he had joined in 1999 as Executive Director of the AP program.
Theresa Kelly has served as Houghton Mifflin’s President, Trade and Reference Division, since September 2004, and as Senior Vice President, Trade and Reference Division, since July 2002. From 1982 to 2002, she served in other capacities within the Trade and Reference Division, including Director of Special Sales and Marketing, Vice President and Director of Markets, and Corporate Vice President, Director of Sales.
Donna Lucki has served as Houghton Mifflin’s President, School Division, since April 2005, and as Senior Vice President and Publisher of the School Division from October 2003 to March 2005. From 2000-2003, she was Senior Vice President, Publisher at Harcourt School Division, a division of Harcourt Education.
Rita Schaefer has served as Houghton Mifflin’s President, McDougal Littell Division, since September 2004 and as Executive Vice President and head of McDougal Littell since 2001. From 1994 to 2000 she served in other capacities within the division, including Vice President, National Sales Manager and Senior Vice President, McDougal Littell.
June Smith has served as Houghton Mifflin’s President, College Division, since September 2004 and as Houghton Mifflin’s Executive Vice President, College Division since 1994.
Steve Zukowski has served as Houghton Mifflin’s President, Great Source Education Group Division since September 2004, while continuing as Chief Operating Officer, School and Supplemental Division, a position he has held since 2003. From 1990 to 2003, he served in other capacities within Houghton Mifflin, including School Division Vice President, Publishing Operations and Vice President, Inventory Management and Business Information Systems; Vice President, Finance and Operations, and President of Sunburst Technology Corporation, which was then a subsidiary of Houghton Mifflin.
Maureen DiMarco has served as Houghton Mifflin’s Senior Vice President, Educational and Governmental Affairs, since early 2002. From 1996 to 2002 she served in other capacities within Houghton Mifflin, including Vice President, Educational and Governmental Affairs, of Riverside, and Corporate Vice President, Educational and Governmental Affairs.
Gerald Hughes has served as Senior Vice President, Human Resources, of Houghton Mifflin since August 2002, when he joined the Company, and as Publishing’s Senior Vice President, Human Resources, since December 2003. From 1988 to 2001 he worked at Harcourt General, Inc. as Labor Counsel, as Vice President and Chief Counsel at Drake Beam Morin, Inc., a subsidiary of Harcourt General, and Vice President, Human Resources, at Harcourt General and The Neiman Marcus Group.
Patrick Meehan has served as Senior Vice President and Chief Information Officer of Houghton Mifflin since May 2004. He was Senior Vice President and President of Promissor from 2003 to 2004. From 1999 to 2002 he served in other capacities within Houghton Mifflin, including Vice President and Chief Operating Officer of Computer Adaptive Technologies and Senior Vice President and President of CAT*ASI (the predecessor of Promissor).
Paul Weaver has served as Senior Vice President and General Counsel of Publishing since September 2003 and of Houghton Mifflin since 1989.
Susan Rao has been Houghton Mifflin’s Vice President, Finance, and Controller, since June 2004, having served as Vice President, Financial Systems, since March of that year. From 2002 to 2004, she had been Vice President, Controller, at Imagitas, Inc., and from 1998 to 2001, Director of Corporate Accounting at Harcourt General. Previously, she was a Senior Manager at Deloitte & Touche.
Clarence Thacker has served as Houghton Mifflin’s Vice President, Manufacturing and Corporate Fulfillment Services, since September 2004. From 2001 to 2004, he had been Vice President, Manufacturing, Operations, and Supply at Harcourt, Inc.
Charles Brizius has been a director of Houghton Mifflin since December 2002. He is a Managing Director at Thomas H. Lee Partners, L.P. Mr. Brizius worked at Thomas H. Lee Company from 1993 to 1995, rejoining in 1997. He is also a director of Warner Music Group, Spectrum Brands, Inc., Front Line Management Companies, Inc. and Ariel Holdings Ltd.
Robert Friedman has been a director of Houghton Mifflin since December 2002. He has served as a Senior Managing Director of The Blackstone Group L.P. since February 1999 and as Chief Administrative Officer and Chief Legal Officer since February 2003. From 1974 until the time he joined Blackstone, Mr. Friedman was a partner with Simpson Thacher & Bartlett LLP, a New York law firm. He also serves on the board of directors of Axis Capital Holdings Limited, Northwest Airlines, Inc., and TRW Automotive Holdings Corp.
Steve Gandy has been a director of Houghton Mifflin since January 2004. He served as President and Chief Executive Officer of Harcourt School Publishers, a subsidiary of Harcourt General, from September 2000 until December 2023, and as Executive Vice President from 1990 until 2000.
Jonathan Goodman has been a director of Houghton Mifflin since December 2002. He is a Principal of Bain Capital Partners, LLC. Mr. Goodman joined Bain Capital in 1995.
Seth Lawry has been a director of Houghton Mifflin since December 2002. He is a Managing Director at Thomas H. Lee Partners, L.P. Mr. Lawry worked at Thomas H. Lee Company from 1989 to 1990, rejoining in 1994. Mr. Lawry serves as a director of ProSiebenSat.1 Media AG, Warner Music Group and Fidelity National Information Services, Inc.
James Levy has been a director of Houghton Mifflin since August 2003. Mr. Levy held the position of Executive Vice Chairman for Riverdeep Group PLC from July 2001 to February 2003 and served on Riverdeep’s board of directors from February 2001 to 2003. Since 1992, Mr. Levy had been at Harcourt, where, after serving simultaneously as president of two of Harcourt’s three operating groups, the Education Group and the Lifelong Learning & Assessment Group, Mr. Levy became President and Chief Operating Officer of Harcourt, Inc., a domestic and international publisher and specialty retailer. He also served as Vice President of Harcourt General, the parent company.
Mark Nunnelly has been a director of Houghton Mifflin since December 2002. He joined Bain Capital Partners, LLC in 1990 as a Managing Director. He serves as a director of Domino’s Pizza, Eschelon Telecom, Warner Music, and UGS, among others.
Michael Perik has been a director of Houghton Mifflin since June 2003. Since 2002 he has served as the Chairman and Chief Executive Officer of Achievement Technologies, Inc., a company that develops software solutions aimed at improving student achievement and performance. From 1999 to 2002 Mr. Perik served on the board of directors of Achievement Technologies. For the six years prior to that he was the Chairman and Chief Executive Officer of The Learning Company, Inc.
James Quella has been a director since April 2005. Since 2004, he has served as a Senior Managing Director and Senior Operating Partner in the Private Equity Group of The Blackstone Group L.P., where he is also a member of the firm’s Private Equity Investment Committee. Prior to joining Blackstone in 2004, Mr. Quella was a Managing Director and Senior Operating Partner with DLJ Merchant Banking Partners-CSFB Private Equity. He serves as a director of Allied Waste Industries, Inc., Celanese Corporation, Graham Packaging Holding Company, and several private companies.
Scott Sperling has been a director of Houghton Mifflin since December 2002. He is Co-President of Thomas H. Lee Partners, L.P. and Trustee and General Partner of various THL Equity Funds. Mr. Sperling is also President of THLee Putnam Capital, a joint venture with Putnam Investments, one of the largest global investment management firms. Mr. Sperling is currently a Director of Fisher Scientific International, Inc., Vertis, Inc., Wyndham International, Warner Music Group, ProSiebenSat.1 Media AG and several private companies. Prior to joining Thomas H. Lee Partners, Mr. Sperling was, for over ten years, Managing Partner of The Aeneas Group, Inc., the private capital affiliate of Harvard Management Company. Before that he was a senior consultant with the Boston Consulting Group.
Michael Ward has been a director of Houghton Mifflin since August 2003. Mr. Ward is a Managing Director of Bain Capital Partners, LLC. He joined Bain Capital in 2003. For five years prior to joining Bain Capital, Mr. Ward held a variety of senior positions at Digitas, Inc., including President and Chief Operating Officer. He serves as a director of El Dorado Marketing, Inc.
Donna A. Lucki, President, School Division, Houghton Mifflin, is married to Anthony Lucki, President, Chief Executive Officer, and Director of Publishing and Houghton Mifflin.
The Board of Directors has established an audit committee comprised of Michael Ward, chairman, and Charles Brizius. The Board has determined that Mr. Ward is an audit committee financial expert, as that term is used in the regulations promulgated under the Securities Exchange Act of 1934. Due to his affiliation with Bain Capital, Mr. Ward is not an independent director, as that term is defined in those regulations.
The Company has adopted a code of ethics that applies to those officers responsible for financial reporting as part of its company-wide code of conduct. The code of conduct, including the section entitled “Financial Reporting: Special Ethical Obligations for Employees with Financial Reporting Responsibility,” is available on the Company’s internet site at www.hmco.com. Any amendments to this portion of the code, or any waivers of its requirements, will be disclosed on the Company’s website.
Item 11.
Item 11. Executive Compensation
Compensation
The following table summarizes the compensation paid to the President and Chief Executive Officer and the four other most highly compensated executive officers during the last three years.
Summary Compensation Table
* Excludes perquisites and other personal benefits that do not exceed the lesser of $50,000 or 10% of total annual salary and bonus.
(1) Includes a signing bonus of $554,167 paid to Mr. Lucki in 2003; and a special bonus of $129,934 paid to each of Ms. Schaefer and Ms. Smith in 2004.
(2) These amounts are Houghton Mifflin’s matching contributions under the 401(k) Savings Plan, contributions under the Supplemental Savings Program part of the Supplemental Benefits Plan, and premiums paid for employee-owned whole life insurance policies. Under the Supplemental Savings Program, we provide benefits substantially equal to benefits that could not be provided under the 401(k) Savings Plan because of limitations under the Internal Revenue Code of 1986, as amended. The table below shows the amounts we paid for each of these categories during 2005 for the officers listed in the table.
In addition, the following payments were made in 2004 pursuant to retention agreements: $699,950 to Ms. Schaefer and $710,130 to Ms. Smith.
The amounts shown for 2003 also included the payment to Ms. Schaefer of $699,950 pursuant to a retention agreement and $114,851 pursuant to the Houghton Mifflin Holdings, Inc., Deferred Compensation Plan; the payment to Ms. Smith of $710,130 pursuant to a retention agreement and $117,203 pursuant to the Houghton Mifflin Holdings, Inc., Deferred Compensation Plan; and the payment of $39,000 to Mr. Lucki in consulting fees prior to becoming an executive officer.
(3) Mr. Lucki became an executive officer on October 1, 2003.
(4) Represents reimbursement of tax payments for life insurance; does not include perquisites and other personal benefits that do not exceed the lesser of $50,000 or 10% of total annual salary and bonus.
(5) Mr. Richards became an executive officer on April 1, 2004.
(6) Ms. Lucki became an executive officer on April 6, 2005.
2003 Stock Option Plan
The Houghton Mifflin Holdings, Inc. 2003 Stock Option Plan was adopted on December 3, 2003 to provide for the grant of options to purchase Holdings’ Class A Common Stock. The Board of Directors of Holdings administers the plan and may, from time to time, grant option awards to directors and employees of Houghton Mifflin and its subsidiaries who, in the opinion of the board, are in a position to make a significant contribution to the success of Houghton Mifflin and its subsidiaries. The Board of Directors of Holdings may grant options that are vested over time and options that vest based on the attainment of performance goals specified by the Board of Directors.
The following table shows stock option grants in 2005 to the officers named in the Summary Compensation Table. The amounts shown as potentially realizable values are based on the assumed appreciation rates required by the SEC, but the real value of these options will depend entirely on the actual future share price.
Option Grants in Last Fiscal Year
The options were granted in three parts, or tranches-Tranche 1, Tranche 2, and Tranche 3. One-third of each participant’s options are in Tranche 1, one-third are in Tranche 2, and one-third are in Tranche 3. Each tranche has its own vesting provisions.
Tranche 1 options vest in equal annual installments over four or five years based on the terms of the grant. The Tranche 1 options vest ratably and become exercisable on each of the anniversaries of the date of the option grant.
The Tranche 2 and Tranche 3 options fully vest and become exercisable on the seventh anniversary of the date they were granted. However, if certain events occur as noted in the option plan, the vesting of the Tranche 2 and/or Tranche 3 options will be accelerated so that the Tranche 2 and Tranche 3 options also vest and become exercisable, consistent with Tranche 1, on each of the anniversaries of the date of the option grant.
Retirement Plan
Houghton Mifflin maintains a tax-qualified, defined benefit Retirement Plan, and establishes an account for each eligible employee. Every year, each employee’s account is credited with an amount that varies depending on the employee’s length of service and earnings, and with interest on the accumulated balance. For calculating the contribution to the Retirement Plan, compensation consists primarily of salary, wages, commissions, and annual incentive compensation. When an employee leaves Houghton Mifflin, he or she has the option to:
•
convert this account to an annuity benefit,
•
leave the account in the Retirement Plan where it will continue to earn interest, or
•
take the account balance as a lump sum payment.
An employee who leaves with fewer than five years of service receives no benefit under the Retirement Plan.
The Internal Revenue Code limits the annual amount of compensation that can be taken into consideration for determining benefits and the annual benefit accruals under a tax-qualified retirement plan. As permitted by the Internal Revenue Code, Houghton Mifflin maintains a Supplemental Executive Retirement Plan that provides retirement benefits in excess of these limits. These supplemental benefits for the officers named in the Summary Compensation Table and nine other executive officers are calculated based on a formula that uses a multiple of the employee’s years of service and average annual earnings for the three highest-paid consecutive years of service in the last ten years before retirement. The following tables show the range of the estimated annual retirement benefits under the Retirement Plan and the Supplemental Executive Retirement Plan at the normal retirement age of 62 (calculated as of December 31, 2004) to those officers. The benefits shown in the tables reflect a single life annuity benefit calculated based on the average annual compensation for three highest conservative years.
Pension Plan Table
As of December 31, 2005, the years of credited service and the compensation that will be taken into account for pension calculations for 2005 for the officers named in the Summary Compensation Table are: Mr. Lucki, 12 years and $1,713,529; Mr. Richards, 2 years and $803,054; Ms. Lucki, 2 years and $519,000; Ms. Schaefer, 12 years and $635,927; and Ms. Smith, 13 years and $524,568. Differences between the amount of compensation shown above and in the Summary Compensation Table reflect differences in accounting for incentive compensation payments, which are included in the year paid when calculating pension benefits.
Compensation of Directors
Directors who are not employees of the Company or the Sponsors receive an annual retainer of $40,000, payable in cash quarterly during the year of service, for attendance at board meetings. Directors who retire, resign, or are elected during a year will receive an amount prorated based on the portion of the year served as a director. Directors who serve on board committees receive $1,500 for each committee meeting attended, and directors who chair committees receive $2,000 for each committee meeting attended. Directors also receive reimbursement for reasonable out-of-pocket expenses incurred in connection with their attendance at meetings of the Board of Directors and any committee meetings. We pay no additional remuneration to our employees or to executives of the Sponsors for serving as directors.
Employment Contracts, Termination of Employment, and Change-in-Control Agreements
Employment Agreement with Anthony Lucki
Houghton Mifflin entered into an employment agreement with Anthony Lucki on September 17, 2003 under which Mr. Lucki is serving as Houghton Mifflin’s President and Chief Executive Officer. The employment
agreement provides for a three-year term that began on October 1, 2003, but the term is automatically extended for successive one-year terms unless either party gives written notice to the contrary at least 90 days prior to the expiration of the current term. Under the terms of the employment agreement, Mr. Lucki will be paid an annual base salary of at least $600,000, subject to increase from time to time by Board of Directors. Mr. Lucki is also eligible to receive an annual bonus of up to 100% of his base salary. Houghton Mifflin also agreed to pay Mr. Lucki a starting bonus equal to $554,167. In addition, Houghton Mifflin agreed to provide Mr. Lucki with an initial grant of options to purchase 14,088 shares of Class A Common Stock of Holdings, term life insurance coverage equal to $3,000,000, and employee benefits comparable to those provided to other senior executives of Houghton Mifflin.
In the event Houghton Mifflin terminates the employment agreement for any reason other than cause or if Mr. Lucki terminates his employment for good reason, as defined in the agreement, Mr. Lucki will be entitled to severance benefits equal to:
•
18 months of his then-current base salary; and
•
continued contributions by Houghton Mifflin to the cost of his participation in Houghton Mifflin’s medical and dental plans for up to 18 months after termination.
The foregoing amounts will be reduced by any benefits payable to Mr. Lucki under any other severance agreement.
The employment agreement also contains standard provisions relating to confidentiality and assignment of intellectual property rights. In addition, Mr. Lucki agreed that during his employment with Houghton Mifflin and for 12 months after his employment terminates, he will not compete with, or solicit employees or clients of, Houghton Mifflin or any of its affiliates. In connection with his employment agreement, Mr. Lucki would also be nominated for election to the Board of Directors of Houghton Mifflin, and has agreed to serve as director of any other affiliated company if so requested.
Rollover of Retention Payments and Deferred Compensation Plan
Houghton Mifflin had entered into retention agreements (which have now expired by their terms), in lieu of its standard severance policy, with approximately 27 employees who are executives and key employees, including Ms. Schaefer and Ms. Smith. Twenty-one of those executives and key employees, including Ms. Schaefer and Ms. Smith have deferred receipt of their retention bonus payments in exchange for an interest in the 2003 Deferred Compensation Plan that gives such employees an interest in shares of the common stock of Holdings. The aggregate amount of the retention bonus payments that were exchanged for an interest in the common stock of Holdings, held in a “Rabbi Trust,” is approximately $3.4 million. The shares held in trust will be distributed upon a change of control, a qualified public offering, any termination of employment, or upon other tag-along or drag-along sales initiated by the Sponsors. Houghton Mifflin has a right to repurchase shares from such employees following termination of their employment. All of the assets of the trust, namely the common stock of Holdings, would be subject to the claims of creditors in the event of insolvency.
Employment Security Agreements
Houghton Mifflin has entered into employment security agreements with 12 officers, including Mr. Richards, Ms. Lucki, Ms. Schaefer, and Ms. Smith. Under the terms of each agreement, the executive covenants not to compete with the Company during the term of the agreement and for a period of one year after termination. The executive also agrees to customary confidentiality and intellectual property assignment provisions. In consideration, the executive is entitled to receive severance payments on termination of his or her employment. If the agreement is terminated by Houghton Mifflin other than “for cause” or by the executive “for good reason,” Houghton Mifflin will continue to pay the executive’s salary for one year from the date of termination at the higher of the executive’s base salary rate at the time of termination and the date of the
agreement. If the employment is terminated by Houghton Mifflin “for cause” or by the executive other than “for good reason,” no payments will be owed by Houghton Mifflin under the agreement. In the event that Houghton Mifflin undergoes a “change of control” transaction (other than as a result of a public offering) prior to July 1, 2007, and the executive is terminated other than “for cause” within one year of the transaction, the executive is entitled to certain payments in respect of unvested options.
Item. 12 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Securities Authorized for Issuance Under Equity Compensation Plans
The following table contains information about the Houghton Mifflin Holdings, Inc. 2003 Stock Option Plan, as of December 31, 2005. This plan was approved by the shareholders of Holdings.
Equity Compensation Plan Information
Security Ownership
Holdings owns 100% of the capital stock of Publishing, which holds 100% of the capital stock of Houghton Mifflin.
The following table sets forth as of January 31, 2005 the number and percentage of shares of Holdings’ common stock beneficially owned by (i) each person known to beneficially own more than 5% of the outstanding shares of Holdings’ common stock, (ii) each director, (iii) each named executive officer, and (iv) all directors and executive officers as a group.
Notwithstanding the beneficial ownership of common stock presented below, a stockholders’ agreement governs the stockholders’ exercise of their voting rights with respect to certain material events and transactions. In addition, the agreement would govern the stockholders’ exercise of their voting rights with respect to the election of directors after an initial public offering of Holdings. The parties to the stockholders’ agreement have agreed to vote their shares as set forth therein. See “Certain Relationships and Related Transactions.” Except as otherwise indicated in a footnote, each of the beneficial owners listed has, to the Company’s knowledge, sole voting and investment power with respect to the indicated shares of common stock. Unless otherwise indicated, the address for each individual listed below is c/o Houghton Mifflin Company, 222 Berkeley Street, Boston, Massachusetts 02116-3764.
* Indicates less than 1% of Holdings’ common stock.
(1) Includes shares that may be acquired upon exercise of stock options that were exercisable on January 31, 2006, or that will become exercisable within 60 days after January 31, 2006. The following list shows the number of these shares.
(2) Represents the aggregate ownership of the Class A and Class L Common Stock of Holdings.
(3) Includes 189,616 Class A and 21,068 Class L shares of common stock owned by Thomas H. Lee Equity Fund V, L.P.; 49,198 Class A and 5,466 Class L shares of common stock owned by Thomas H. Lee Parallel Fund V, L.P.; 2,613 Class A and 290 Class L shares of common stock owned by Thomas H. Lee Equity (Cayman) Fund V, L.P. (collectively, the “THL Funds”); 1,481 Class A and 165 Class L shares of common stock owned by Putnam Investments Holdings, LLC; 1,273 Class A and 141 Class L shares of common stock owned by Putnam Investments Employees’ Securities Company I LLC; 1,137 Class A and 126 Class L shares of common stock owned by Putnam Investments Employees’ Securities Company II, LLC (collectively, the “Putnam Funds”); 450 Class A and 50 Class L shares of common stock owned by 1997 Thomas H. Lee Nominee Trust (the “Lee Trust”); and 233 Class A and 26 Class L shares of common stock owned by Thomas H. Lee Investors Limited Partnership (“Investors”). The THL Funds general partner is THL Equity Advisors V, LLC, whose sole member is Thomas H. Lee Partners, L.P., whose general partner is Thomas H. Lee Advisors, LLC (collectively, “Advisors”). Shares held by the THL Funds may be deemed to be beneficially owned by Advisors. Advisors disclaim any beneficial ownership of any shares held by the THL Funds. The Putnam Funds, the Lee Trust and Investors are co-investment entities of the THL Funds. Putnam Investment Holdings, LLC, a wholly owned subsidiary of Putnam Investments Trust, is the managing member of Putnam Investments Employees’ Securities I LLC and Putnam Investments Employees’ Securities II LLC and each disclaims beneficial ownership of any shares other than the shares held directly by such entity. U.S. Bank, N.A. (successor to State Street Bank & Trust Company), not personally but solely under a Trust Agreement dated as of August 18, 1997 and known as the Thomas H. Lee Nominee Trust, is the trustee of the Lee Trust and disclaims any beneficial ownership of shares held by the Lee Trust. THL Investment Management Corp. is the general partner of Investors and disclaims beneficial ownership of shares held by Investors. Each of the THL Funds, Advisors, Investors, and the Lee Trust has an address c/o Thomas H. Lee Partners, L.P., 75 State Street, Suite 2600, Boston, Massachusetts 02109. The Putnam Funds have an address c/o Putnam Investment, Inc., 1 Post Office Square, Boston, Massachusetts 02109.
(4) Includes (i) 65,475 Class A shares and 7,275 Class L shares of common stock held by Bain Capital VII Coinvestment Fund, LLC (“Coinvest”), whose sole member is Bain Capital VII Coinvestment Fund, L.P. (“Coinvestment”), whose general partner is Bain Capital Partners VII, L.P. (“Partners VII”), whose general partner is Bain Capital Investors, LLC (“BCI”); (ii) 178,792 Class A shares and 19,446 Class L shares of common stock held by Bain Capital Integral Investors, LLC (“Integral”), whose administrative member is Bain Capital Fund VI, L.P. (“Fund VI”), whose general partner is Bain Capital Partners VI, L.P. (“Partner VI”), whose general partner is BCI; and (iii) 1,732 Class A shares and 612 Class L shares of common stock held by BCIP TCV, LLC (“BCIP”), whose administrative member is BCI. Each of the entities listed in this footnote has an address c/o Bain Capital, LLC, 111 Huntington Avenue, Boston, Massachusetts 02199.
(5) Includes 102,636 Class A shares and 11,404 Class L shares of common stock owned by Blackstone Capital Partners III Merchant Banking Fund L.P., 19,442 Class A shares and 2,160 Class L shares of common stock owned by Blackstone Offshore Capital Partners III L.P. and 923 Class A shares and 103 Class L shares of common stock owned by Blackstone Family Investment Partnership III L.P. (the “Blackstone Funds”) for each of which Blackstone Management Associates III L.L.C. (“BMA”) is the general partner having voting and investment power over the shares held or controlled by each of the Blackstone Funds. Messrs. Peter G. Peterson and Stephen A. Schwarzman are the founding members of BMA and as such may be deemed to share beneficial ownership of the shares held or controlled by the Blackstone Funds. Each of BMA and Messrs. Peterson and Schwarzman disclaims beneficial ownership of such shares. Messrs. Freidman and Quella, directors of Houghton Mifflin, Publishing, and Holdings, are members of Blackstone Management Associates III L.L.C. and disclaim any beneficial ownership of shares beneficially owned by the Blackstone Funds.
(6) Messrs. Lawry, Sperling, and Brizius, directors of Houghton Mifflin, Publishing, and Holdings, are managing directors of Thomas H. Lee Partners, L.P. and disclaim any beneficial ownership of any shares beneficially owned by the Thomas H. Lee Funds. Messrs. Lawry, Sperling, and Brizius have an address c/o Thomas H. Lee Partners, L.P., 75 State Street, Suite 2600, Boston, Massachusetts 02109.
(7) Mr. Nunnelly, a director of Houghton Mifflin, Publishing, and Holdings, is a managing director of Bain Capital, LLC. Amounts disclosed for Mr. Nunnelly are also included above in the amounts disclosed in the table next to “Bain Funds.” Includes (i) 65,475 Class A shares and 7,275 Class L shares of common stock held by Coinvest, whose sole member is Coinvestment, whose general partner is Partners VII, whose general partner is BCI, of which Mr. Nunnelly is a member; (ii) 178,792 Class A shares and 19,446 Class L shares of common stock held by Integral, whose administrative member is Fund VI, whose general partner is Partner VI, whose general partner is BCI, of which Mr. Nunnelly is a member; and (iii) 1,732 Class A shares and 612 Class L shares of common stock held by BCIP, whose administrative member is BCI, of which Mr. Nunnelly is a member. Mr. Nunnelly disclaims beneficial ownership of any such shares in which he does not have a pecuniary interest. Mr. Nunnelly has an address c/o Bain Capital, LLC, 111 Huntington Avenue, Boston, Massachusetts 02199.
(8) Except for shares that may be acquired upon exercise of options (see note 1 above), all shares beneficially owned by Mr. Lucki, Mr. Meehan, Mr. Richards, Ms. Schaefer, and the Company’s other executive officers represent interests in the 2003 Deferred Compensation Plan.
(9) Does not include shares owned by Donna Lucki, as to which Mr. Lucki disclaims beneficial ownership.
(10) Does not include shares owned by Anthony Lucki, as to which Ms. Lucki disclaims beneficial ownership.
(11) Includes the beneficial ownership of shares held by Thomas H. Lee Funds, Bain Funds, and Blackstone Management Associates III L.L.C. by Messrs. Brizius, Friedman, Lawry, Nunnelly, Quella, and Sperling as members or managing directors of Thomas H. Lee Funds, Bain Funds, and Blackstone Management Associates III L.L.C. If beneficial ownership of such shares are not included, all current directors and executive officers as a group would have beneficial ownership of 8,666 shares of Class A Common Stock and 146 shares of Class L Common Stock, which would be less than 1% of Holdings’ common stock.
Item 13.
Item 13. Certain Relationships and Related Transactions
Stockholders Agreement
Houghton Mifflin has entered into a stockholders agreement with Holdings and the Sponsors and members of its management participating in the 2003 Deferred Compensation Plan described in “Executive Compensation-Rollover of Retention Payments and Deferred Compensation Plan.” Future holders of the common stock of Holdings may also be required to become parties to the agreement. The stockholders agreement provides that after the initial public offering of Holdings, the holders of a majority of the shares thereof originally issued to the Sponsors will have the right to determine the size of the Board of Directors of Holdings. In addition, the stockholders agreement provides that in the event that the size of the Board of Directors of Holdings increases by any number of members, THL, and Bain Capital will have the right to elect the same number of
additional members, and Blackstone will have the right to elect a number of directors that is at least 20% of the total number of directors elected by the Sponsors. The stockholders agreement also provides that Houghton Mifflin’s Board of Directors will at all times consist of the same members as the board of Holdings.
The stockholders agreement prohibits the parties thereto from transferring any of their stock except transfers by a natural person to an immediate family member or upon the death of that natural person and, in the case of an investment fund, transfers to other investment funds affiliated with the investment fund and to partners or members of the fund in a pro rata distribution. The agreement also gives the holders of a majority of the shares originally issued to the Sponsors the right to require all other parties to the agreement to sell their stock to a buyer in the event that such majority is selling 80% or more of their stock. The agreement also gives certain parties the right to participate in specified issuances of capital stock.
The stockholders agreement provides that beginning December 31, 2009, or prior to such date with the prior approval of the holders of the majority of shares originally issued to the Sponsors, any holder of shares originally issued to the Sponsors may sell any portion of their shares to any third party. In such event, however, all parties to the agreement have the right to participate in the sale as a seller subject to a pro rata cut-back in which the holder of shares can only sell their pro rata percentage of shares. In addition, the holders of stock originally issued to the Sponsors have a right of first offer to purchase any shares of stock proposed to be sold in any such transaction.
Any right of the holders of stock originally issued to the Sponsors to join in the sale of shares, to participate in any issuance of capital stock or to require other holders to sell shares terminate upon the earlier of a change in control of Houghton Mifflin or a qualified public offering of the shares of Holdings.
Beginning after the initial public offering of Holdings, the stockholders agreement gives the holders of stock originally issued to the Sponsors the right to require Holdings to register the common stock held by such stockholders for sale to the public under the Securities Act of 1933. Such registrations are subject to a potential underwriter’s cut-back in the number of shares to be registered if the underwriter determines that marketing factors require a limitation in the number of shares to be underwritten. The stockholders agreement also gives certain stockholders that are parties to the agreement the right to participate in registered public offerings of Holdings, other than the initial public offering of Houghton Mifflin. The stockholders agreement also requires Holdings, Publishing, and Houghton Mifflin indemnify the parties to the agreement and their affiliates from liability arising from any violation of securities laws by Holdings, Publishing, or Houghton Mifflin for any material misstatements or omissions made by Holdings, Publishing, or Houghton Mifflin in connection with such a public offering.
Management Agreement
Houghton Mifflin has entered into a management agreement with Holdings and the Sponsors. Pursuant to this agreement, Houghton Mifflin paid an aggregate of $50.0 million plus related fees and expenses to the Sponsors in consideration for their services in connection with the Acquisition, and associated financing, refinancing of the Senior Notes, the Senior Subordinated Notes, the 2004 Senior Notes, and the 2006 Senior Notes. In consideration for ongoing consulting and management advisory services, the management agreement requires Houghton Mifflin to pay the Sponsors an aggregate annual fee of $5.0 million per year, which is payable quarterly in advance. In the case of future services provided in connection with any future acquisition, disposition, or financing transactions, the management agreement requires Houghton Mifflin to pay the Sponsors an aggregate fee of one percent of the gross transaction value of such transaction. The agreement also requires Houghton Mifflin and Holdings to pay the reasonable expenses of the Sponsors in connection with, and indemnify them for liabilities arising from, the management agreement, the Acquisition and any related transactions, their equity investment in Holdings, Houghton Mifflin’s operations, and the services they provide to Houghton Mifflin and Holdings. The management agreement terminates on December 30, 2012.
Item 14.
Item 14. Principal Accountant Fees and Services
The Audit Committee of the Board of Directors appointed PricewaterhouseCoopers LLP as the independent accountants to audit the Company’s consolidated financial statements for the fiscal year ending December 31, 2005.
Audit Fees. PricewaterhouseCoopers LLP billed Houghton Mifflin an aggregate of $1.3 million and $1.4 million in fees and expenses for audit services for the years ended December 31, 2005 and 2004, respectively. PricewaterhouseCoopers LLP billed Publishing $0.1 million in fees and expenses for audit services for the year ended December 31, 2004; no amounts were billed for such services for the year ended December 31, 2005. Audit fees include fees and expenses for professional services rendered in connection with the audit of the Company’s financial statements for those years, reviews of the financial statements included in each of the Company’s Quarterly Reports on Form 10-Q during those years and fees for services related to registration statements, consents and assistance with and review of documents filed with the Securities and Exchange Commission.
Audit-Related Fees. PricewaterhouseCoopers LLP billed Houghton Mifflin $0.2 million in fees and expenses for the year ended December 31, 2005. Nominal fees and expenses were paid to PricewaterhouseCoopers LLP in 2004. Audit-related services included due diligence investigations related to the Company’s acquisitions, accounting advice, and assistance with Sarbanes-Oxley Section 404 advisory services.
Tax Fees. PricewaterhouseCoopers LLP billed Houghton Mifflin nominal fees and expenses for tax services in 2005. No such fees were paid in 2004.
All Other Fees. PricewaterhouseCoopers LLP billed Houghton Mifflin nominal fees and expenses during the years ended December 31, 2005 and 2004 for all other services, all of which constituted permitted services.
During 2005, in each case where approval was sought for the provision of non-audit services, the Audit Committee considered whether the independent auditors’ provision of such services to the Company was compatible with maintaining the auditors’ independence, and determined that it was compatible.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) 1. Consolidated Financial Statements are listed in the accompanying Index to Consolidated Financial Statements on page.
2. Financial Statement Schedule for the three years ended December 31, 2005: Schedule II-Consolidated Valuation and Qualifying Accounts is on page 54.
Houghton Mifflin has omitted all other schedules because the required information has been included in the consolidated financial statements or notes or the schedules are not required to be submitted.
3. Houghton Mifflin has filed the Exhibits listed in the accompanying Index to Exhibits on page 61 as part of this Report.
HOUGHTON MIFFLIN COMPANY
SCHEDULE II-CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS
Years ended December 31, 2005, 2004, and 2003
(In thousands of dollars)
(1) Reflects additions (deductions) to the allowance from acquisitions.
(2) Books actually returned during the year.
(3) Write-offs of unearned author advances.
(4) Write-offs of uncollectible customer receivables, net of recoveries.
(5) Inventory physically destroyed during the year.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON
FINANCIAL STATEMENT SCHEDULES
To the Board of Directors and Stockholder
of HM Publishing Corp:
Our audits of the consolidated financial statements referred to in our reports dated March 30, 2006 appearing in this Form 10-K also included an audit of the financial statement schedule listed in Item 15(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
/s/ PricewaterhouseCoopers LLP
Boston, Massachusetts
March 30, 2006
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON
FINANCIAL STATEMENT SCHEDULES
To the Board of Directors and Stockholder
of Houghton Mifflin Company:
Our audits of the consolidated financial statements referred to in our reports dated March 30, 2006 appearing in this Form 10-K also included an audit of the financial statement schedule listed in Item 15(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
/s/ PricewaterhouseCoopers LLP
Boston, Massachusetts
March 30, 2006
SIGNATURES
Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, the Registrants have duly caused this report to be signed on their behalf by the undersigned, thereunto duly authorized.
HM PUBLISHING CORP.
HOUGHTON MIFFLIN COMPANY
Registrants
By:
/s/ ANTHONY LUCKI
Anthony Lucki
President and Chief Executive Officer
March 30, 2006
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
* Denotes a management contract or compensation plan.