S-1 1 d163477ds1.htm FORM S-1 Form S-1
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As filed with the Securities and Exchange Commission on September 4, 2015

Registration No. 333-            

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

McGraw-Hill Education, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   2731   80-0899290

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

2 Penn Plaza

New York, NY 10121

(646) 766-2000

(Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices)

 

 

David B. Stafford, Esq.

Senior Vice President and General Counsel

McGraw-Hill Education, Inc.

2 Penn Plaza

New York, NY 10121

(646) 766-2626

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

With copies to:

Monica K. Thurmond, Esq.

Paul, Weiss, Rifkind, Wharton & Garrison LLP

1285 Avenue of the Americas

New York, NY 10019-6064

(212) 373-3000

 

Michael Kaplan, Esq.

Byron Rooney, Esq.

Davis Polk & Wardwell LLP

450 Lexington Avenue

New York, NY 10017

(212) 450-4000

 

 

Approximate date of commencement of proposed sale to public: As soon as practicable after this Registration Statement becomes effective.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933 check the following box:  ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   x  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

 

 

CALCULATION OF REGISTRATION FEE

 

 

Title of each class of

securities to be registered

  Proposed
maximum
aggregate
offering price(1)(2)
  Amount of
registration fee

Common stock, par value $0.01 per share

  $100,000,000   $11,620

 

 

(1) Estimated solely for the purpose of calculating the registration fee in accordance with Rule 457(o) of the Securities Act of 1933, as amended.
(2) Includes offering price of any additional shares that the underwriters have an option to purchase.

 

 

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until this Registration Statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine.

 

 

 


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The information in this prospectus is not complete and may be changed. The Issuer may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.

 

SUBJECT TO COMPLETION, SEPTEMBER 4, 2015

PRELIMINARY PROSPECTUS

 

 

LOGO

McGraw-Hill Education, Inc.

Common Stock

 

 

This is the initial public offering of the common stock of McGraw-Hill Education, Inc., a Delaware corporation (the “Issuer”). We are offering             shares of our common stock. No public market currently exists for our common stock.

We intend to apply to list our common stock on the             under the symbol “MHED.”

We anticipate that the initial public offering price will be between $         and $         per share.

 

 

Investing in our common stock involves risks. Please see “Risk Factors” beginning on page 23 of this prospectus.

 

     Per
share
     Total  

Price to the public

   $                    $                

Underwriting discounts and commissions(1)

   $                    $                

Proceeds to us (before expenses)

   $                    $                

 

(1) Please see “Underwriting” for a description of all underwriting compensation payable in connection with this offering.

We have granted the underwriters the option to purchase up to             additional shares of common stock on the same terms and conditions set forth above if the underwriters sell more than             shares of common stock in this offering.

Neither the Securities and Exchange Commission nor any state securities commission nor any other regulatory authority has approved or disapproved of these securities nor have any of the foregoing authorities passed upon or endorsed the merits of these securities or the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.

The underwriters expect to deliver the shares on or about                     , 2015.

 

 

 

 

The date of this prospectus is                     , 2015.


Table of Contents

TABLE OF CONTENTS

 

     Page  

PRESENTATION OF FINANCIAL INFORMATION

     ii   

USE OF NON-GAAP FINANCIAL INFORMATION

     ii   

MARKET AND INDUSTRY DATA

     iii   

TRADEMARKS

     iv   

PROSPECTUS SUMMARY

     1   

THE OFFERING

     17   

SUMMARY HISTORICAL COMBINED CONSOLIDATED FINANCIAL DATA

     19   

RISK FACTORS

     23   

DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS

     37   

USE OF PROCEEDS

     39   

DIVIDEND POLICY

     40   

CAPITALIZATION

     41   

DILUTION

     42   

SELECTED HISTORICAL COMBINED CONSOLIDATED FINANCIAL DATA

     44   

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     49   

INDUSTRY

     102   

BUSINESS

     105   

MANAGEMENT

     123   

COMPENSATION DISCUSSION AND ANALYSIS

     128   

CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

     159   

PRINCIPAL STOCKHOLDERS

     161   

DESCRIPTION OF CAPITAL STOCK

     163   

DESCRIPTION OF MATERIAL INDEBTEDNESS

     166   

SHARES ELIGIBLE FOR FUTURE SALE

     171   

U.S. FEDERAL INCOME TAX CONSIDERATIONS

     173   

UNDERWRITING

     177   

LEGAL MATTERS

     182   

EXPERTS

     182   

WHERE YOU CAN FIND MORE INFORMATION

     182   

INDEX TO COMBINED CONSOLIDATED FINANCIAL STATEMENTS OF MCGRAW-HILL EDUCATION, INC. AND SUBSIDIARIES

     F-1   

We and the underwriters have not authorized anyone to give you any information other than that contained in this prospectus. We and the underwriters take no responsibility for, and can provide no assurance as to the reliability of, any other information that others may give you. This prospectus and any accompanying free writing prospectus is not an offer to sell or a solicitation of an offer to buy securities anywhere or to anyone where or to whom we or the underwriters are not permitted to offer or sell securities under applicable law. The

 

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delivery of this prospectus and any accompanying free writing prospectus does not, under any circumstances, mean that there has not been a change in our affairs since the date of this prospectus. Subject to our obligation to amend or supplement this prospectus as required by law and the rules and regulations of the SEC, the information contained in this prospectus and any accompanying free writing prospectus is correct only as of the date of such document, regardless of the time of delivery of this prospectus and any accompanying free writing prospectus or any sale of these securities.

PRESENTATION OF FINANCIAL INFORMATION

This prospectus contains financial statements of McGraw-Hill Education, Inc. (formerly known as Georgia Holdings, Inc.). On March 22, 2013, MHE Acquisition LLC, acquired all of the outstanding equity interests of certain subsidiaries of The McGraw-Hill Companies, Inc. (“MHC”) pursuant to the Purchase and Sale Agreement, dated as of November 26, 2012 and as amended on March 4, 2013 (collectively, the “Acquired Business”). As a result of this transaction, investment funds affiliated with Apollo Global Management, LLC acquired 100% of MHE Acquisition LLC. We refer to the purchase of the Acquired Business and the related financing transactions as the “Founding Acquisition.” Following the Founding Acquisition, MHC has been known as McGraw Hill Financial, Inc. See “Prospectus Summary—Corporate Structure” for further information on the Founding Acquisition and our resultant corporate structure.

The Successor period ended December 31, 2013 refers to the period from March 23, 2013 to December 31, 2013, and the Predecessor period ended March 22, 2013 refers to the period from January 1, 2013 to March 22, 2013. The term “Successor” refers to McGraw-Hill Education, Inc. following the Founding Acquisition and the term “Predecessor” refers to McGraw-Hill Education, LLC prior to the Founding Acquisition.

USE OF NON-GAAP FINANCIAL INFORMATION

We have provided Adjusted Revenue, EBITDA, Adjusted EBITDA and Free Cash Flow From Operations and the ratios related thereto in this prospectus because we believe they provide investors with additional information to measure our performance. We use Adjusted Revenue as a performance measure because full payment for digital and print solutions is normally collected close to the time of sale whereas revenue from multi-year deliverables is recognized ratably over the term of the customer contract. We believe that the presentation of Adjusted EBITDA is appropriate to provide additional information to investors about certain material non-cash items and about unusual items that we do not expect to continue at the same level in the future as well as other items. Further, we believe Adjusted EBITDA provides a meaningful measure of operating profitability because we use it for evaluating our business performance and understanding certain significant items.

Adjusted Revenue, EBITDA, Adjusted EBITDA and Free Cash Flow From Operations are not presentations made in accordance with U.S. GAAP, and our use of terms, varies from others in our industry. Adjusted Revenue, EBITDA, Adjusted EBITDA and Free Cash Flow From Operations should not be considered as alternatives to revenue, income from continuing operations, income from operations, or any other performance measures derived in accordance with U.S. GAAP as measures of operating performance or cash flows as measures of liquidity. Adjusted Revenue, EBITDA, Adjusted EBITDA and Free Cash Flow From Operations have important limitations as analytical tools, and you should not consider them in isolation or as substitutes for analysis of our results as reported under U.S. GAAP. Further, EBITDA:

 

    excludes certain tax payments that may represent a reduction in cash available to us;

 

    does not reflect any cash capital expenditure requirements for assets being depreciated and amortized that may have to be replaced in the future;

 

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    does not reflect changes in, or cash requirements for, our working capital needs; and

 

    does not reflect the significant interest expense, or the cash requirements necessary to service interest or principal payments, on our indebtedness.

In addition, Adjusted EBITDA:

 

    includes estimated cost savings and operating synergies, including some adjustments not permitted under Article 11 of Regulation S-X;

 

    does not include one-time expenditures, including costs required to realize the synergies referred to above;

 

    reflects net effect of converting deferred revenues (inclusive of deferred royalties) on digital sales to a cash basis assuming the collection of all receivable balances;

 

    does not include management fees paid to entities and investment funds affiliated with Apollo Global Management, LLC, which will discontinue upon completion of this offering; and

 

    does not reflect the impact of earnings or charges resulting from matters that we and the lenders under our senior secured credit facilities may consider not to be indicative of our ongoing operations.

Free Cash Flow From Operations reflects Adjusted EBITDA, as reduced for:

 

    the change in working capital from operations; and

 

    capital expenditures.

Our definitions of Adjusted EBITDA and Free Cash Flow From Operations allows us to add back certain non-cash and other charges or costs that are deducted in calculating net income from continuing operations. However, these are expenses that may recur, vary greatly and can be difficult to predict. They can represent the effect of long-term strategies as opposed to short-term results. In addition, certain of these expenses can represent the reduction of cash that could be used for other corporate purposes.

Because of these limitations, we rely primarily on our U.S. GAAP results and use Adjusted Revenue, EBITDA, Adjusted EBITDA and Free Cash Flow From Operations only supplementally. See “Prospectus Summary—Our Key Metrics” and “Management’s Discussion and Analysis—Non-GAAP Measures.”

MARKET AND INDUSTRY DATA

We include in this prospectus statements regarding factors that have impacted our and our customers’ industries, such as our customers’ access to capital. Such statements regarding our and our customers’ industries and market share or position are statements of belief and are based on market share and industry data and forecasts that we have obtained from industry publications and surveys, including Condition of College and Career Readiness, ACT; AAP Annual Report 2014 - Pre-K-12 Education, Association of American Publishers; Capital Markets’ Education and Training Report (2014), The Bank of Montreal; Student Attitudes Toward Content in Higher Education, (c) 2015 Book Industry Study Group, Inc. (“BISG”); The College Textbook Market Disruption and Transformation, Boston University; The English Effect, British Council; Employment Projection Program 2012-2022, Bureau of Labor Statistics; case studies by Clemson University; “Remediation: Higher Education’s Bridge to Nowhere; Four-Year Myth: Make College more Affordable”, Complete College America; publications by 5 Minute English; Preparing Students for College and Career Success, Foundation for Excellence in Education; Recovery Job Growth and Education Requirements Through 2020, Georgetown University Public Policy Institute; Education Sector Factbook 2012, GSV; case studies by Jefferson Community and Technical College; Global Bandwidth Index December 2014, Juniper Networks; case studies by Madison Area Technical College; MPI Annual Report 2014, Management Practice Inc.; publications by National

 

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Association of State Budget Office; The Condition of Education 2015, The National Center for Education Statistics; SIMBA Publishing for the PreK-12 Market 2015-2016, Simba Information; publications by Student Monitor; Global E-learning Market 2015-2019, Technavio; publications by Training Magazine; publications by UNESCO; case studies by University of Texas at El Paso; publications by Veronis Shuler Stevenson; and Management Practice Inc. (“MPI”), as well as internal company sources. Industry publications, surveys and forecasts generally state that the information contained therein has been obtained from sources believed to be reliable, but there can be no assurance as to the accuracy or completeness of such information. Neither we nor the underwriters have independently verified any of the data from third-party sources, nor have we ascertained the underlying economic assumptions relied upon therein. In addition, while we believe that the market share, market position and other industry information included herein is generally reliable, such information is inherently imprecise. While we are not aware of any misstatements regarding the industry data presented herein, our estimates involve risks and uncertainties and are subject to change based on various factors, including those discussed under the caption “Risk Factors” in this prospectus.

TRADEMARKS

This prospectus contains references to our trademarks and service marks. Solely for convenience, trademarks and trade names referred to in this prospectus may appear without the ® or TM symbols, but such references are not intended to indicate, in any way, that we will not assert, to the fullest extent under applicable law, our rights or the rights of the applicable licensor to these trademarks and trade names. We do not intend our use or display of other companies’ trade names, trademarks or service marks to imply a relationship with, or endorsement or sponsorship of us by, any other companies.

 

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PROSPECTUS SUMMARY

The following summary highlights certain information contained elsewhere in this prospectus and is qualified in its entirety by the more detailed information and historical financial statements included elsewhere herein. Because this is a summary, it is not complete and may not contain all of the information that may be important to you in making an investment decision. Before making an investment decision, you should carefully read the entire prospectus, including the information presented under “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our combined consolidated and consolidated financial statements and related notes presented elsewhere in this prospectus.

Unless otherwise indicated by the context, references in this prospectus to (i) the “Company,” the “Issuer”, “we,” “our,” “us,” “MHE” and “McGraw-Hill Education” refer to McGraw-Hill Education, Inc., a Delaware corporation, together with its consolidated subsidiaries; (ii) “MHGE” refers to MHGE Parent, LLC, a Delaware limited liability company, together with its consolidated subsidiaries; and (iii) “MHSE” refers to McGraw-Hill School Education Intermediate Holdings, LLC, a Delaware limited liability company, together with its consolidated subsidiaries.

The Science of Learning

We help unlock the potential of each learner by accelerating learning through intuitive, engaging, efficient and effective experiences. We define the Science of Learning as the understanding of how individuals learn and apply that understanding, grounded in research, to our content, technology and user experience to produce learning solutions that directly and positively impact individual student outcomes. As a learning science company, our goal is to empower educators and learners with information and intuitive learning environments in which to engage more personally with each other and with critical concepts in order to promote more effective and efficient learning.

Company Overview

We are a leading provider of outcome-focused learning solutions, delivering both curated content and digital learning tools and platforms to the students in the classrooms of approximately 250,000 higher education instructors, 13,000 pre-kindergarten through 12th grade (“K-12”) school districts and a wide variety of academic institutions, professionals and companies in over 135 countries. We have evolved our business from a print-centric producer of textbooks and instructional materials to a leader in the development of digital content and technology-enabled adaptive learning solutions that are delivered anywhere, anytime. We believe we have established a reputation as an industry leader in the delivery of innovative educational content and methodologies. For example, in the higher education market, we were the first in our industry to introduce digital custom publishing, which permits instructors to tailor content to their specific needs. We also created LearnSmart, one of the first digital adaptive learning solutions in the higher education market, which leverages our proprietary content and technology to provide a truly personalized learning experience for students. Today we have over 1,000 adaptive products in higher education. Since 2009, all of our major K-12 programs have also been created in an entirely digital format.

We believe our brand, content, relationships, and distribution network provide us with a distinct competitive advantage. Over our 125 year history, the “McGraw-Hill” name has grown into a globally recognized brand associated with trust, quality and innovation. We partner with more than 14,000 authors and educators in various fields of study who contribute to our large and growing collection of proprietary content. Our collection includes well-known titles and programs across each of our principal markets. For example, in the United States higher education market, Economics: Principles, Problems, and Policies (McConnell/Brue/Flynn) is a leading Economics program. Led by our flagship reading program for the U.S. K-12 market, Reading Wonders, we

 



 

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generated approximately a 33% market share in new reading adoptions across all formats in 2014. In addition, Harrison’s Principles of Internal Medicine is one of the most widely-sold global medical reference solutions to the professional market, with our complementary digital offering AccessMedicine available in almost every medical school in the United States. We sell our products and solutions across multiple platforms and distribution channels, including our large network of nearly 1,450 sales professionals.

As learners and educators have become increasingly outcome-focused in their search for more effective learning solutions, we have embraced adaptive learning tools as a central feature of our digital learning solutions. Adaptive learning is based on educational theory and cognitive science that emphasizes personalized delivery of concepts, continuous assessment of gained and retained knowledge and skills, and design of targeted and personalized study paths that help students improve in their areas of weakness while retaining competencies. We have developed a unique set of digital solutions by combining innovative adaptive learning methods with our proprietary content and digital delivery platforms. These solutions provide immediate feedback and are more effective than traditional print textbooks in driving positive student outcomes. For example, in a 2012 study at Clemson University, the Pre-Calculus pass rate improved from 50% in the traditional course to 70% in a course utilizing our ALEKS solution. Furthermore, studies have demonstrated that our LearnSmart solution has consistently improved student outcomes. At Jefferson Community and Technical College in the first semester after introducing SmartBooks, the number of students earning A’s and B’s increased 10% from 56% to 66%. At Madison Area Technical College, student exam score averages have also climbed consistently by as a much as 10% on the first test and 17% on the final exam after implementing SmartBooks. In the United States higher education market, where the pace of digital adoption is the most rapid of all of our end markets, the success of our sales of adaptive offerings has led to a 140 basis point increase in higher education market share from 2012 to 2014 according to Management Practices, Inc. (“MPI”), an independent education research firm.

Our four operating segments are:

 

  (1) Higher Education (45% of total revenue in 2014): We are a top-three provider in the United States higher education market with a 21% market share as of December 2014 according to MPI. We provide students, instructors and institutions with adaptive digital learning tools, digital platforms, custom publishing solutions and traditional printed textbook products. The primary users of our solutions are students enrolled in two- and four-year non-profit colleges and universities, and to a lesser extent, for-profit institutions. We sell our Higher Education solutions to well-known online retailers, distribution partners and college bookstores, who subsequently sell to students. We also increasingly sell directly to students via our proprietary e-Commerce platform, which currently represents our third largest distribution channel in this segment, with revenue having grown from $20.0 million and $46.0 million for the periods from January 1, 2013 to March 22, 2013 (Predecessor) and March 23, 2013 to December 31, 2013 (Successor), respectively, to $105 million for the year ended December 31, 2014 (Successor). For the year ended December 31, 2014 (Successor), 38% of Higher Education revenue was derived from digital products.

 

  (2) K-12 (31% of total revenue in 2014): We are a top-three provider in the United States K-12 curriculum and learning solutions market with a 19% market share as of December 2014 according to the Association of American Publishers (“AAP”). We sell our learning solutions directly to K-12 school districts across the United States. While we offer all of our major curriculum and learning solutions in digital format, given the varying degrees of availability and maturity of our customers’ technological infrastructure, a majority of our sales are derived from selling blended print and digital solutions. We believe that the quality of our blended offerings has been driving significant growth in both print and digital revenue. For the year ended December 31, 2014, 21% of K-12 revenue was derived from digital learning solutions.

 

  (3)

International (18% of total revenue in 2014): We leverage our global scale, including approximately a 470 person sales force, brand recognition and extensive product portfolio to serve students in the higher

 



 

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  education, K-12 and professional markets in over 135 countries outside of the United States. Our products and solutions for the International segment are produced in nearly 60 languages and primarily originate from our offerings produced for the United States market and that are later adapted to different international markets. Sales of digital products are growing significantly in this market, and we continue to increase our inventory of digital solutions. For the year ended December 31, 2014, 9% of International revenue was derived from digital products.

 

  (4) Professional (6% of total revenue in 2014): We are a leading provider of medical, technical and engineering content for the professional, education and test prep communities. Our digital subscription products have averaged approximately 93% annual retention rates over the last three years and are sold to over 2,700 customers, including corporations, academic institutions, libraries and hospitals. For the year ended December 31, 2014, 44% of Professional revenue was derived from digital products, including digital subscription sales.

For the six months ended June 30, 2015 and the year ended December 31, 2014, we generated revenue of $670 million and $1,856 million, respectively. For the six months ended June 30, 2015 and the year ended December 31, 2014, we generated a net (loss) of $(256) million and $(331) million, respectively. For the six months ended June 30, 2015 and the year ended December 31, 2014, we generated Adjusted Revenue of $711 million and $2,035 million, respectively, and Adjusted EBITDA of $9 million and $472 million, respectively. See “Summary Historical Combined Consolidated Financial Data.”

Our Digital Learning Solutions

Since the acquisition of our business in 2013 by funds affiliated with Apollo Global Management, LLC (together with its subsidiaries, “Apollo”), we have invested significantly in our digital learning solutions and our in-house Digital Platform Group (“DPG”). DPG was formed in 2013 to drive innovation and develop, maintain and leverage our digital learning solutions, technology tools and platforms across our entire business. To maintain and grow our leading digital position, we have increased our annual digital learning solutions spending, including operating and capital expenditures, from less than $90 million in 2012 to $150 million in 2014. We expect to invest in excess of $175 million in 2015. We believe that the effectiveness of our product platforms and DPG support capability give us a competitive advantage because we are not reliant on third parties and do not need to rationalize and integrate multiple product platforms obtained through acquisitions with siloed technology support models. In addition, our digital capabilities have allowed us to drive market share growth, promote recurring usage by instructors, sell directly to students and disintermediate used and rental printed textbooks.

DPG’s mission-driven technology team manages concurrent, enterprise-wide projects leading to continuous innovation, an effective software development life-cycle, reduced cycle times and consistent on-time releases. DPG has also increased the reliability and performance of our learning solutions platforms through an intense focus on ongoing product assessment and improvement. Due to our focus on developing innovative digital solutions, we have been able to attract top technology talent and currently employ approximately 450 full-time employees in DPG, including nearly 200 engineers, more than 75 user experience designers, 75 technical product managers, 20 data scientists and software solutions architects and over 80 customer-facing and other associated support staff across our digital hubs in Boston, Seattle, Irvine, New York City and Columbus.

We have complemented our internally developed digital learning solutions with select acquisitions, including ALEKS, LearnSmart and Engrade. These acquisitions, along with our internal capabilities, enable us to own and control all of the key technologies necessary to implement our digital strategy.

We believe that user engagement data on our learning platforms is one of the most important metrics available to track learning progress. According to Student Attitudes Toward Content in Higher Education (2015, BISG), 80% of the higher education faculty in the United States who use an integrated digital learning system

 



 

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rely on completion of digital homework assignments to measure student progress. Therefore, we monitor growth in unique users and number of homework assignments assigned and submitted as indicators of student and instructor engagement, all of which have experienced significant growth. In 2014, homework assigned by instructors and homework submitted by students increased by 52% and 32%, respectively. In addition, we believe the value that our learning solutions provide can be seen in the growth of our digital revenue. For the year ended December 31, 2014 (Successor), the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor), digital revenue was $517 million, $344 million and $74 million and $333 million, respectively. This represents 28%, 21% and 36% and 17% of total revenue, respectively, or an increase of 24% from 2013 to 2014 and 26% from 2012 to 2013.

We organize our digital learning solutions in two categories: Open Digital Learning Environment and Adaptive / Intelligent Content.

 

 

LOGO

Open Digital Learning Environment

Our Open Digital Learning Environment solutions are designed to facilitate student-instructor interaction. These solutions allow instructors to create and assign materials, build lesson plans, use third party content, integrate into a student information system, manage grading and track student engagement and progress. Unlike traditional methods of learning, our solutions allow students the flexibility to interact with course content and the instructor anytime and anywhere. We believe these products promote higher student retention and better outcomes. Our solutions include:

 

    Connect: a mobile-first open learning environment for the higher education market with 1.9 million unique users year-to-date as of June 30, 2015, an increase of 13% over the prior year. Using the Connect solution, instructors created 6.5 million assignments, and students submitted nearly 40.8 million assignments, representing year-over-year growth rates of 11% and 14%, respectively;

 

    Engrade Pro: an open platform for K-12 education that unifies data, curriculum and educational tools to drive student achievement and inform district educational strategy; and

 

    ConnectEd: an open learning environment delivering our content for K-12 with 1.9 million unique users year-to-date as of June 30, 2015, an increase of 63% over the prior year.

Adaptive / Intelligent Content

We believe that our digital adaptive technologies, which are delivered in our open digital learning environment, help students study more effectively and efficiently by guiding them through a personalized experience. Individual learning plans are continually adapted to the student’s needs to focus their attention on what they need to learn the most, at precisely the time they need to learn it. Key offerings of our Adaptive/Intelligent Content include:

 

   

LearnSmart: an adaptive learning program that personalizes learning and designs targeted study paths for students, with 1.2 million unique users year-to-date as of June 30, 2015, an increase of 33% over

 



 

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the prior year. LearnSmart is primarily sold in the higher education market and is being expanded to K-12 and International. In the higher education market, LearnSmart is utilized in a wide variety of courses, including managerial accounting, economics, communications, Spanish and social studies;

 

    ALEKS: an adaptive learning math product for the K-12 and higher education markets, with 1.3 million unique users year-to-date as of June 30, 2015, an increase of 42% over the prior year;

 

    SmartBooks: an adaptive reading product introduced in Higher Education in 2013 designed to help students understand and retain course material by guiding each student through a highly personal study experience. The student reads the chapters in SmartBooks and is prompted by LearnSmart questions to identify recommended areas of focus. This product is primarily sold in the higher education market across a variety of courses. We began to release SmartBooks in the K-12 and international markets during 2015; and

 

    Connect Insight: a visual analytics dashboard, available to both instructors and students, that provides actionable information about student performance to help improve class effectiveness. Connect Insight presents assignment, assessment, and topical performance results along with a time metric that is easily visible for aggregate or individual results. Using visual data displays that are each framed by an intuitive question, Connect Insight gives both instructors and students the ability to take a just-in-time approach to teaching and learning.

Our business model is transitioning to digital learning solutions with the benefit of the transition most observable in our Higher Education business. While the overall market adoption of digital has been slower in K-12 than Higher Education, recent sales of digital have begun to increase in the K-12 market as well. The following charts illustrate the growth in digital revenue as a percentage of the total revenue generated by Higher Education and K-12, our two largest business segments, during the period from 2010 to 2014. In 2014, these two segments generated 76% of our total revenue.

 

 

LOGO

Our Market Opportunity

The Market for Learning Solutions is Large and Growing

We compete in the market for educational services in the United States and abroad. It is one of the largest sectors in the United States economy and, according to GSV, spending on education in 2012 was $1.4 trillion. Global educational expenditures in 2012 were $4.5 trillion and are forecast to increase to $6.4 trillion in 2017, according to GSV. Our learning solutions address multiple segments in the education market including higher education, K-12, professional education and international.

 



 

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We are a leading provider in the market for new instructional solutions in the United States higher education segment, which was estimated to be approximately $4.3 billion in 2014, according to MPI. This market includes digital learning solutions, as well as traditional and custom print textbooks, but excludes rental and used print textbooks. Rental and used materials are commonly purchased by students as a substitute for new materials. Based on estimates for used and rental substitutes, the overall market for textbooks is significantly larger than the market for new instructional materials. According to a report from Veronis Shuler Stevenson, used text purchases represent approximately 30% of the overall market and rental textbooks represent approximately 8% of the overall market for instructional materials based on a report from Student Monitor. We believe the increased use of digital products will drive significant growth in our addressable market given digital products are not provided in a rental or used form.

We expect another key long-term driver of growth in the higher education market to be increasing student enrollment, which has been steadily growing over the last several decades. Enrollment at degree-granting institutions in the United States was over 20 million in Fall 2013, representing a 2.2% CAGR since 2000 and a 2.0% CAGR since 1970, according to the National Center for Education Statistics (“NCES”). Since 1970, there have been only three years in which enrollment declined by more than 1% over the prior year (1976, 1984, 1993), and in all three cases, enrollment resumed growth within three years.

Our addressable K-12 market in the United States was approximately $5.6 billion for the 2015-2016 school year, including adoption and open territory states, according to Simba Information. According to the latest available data from NCES, K-12 enrollment in the United States as of 2011 was nearly 55 million, and enrollment is projected to grow at a compound annual growth rate of 0.4% from 2013 to 2023. We define our K-12 market as divided among basal (core or alternative required grade-level taught subjects that are delivered in a specific order with increasing difficulty), supplemental (academic instruction provided outside the required programs) and intervention products (targeted instruction to students lacking proficiency in a subject matter, or those who have special learning or behavioral needs). Nineteen states, known as adoption states, approve and procure new basal programs, usually every five to eight years on a state-wide basis for each major area of study, before individual schools or school districts are permitted to schedule the purchase of materials. In all remaining states, known as open territories, each individual school or school district can procure materials at any time, though they usually do so on a five to eight year cycle. Growth in the K-12 market is driven by demand for new materials to address college and career readiness standards, increasing state and local budgets for educational materials, and rising student enrollment. Property tax revenue, the primary source for state and local funds for purchases of instructional materials, has been increasing in the United States along with a rise in property values. A rebound in state and local tax revenues has allowed many locales to increase their K-12 spending to address years of pent-up demand created during the recession that started in 2008. Funding levels as reported by the National Association of State Budget Offices have been somewhat volatile recently, though it appears that funding is improving, particularly at a state level, as tax revenues improve. In 2013, total elementary and secondary education funding improved 4.1%, driven by a 5.1% annual increase at the state level.

As the United States economy continues to recover, we expect the market for professional education resources to grow, particularly among industry sectors that are experiencing more rapid growth in jobs. The Professional and Business Services and Healthcare and Social Assistance industry sectors are expected to add 8 million jobs by 2022, more than all other United States industries combined, according to the Bureau of Labor Statistics (“BLS”). We derive a substantial portion of our Professional revenue from these two markets.

The global e-Learning market, including higher education, K-12 and professional training, is expected to grow from $74 billion in 2015 to $131 billion by 2019, with educational content accounting for approximately 80% of the total, according to Technavio. This large international education market is increasingly focused on digital content due to the growing penetration of the smartphone. Individuals in developing countries are nearly twice as likely to use connected devices (i.e. mobile phones or tablets) for educational purposes on a regular basis as those in developed markets, according to Juniper Networks. Today, through our significant

 



 

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investment in digital solutions and DPG, we provide a number of mobile offerings and plan to increasingly capitalize on these strong market trends in the future.

Needs of the Global Knowledge-Based Economy are Driving Increased Demand for Education

The accelerating shift toward a knowledge-based economy is fueling demand for higher levels of education around the world. The importance of higher education in the United States is clear. 65% of all jobs in the United States will require some form of postsecondary education or training by 2020, up from 28% in 1973 and 59% in 2010, according to Georgetown University Public Policy Institute. As higher education becomes more important to the success of the global economy, governments have increased their emphasis on student preparation and postsecondary readiness through funding requirements of primary and secondary education programs.

The trend towards increased globalization has generated demand for higher levels of educational attainment in international markets as well. There are more than 50 countries in which English is either the official or the primary language and, in many developing countries, educational agendas emphasize the use of English as a universal language for commerce and other sectors of the economy. English is spoken at a useful level by approximately 1.75 billion people worldwide, and is projected to increase to 2.0 billion by 2020, according to the British Council. We believe this trend will increase the readily addressable market for our educational solutions, which are often initially created for English-speaking students before being adapted for international markets.

We expect the investment in education to continue to grow as student enrollment rises around the world. According to UNESCO, global higher education enrollment was nearly 198 million students in 2013, doubling since 2000, and K-12 global enrollment was almost 1.5 billion students in 2013, representing an increase of 20% since 2000.

Increasing Requirement for Higher Student Outcomes and Accountability of Education Providers

Despite the significant government expenditures in education, low college graduation rates and insufficient job placement in the United States have resulted in additional social and economic costs including rising aggregate and per capita student loan debt and increasing incidents of default. In addition, American students are not always learning the skills and knowledge they need to succeed in an increasingly competitive global marketplace.

According to Complete College America, excluding top schools, only 19% of students on average graduate from 4-year schools “on time” (6-years) across the United States and, according to NCES, approximately 60% of first-time, full-time students graduated from 4-year and 2-year institutions in 2013.

In a recent study by the Foundation for Excellence in Education, two-thirds of college professors report that what is taught in high school does not prepare students for college and, according to ACT, 2011, only one in four high school students graduates ready for college in all four core subjects (English, reading, math and science), resulting in a third of students who enter college requiring remedial courses to meet basic levels of proficiency.

Public and political scrutiny of the disparity between funding and student outcomes has increased demand for greater transparency and accountability for spending on education. With educational institutions under pressure to increase their student retention and graduation rates, new and more effective methods of teaching and learning are in demand. Almost 80% of faculty in higher education in the United States believe the most important initiative at their institution is improving student learning outcomes, according to a BISG 2015 survey.

Public policy initiatives aimed at improving student outcomes and accountability within higher education in the United States extend to college and career readiness standards in the K-12 market. An important aspect of

 



 

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postsecondary student success is adequate preparation via primary and secondary education. Currently, 1.7 million students each year begin college in remediation and approximately one-third complete bachelor’s degrees in six years, according to Complete College America. In the United States, improved college readiness has been a focal point for lawmakers, which has led to an increased focus on the linkage between K-12 funding and higher student achievement of educational standards.

As a learning science company, we believe our learning solutions are uniquely suited to facilitate educational institutions in improving student outcomes. For example, our ALEKS solution was a central tool used by the University of Texas at El Paso to increase passage of entry level math courses, which resulted in improved success rates for at-risk students entering these programs.

Educators and Students are Increasingly Embracing Digital Learning Solutions

Trends across all of our markets are driving demand for outcome-driven, adaptive and personalized learning tools which incorporate data and analytics to help both instructors and students improve learning effectiveness. The percentage of students in higher education using digital course materials in Spring 2015 was approximately 70%, according to the BISG 2015 survey. Growth in digital solutions is driven by their proven and demonstrable impact on improving student outcomes and through the advancement of enabling technology such as eReaders, tablets, other hand held devices and laptop computers.

The education market’s transition to digital offers many important benefits to instructors, students and providers of learning solutions. For instructors and students, the benefits of the digital transition include:

 

    Facilitating more effective creation of interactive and adaptive learning solutions designed to reinforce and test concepts taught in primary course materials;

 

    Improving the ability to capture data around student comprehension and performance and making it available to the students and instructors in real-time. This information can then be integrated into instruction and studying, promoting a more interactive and effective overall learning process; and

 

    Reducing the cost of effective learning solutions to the student.

For learning solutions providers, the benefits of the digital transition include:

 

    Allowing for a more direct relationship with the end-user in the higher education market as students purchase licenses for digital learning solutions directly from the learning solutions provider;

 

    Improving the learning experience through continuous feedback from the billions of interactions students have with our adaptive tools;

 

    Allowing faster, more efficient and less expensive creation and updating of content;

 

    Disintermediation of the print used and rental market within higher education; and

 

    An improved business model with greater visibility, predictability, margins and free cash flow generation.

Our Competitive Strengths

We believe the following to be our most important competitive strengths:

Widely recognized brand with global reach and expansive scale.

We believe our brand recognition is driven by our long-standing history of over 125 years in the industry and our ownership of globally well-known titles such as Harrison’s Principles of Internal Medicine and

 

 

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Samuelson’s Economics, which have been cornerstones of education around the world for decades. We distribute our products in over 135 countries across Asia-Pacific, Europe, India, Latin America and the Middle East, and approximately 25% of our nearly 5,000 employees are based in over 35 offices in 27 countries outside of the United States. We believe that our brand, global reach and scale provide us with a defensible market position and present significant barriers to entry. We expect to leverage our market position and internal infrastructure and operational resources to further grow revenues and gain market share by increasing distribution of learning solutions through our network.

In the United States, our products are sold in over 5,000 higher education institutions and 13,000 K-12 school districts across all 50 states. Our nearly 1,450 person sales force maintains close relationships with the individual instructors that represent the primary decision makers in the higher education market and the states, school districts, and individual schools that primarily make purchase decisions in the K-12 market. In the K-12 market, our market leading basal programs such as My Math and Reading Wonders have enabled us to achieve approximately 29% total market share in large state adoptions in 2014. In addition, our growing suite of digital products allows us to develop direct relationships with an even larger group of customers, including over 3 million higher education students and instructors who were users of our Connect platform in 2014, including almost 300,000 outside the United States.

Proprietary and unique content, developed over many years, leveraged in digital adaptive learning.

Our portfolio of proprietary content developed over 125 years and built around market leading titles has been the foundation of our transformation into a large and growing digital learning solutions provider. In 2014, we generated 49% of our Higher Education revenues from titles with #1 or #2 market shares in their respective disciplines. This market leadership has uniquely positioned us to extend our portfolio of traditional print products by offering digital alternatives and new digital solutions that incorporate our existing content and curriculum. The future potential of digital learning solutions is illustrated by a 2015 BISG survey which states that 77% of the instructors who use an integrated digital learning system, such as our Connect platform, require the purchase of that system for their courses and base approximately 26% of the students’ grades on homework assigned through such platforms.

In addition to leveraging digital formats to extend the reach of existing print content, we create all new content in a digital format and optimize it for use in an adaptive environment. This has reduced our development costs and enhanced our ability to use new content for the future development of additional products. We believe that our repositories of over nine petabytes of digital content, which is over nine million gigabytes, provide us with an opportunity to more quickly and effectively bring future products to market. Our centralized DPG team ensures that all of our digital solutions are immediately available to customers running a wide range of different technology architectures.

Diversified portfolio of education businesses and unified approach to digital.

We have a unique presence across the learning continuum, including higher education, K-12 and professional, with additional operations in the international markets. Our presence across the full continuum allows us to mitigate the cyclicality of the individual segments. The higher education segment of our business, which represented approximately 45% of our revenue in 2014, has historically proven to be countercyclical, balancing out cycles experienced by the K-12 business. During and immediately following recent economic downturns, postsecondary enrollment rates have tended to rise while postsecondary attrition rates have tended to decline. We believe this is driven by the lower opportunity cost for enrolling or staying in college during times of relative economic weakness and higher unemployment. In the current economic environment, characterized by a slow recovery, the K-12 market is benefiting from increased state and local government spending while higher education enrollment has begun to slow.

 



 

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In addition to making our product development more innovative and faster to market, our DPG organization has allowed us to spread significant R&D spend across our entire revenue base and leverage investments in products developed for one segment across our entire product suite. This centralized approach provides superior capital efficiency to a siloed development model. The creation of DPG, along with the acquisitions of ALEKS, LearnSmart and Engrade, enables us to own and control all of the key technologies necessary to implement our digital strategy.

First mover in digital adaptive learning solutions and strong capabilities in digital technology.

We believe the significant investment we have made in our digital capabilities has made us a longstanding leader in digital adaptive learning. Today, our annualized spend in our Digital Platform Group, including operating and capital expenditures, has grown to $150 million in 2014, up from $90 million in 2012. In 2015, we expect to invest in excess of $175 million in DPG. In addition to our organic investments, we have committed in excess of $200 million for the acquisitions of ALEKS, LearnSmart and Engrade, which have significantly strengthened our platform and adaptive digital offerings. Our LearnSmart solution has been one of the most widely used adaptive platforms in higher education since its launch in 2009, and ALEKS, our digital adaptive learning solution originally developed for K-12 math, originated in 1992 with a National Science Foundation grant. Our long history of offering adaptive learning solutions has allowed us to develop a growing and robust database of student interactions relating to achievement of learning objectives, which we use to continuously improve the effectiveness of our platforms. For example, LearnSmart has generated over four billion interactions with students since inception, growing at a rate of more than 100 million interactions per month. In addition to using this information to enhance the effectiveness of our adaptive tools, we share data on interactions with instructors to help them more effectively integrate our solutions into their lessons, focusing on content that students are having difficulty learning, reinforcing our relationships and making our solutions more difficult to displace.

Our interactions data are also leveraged on an ongoing basis to create new adaptive technology solutions. For Higher Education, our SmartBooks adaptive offering, introduced in 2013, is among the first adaptive reading experiences for higher education that utilizes data analytics combined with a deep repository of proprietary content to improve learning outcome. In the higher education market alone, we have increased our number of adaptive products from 40 in 2012 to over 1,000 at the end of 2014.

Highly attractive business model positioning us for growth.

We enjoy a business model that is highly cash generative. Since 2012 through the end of 2014, we have generated Free Cash Flow From Operations of approximately $1.5 billion. As we derive an increasing amount of Adjusted Revenue from digital products, we have been able to operate our business with decreasing levels of pre-publication and capital expenditures and less working capital requirements. Our strong cash flow has enabled significant investment in our digital capabilities, several key strategic acquisitions, return of capital to our shareholders and continued deleveraging. Since the Founding Acquisition in 2013, our strong cash flow has funded three acquisitions, including ALEKS, LearnSmart and Engrade, that included cash components totaling $138 million. We also completed a minority interest buy-out of Ryerson Canada (our Canadian business) for $27 million and made a minority investment in English Language Learning provider Busuu for €6 million. In addition, we have made significant investments in the staffing of DPG, which supports ongoing innovation, development and maintenance of our technology platforms, reducing our pre-publication and capital expenditure requirements and our dependence on third parties.

In addition to our ongoing shift towards a more digitally-enabled model, another important driver of increasing free cash flow generation has been our demonstrated success in implementing various cost saving measures. We expect these opportunities to continue to improve our operating margins and fund additional

 



 

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investment in our digital capabilities. Since our March 2013 sale to Apollo through June 30, 2015, we have identified and actioned $150 million of annualized cost savings, with approximately $100 million realized to date. We plan to achieve the full run-rate benefit of these savings by the end of 2017.

Talented management team and employee base.

Since being acquired by Apollo in March 2013, we have enhanced our leadership team with the addition of proven leaders, including a new CEO, Presidents of each business segment, a Head of Strategy, a new CIO and a Head of Communications. Our leadership team consists of professionals averaging over 20 years of experience in a range of industries that include education, technology and media with various leadership positions at Bain, Gartner, Harvard Business School, Pearson, Reed Elsevier, Standard & Poor’s, Sylvan Learning, Symbian, UBM, and Wolters Kluwer as well as start-ups such as Intelligent Solutions. We have nearly 5,000 employees world-wide with approximately 450 full-time employees in DPG, including nearly 200 engineers, more than 75 user experience designers, 75 technical product managers, 20 data scientists and software solutions architects and over 80 customer-facing and other supporting staff.

Our Growth Strategies

The key elements of our growth strategies are described below.

Further our leadership in digital solutions and digital technology.

We intend to capitalize on the increasing market demand for digital learning solutions by expanding our portfolio of technology-enabled adaptive tools and learning solutions. By leveraging a common software architecture and platform, we will be able to quickly design, develop and test innovative products. Our next generation products, several of which have been recently deployed or are currently in development, will also benefit from the experience we have gained from our existing product suite. These products will have enhanced flexibility, provide greater ability for our users to create custom solutions, and better analyze learning data. We believe these next generation products will further our leadership in our key markets and allow us to grow our revenues at a faster rate than the overall market.

We also expect that increased adoption of our digital solutions in the higher education market will expand our revenue opportunity by limiting the availability of used and rental alternatives. As instructors mandate and integrate digital solutions into their classrooms, learning will become more personalized. We believe there is a significant growth opportunity for the use of personalized learning programs, which can further the disintermediation of the used and rental market.

In order to better leverage technology across all of our businesses, drive product innovations and create a more efficient product development process, we are consolidating technologies to eliminate duplicative capabilities. We expect this effort will reduce maintenance costs and unlock creative synergies across our engineering teams. We will also streamline our tools and platforms for efficient and effective delivery with open application program interfaces. This rationalization and simplification of our delivery platforms will reduce costs, freeing up capital for investment in new products.

Increase our penetration in our largest, most profitable disciplines and sub-markets.

In Higher Education, we intend to make additional investments in large customer segments with the greatest strategic value, such as freshman and sophomore general education and developmental courses. As a core competency, we will continue to identify high value segments through rigorous customer segmentation analysis and discipline-specific market insight. These key areas contain the least specialized curriculum, have the highest

 



 

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enrollment, are likely to be taught at a high percentage of institutions and will benefit the most from digital solutions that track students’ progress. By focusing our investments on these areas, we believe we can increase market share and drive further revenue growth. Going forward, we will prioritize opportunities based on rigorous customer segmentation analysis and specific market insights.

To increase penetration and drive better student outcomes in K-12, we will target synergies across the entire learning environment, including technology platforms and services, and leverage our existing sales, marketing and product development capabilities to further penetrate the market. We will leverage our digital adaptive assets, ALEKS and LearnSmart, to accelerate our penetration of digital products while also emphasizing the research-basis of revitalized programs such as Everyday Mathematics and Open Court Reading. We will continue to compete in all major state adoptions, especially the upcoming California adoption in 2016, as well as Texas, Florida and other adoption states in 2017 and later years.

Introduce new enterprise solutions aimed at education effectiveness and student retention.

We believe our learning science focus, highly talented DPG team and the large amount of data we collect via our adaptive learning solutions uniquely position us to offer enterprise services that help our institutional customers improve educational outcomes and accountability. We intend to sell a number of new products and services, including our Connect Insight product, that offer enterprise-wide course development and design services, analytical tools focused on optimizing student performance and retention, and college and career readiness programs and services.

Leverage our digital solutions in International and Professional markets.

We intend to leverage our large global sales presence, our DPG team, deep local knowledge and numerous strategic partnerships to adapt our leading portfolio of English language content and digital solutions to meet local market needs, such as culture, language and curricula. We believe that this will allow us to rapidly scale our presence in international markets, with particular focus on emerging markets in Latin America, the Middle East, Africa and Asia Pacific.

We also believe we can achieve significant growth by utilizing our adaptive learning competencies to enter and disrupt attractive education segments. These include the high stakes test preparation markets in selected geographies, vocational and skills-based training markets, and the corporate training market where personalized adaptive learning has significant value to the enterprise.

License our software and platforms to other education industry participants and the corporate training market.

We intend to license our leading portfolio of software, platforms and capabilities to other market participants in both the education and corporate markets. Education industry participants, such as universities and international content providers, can save significant development costs by using our technology to deliver their own content, in their own local languages and with features designed for their own unique markets. We have estimated this addressable market at approximately $1 billion, which is based on our estimate of the potential for publishers who do not have their own digital solution or are sub-scale in education to outsource their technology development efforts to us.

We will also market to corporate partners who can benefit from our proven and effective adaptive technology, especially in high-stakes areas where it is important to demonstrate mastery. This will allow corporate partners to provide personalized corporate training and professional development programs that capitalize on our data reporting and analysis tools. In 2015, we launched our first successful pilot of this

 



 

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program, which we have already expanded, and our pipeline of potential education and corporate clients is building. We believe the large corporate training market is a significant opportunity of $55 billion according to Training Magazine.

Continue to evolve our digital-centric business model to generate significant free cash flow.

We will continue to drive towards a digital-centric business model which will allow us to continue to generate significant free cash flow over time as we derive an increasing proportion of our sales from digital learning solutions. We expect our digital-centric model to continue to result in higher margins and lower capital intensity as we drive efficiencies in our business from reduced operating expenditures, reduced print inventory and more efficient pre-publication investment relative to revenue. We expect to use our free cash flow to fund our growth, delever our balance sheet and, potentially, return capital to shareholders over time.

Selectively pursue acquisitions.

We will consider acquisitions that expand our product offerings, accelerate our digital product development and add important content. We believe our brand and scale allow us to derive significant benefit from emerging education technology companies, which would be challenged to attain a significant market position as standalone companies.

Our Key Metrics

We measure our business using several key financial metrics, including Adjusted Revenues and Adjusted EBITDA and the ratios related thereto.

Adjusted Revenue is a non-GAAP financial measure that we define as the total amount of revenue that would have been recognized in a period if we recognized all revenue immediately at the time of sale. We use Adjusted Revenue as a performance measure given that we typically collect full payment for our digital and print solutions near the time of sale, but recognize revenue from digital solutions and multi-year deliverables ratably over the term of our customer contracts. Adjusted Revenue is a key metric we use to manage our business as it reflects the sales activity in a given period and provides comparability during this time of transition, particularly in the K-12 market, in which customers typically pay for five to eight-year contracts upfront. Adjusted Revenue is GAAP revenue plus the net change in deferred revenue.

Adjusted EBITDA is a non-GAAP financial measure defined as net income from continuing operations plus net interest, income taxes, depreciation and amortization (including amortization of pre-publication investment cash costs) and adjusted to exclude unusual items and other adjustments required or permitted in calculating covenant compliance under our debt agreements less cash spent for pre-publication investment in addition to the change in deferred revenue.

For further information on non-GAAP financial measures and a description of how we calculate each of our key metrics and operating factors that impact these metrics, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Non-GAAP Measures” and “Use of Non-GAAP Financial Information.”

 



 

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The table below show the metrics for the year ended December 31, 2012 (Predecessor), January 1 to March 22, 2013 (Predecessor), March 23 to December 31, 2013 (Successor), year ended December 31, 2014 (Successor), six months ended June 30, 2014 and 2015 (Successor):

 

    Adjusted Revenue, Adjusted EBITDA and Adjusted EBITDA % Margin   
(Dollars in thousands)   Successor          Predecessor  
    Six Months
Ended June 30,
2015
    Six Months
Ended June 30,
2014
    Year Ended
December 31,
2014
    March 12,
2013 to
December 31,
2013
         January 1,
2013 to
March 22,
2013
    Year Ended
December 31,
2012
 

Adjusted Revenue

  $ 710,621      $ 691,283      $ 2,034,838      $ 1,758,299          $ 212,137      $ 1,978,112   

Adjusted EBITDA

  $ 8,557      $ 7,988      $ 472,366      $ 498,126          $ (62,970   $ 413,138   

Adjusted EBITDA % Margin

    1.2     1.2     23.2     28.3         (29.7 %)      20.9

The Founding Acquisition

Pursuant to a Purchase and Sale Agreement, dated as of November 26, 2012 and as amended on March 4, 2013 (the “Purchase and Sale Agreement”), among MHE Acquisition, LLC, The McGraw-Hill Companies, Inc. (“MHC”) and certain other subsidiaries of MHC named therein, as sellers (collectively, the “Sellers”), and McGraw-Hill Education LLC, MHE Acquisition, LLC acquired from the Sellers the Acquired Business. The Acquired Business included all of MHC’s educational materials and learning solutions business, which was comprised of: (i) the Higher Education, Professional and International Group, which included post-secondary education and professional products both in the United States and internationally and (ii) the School Education Group business, which included school and assessment products targeting students in the pre-kindergarten through secondary school market. As of completion of the acquisition, Apollo and certain co-investors directly or indirectly owned all of the equity interests of the Issuer, which owned all of the equity interests of MHE Acquisition, LLC.

Throughout this prospectus, we collectively refer to the acquisition, the related restructuring, the investment in MHE Acquisition, LLC’s equity, the issuance of 9.75% first priority senior secured notes due 2021 (the “MHGE Senior Secured Notes”) by McGraw-Hill Global Education Holdings, LLC (“MHGE Holdings”), the entry into an $810 million term loan credit facility (the “MHGE Term Loan”) and a $240 million revolving credit facility (the “MHGE Revolving Facility” and together with the MHGE Term Loan, the “MHGE Facilities”) by MHGE Holdings and the entry into an $150 million asset based revolving credit facility (the “MHSE Revolving Facility”) by McGraw-Hill School Education Holdings, LLC, each such debt issuance occurring concurrently with the acquisition, as the “Founding Acquisition.”

 



 

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Corporate Structure

The diagram below sets forth a simplified version of our organizational structure and our principal indebtedness as of the date of the prospectus. This chart is provided for illustrative purposes only and does not represent all legal entities affiliated with, or all obligations of, the Issuer.

 

 

LOGO

 

(1) 8.500% / 9.250% Senior PIK Toggle Notes due 2019 (the “MHGE PIK Toggle Notes”).
(2) MHGE Intermediate Holdings, LLC has pledged the equity of MHGE Holdings to secure the MHGE Facilities.
(3) 9.75% First Priority Senior Secured Notes due 2021.
(4)

As of June 30, 2015, there were no outstanding obligations under the MHGE Revolving Facility. As of June 30, 2015, there were $677.3 million face value of loans outstanding under the MHGE Term Loan, which reflects an $81.0 million voluntary prepayment on December 31, 2013, a $35.0 million voluntary

 



 

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  prepayment in connection with the repricing transaction that closed on March 24, 2014 and a $0.3 million voluntary prepayment in connection with the repricing transaction that closed on May 4, 2015.
(5) All wholly owned domestic subsidiaries of MHGE Holdings, other than any domestic subsidiary that is a subsidiary of a foreign subsidiary, guarantee and pledge certain assets under the MHGE Facilities and the MHGE Secured Notes.
(6) McGraw-Hill School Education Intermediate Holdings, LLC has pledged the equity of McGraw-Hill School Education Holdings, LLC to secure the MHSE Revolving Facility and a $250.0 million term loan credit facility (the “MHSE Term Loan”).
(7) As of June 30, 2015, there were no outstanding obligations under the MHSE Revolving Facility, except for $10.0 million of letters of credit.
(8) As of June 30, 2015, there were $246.3 million face value of loans outstanding under the MHSE Term Loan.
(9) All wholly owned domestic subsidiaries of McGraw-Hill School Education Holdings, LLC, other than any domestic subsidiary that is a subsidiary of a foreign subsidiary, guarantee and pledge certain assets under the MHSE Revolving Facility and MHSE Term Loan.

Our Sponsor

Apollo, founded in 1990, is a leading global alternative investment manager with offices in New York, Los Angeles, Houston, Bethesda, Chicago, Toronto, London, Frankfurt, Madrid, Luxembourg, Mumbai, Delhi, Singapore, Hong Kong and Shanghai. Apollo had assets under management of approximately $163 billion as of June 30, 2015 in its affiliated private equity, credit and real estate funds invested across a core group of nine industries where Apollo has considerable knowledge and resources. Apollo’s team of approximately 331 investment professionals possesses a broad range of transactional, financial, managerial and investment skills, which has enabled the firm to deliver strong long-term investment performance throughout expansionary and recessionary economic cycles. Apollo has a successful track record of managing investments in education companies such as Laureate International Universities, Connections Education, Sylvan Learning and Berlitz. Moreover, Apollo has considerable experience leading large, complex carve-out transactions, including its affiliated funds’ current and prior portfolio companies Berry Plastics (original acquisition from Tyco International), Constellium (acquired from Rio Tinto), EP Energy (acquired from El Paso Corporation), Evertec (acquired from Banco Popular), General Nutrition Centers (acquired from Royal Numico), Hostess (selected assets acquired from Hostess Brands, Inc.), Noranda (acquired from Xstrata) and United Agri Products (acquired from ConAgra Foods).

Corporate Information

Our principal executive offices are located at 2 Penn Plaza, New York, NY 10121 and our telephone number is (646) 766-2000. We also maintain a website at www.mheducation.com. Our website and the information contained therein or connected thereto is not incorporated into this prospectus or the registration statement of which it forms a part.

 



 

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THE OFFERING

 

Issuer

McGraw-Hill Education, Inc.

 

Common stock offered by us

            shares (or             shares, if the underwriters exercise in full their option to purchase additional shares).

 

Option to purchase additional shares

We have granted the underwriters an option to purchase up to an additional              shares from us. The underwriters may exercise this option at any time within 30 days from the date of this prospectus.

 

Total shares of common stock offered

            shares (or             shares, if the underwriters exercise in full their option to purchase additional shares).

 

Common stock to be outstanding after the offering

            shares (or             shares, if the underwriters exercise in full their option to purchase additional shares).

 

Use of Proceeds

We expect to receive approximately $         of net proceeds (based upon the assumed initial public offering price of $         per share, the midpoint of the range set forth on the cover page of this prospectus) from the sale of the common stock offered by us, after deducting underwriting discounts and commissions and estimated offering expenses payable by us. Each $1.00 increase (decrease) in the public offering would increase (decrease) our net proceeds by approximately $         million.

 

  We intend to use approximately $         million of the net proceeds from this offering to pay related fees and expenses. The remaining net proceeds will be used for general corporate purposes.

 

Dividend Policy

We currently intend to retain all future earnings, if any, for use in the operation of our business and to fund future growth. The decision whether to pay dividends in the future will be at the sole discretion of our board of directors after taking into account various factors, including legal requirements, our subsidiaries’ ability to make payments to us, our financial condition, operating results, cash flow from operating activities, available cash, business opportunities, restrictions in our debt agreements and other contracts, current and anticipated cash needs and other factors our board of directors deems relevant. See “Dividend Policy.”

 

Listing and trading symbol

We intend to apply to list our common stock on the         , under the symbol “MHED.”

 

Risk factors

You should carefully read and consider the information set forth under the heading “Risk Factors” and all other information set forth in this prospectus before deciding to invest in our common stock.

 

Directed share program

At our request, the underwriters have reserved for sale at the initial public offering price up to          percent of the common stock offered

 



 

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by this prospectus for employees, directors and other persons associated with us who have expressed an interest in purchasing common stock in the offering. If purchased by these persons, these shares will be subject to a         -day lock-up restriction. The number of shares available for sale to the general public in the offering will be reduced to the extent these persons purchase such reserved shares. Any reserved shares not so purchased will be offered by the underwriters to the general public on the same terms as the other shares. See “Underwriting.”

The information above excludes             shares of common stock reserved for issuance under our management equity plan, adopted by the Board of Directors on May 15, 2013 and which we expect to amend and restate in connection with the completion of this offering. As of                     , 2015, there were a total of             shares of common stock underlying outstanding stock options issued under our management equity plan with a weighted average exercise price of $                . See “Compensation Discussion and Analysis—Compensation Programs.”

 



 

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SUMMARY HISTORICAL COMBINED CONSOLIDATED FINANCIAL DATA

The following table presents the summary historical combined consolidated financial and operating results of the Company.

The combined statement of operations for the year ended December 31, 2012 and for the period from January 1, 2013 to March 22, 2013 is derived from the audited combined financial statements of our Predecessor included elsewhere in this prospectus. The combined balance sheet data as of December 31, 2012 has been derived from our audited combined financial statements of our Predecessor which is not included elsewhere in this prospectus. The consolidated statement of operations for the period from March 23, 2013 to December 31, 2013 and the year ended December 31, 2014 and the consolidated balance sheet data as of December 31, 2013 and 2014 have been derived from the audited consolidated financial statements of the Company (Successor) included elsewhere in this prospectus. The consolidated statement of operations for the six months ended June 30, 2014 and 2015 and the consolidated balance sheet data as of June 30, 2015 have been derived from the unaudited consolidated financial statements of the Company (Successor) included elsewhere in this prospectus. The consolidated balance sheet data as of June 30, 2014 has been derived from the unaudited consolidated financial statements of the Company not included elsewhere in this prospectus.

The summary combined consolidated financial and operating results presented below should be read in conjunction with our audited and unaudited combined consolidated financial statements and accompanying notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus. Our historical combined financial information may not be indicative of our future performance and does not necessarily reflect what our financial position and results of operations would have been had we operated as a separate, stand-alone entity during the periods presented, including changes that occurred in our operations and capitalization as a result of the Founding Acquisition.

 

(Dollars in thousands, except per share data)   Successor     Predecessor  
    Six Months
Ended
June 30,
2015
    Six Months
Ended
June 30,
2014
    Year Ended
December 31,
2014
    March 23 to
December 31,
2013
    January 1 to
March 22,
2013
    Year Ended
December 31,
2012
 

Statements of Operations

           

Revenue

  $ 670,143      $ 679,080      $ 1,855,779      $ 1,589,574      $ 229,441      $ 1,917,599   

Cost of sales

    188,536        222,186        533,913        777,384        64,006        541,306   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross Profit

    481,607        456,894        1,321,866        812,190        165,435        1,376,293   
 

Operating expenses:

           

Operating and administration expenses

    525,136        552,388        1,194,656        841,652        208,816        1,224,126   

Depreciation

    13,945        14,523        22,086        23,538        5,817        28,083   

Amortization of intangibles

    47,104        57,277        104,157        69,181        6,326        25,130   

Impairment charge

    —          —          23,800        —          —          412,886   

Transaction costs

    —          3,421        3,932        56,820        —          —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

    586,185        627,609        1,348,631        991,191        220,959        1,690,225   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating (loss) income

    (104,578     (170,715     (26,765     (179,001     (55,524     (313,932

Interest expense (income), net

    96,765        89,626        181,890        137,283        488        (1,688

Other (income) expense

    (4,779     (7,329     (8,420     —          —          (16,868
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

(Loss) Income from operations before taxes on income

    (196,564     (253,012     (200,235     (316,284     (56,012     (295,376

Income tax (benefit) provision

    (2,527     (108,582     112,571        (130,158     (20,410     (19,704
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income from continuing operations

    (194,037     (144,430     (312,806     (186,126     (35,602     (275,672

Net (loss) income from discontinued operations, net of taxes

    (62,163     10,680        (18,157     18,617        4,058        23,897   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income

    (256,200     (133,750     (330,963     (167,509     (31,544     (251,775
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less: net (income) loss attributable to non-controlling interests

    —          299        299        (2,251     631        (4,559
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income attributable to McGraw-Hill Education, Inc.

  $ (256,200   $ (133,451   $ (330,664   $ (169,760   $ (30,913   $ (256,334
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) earnings per share from continuing operations—basic and diluted

  $ (18.47   $ (13.93   $ (30.09   $ (18.74   $ (3.50   $ (28.02

Weighted average shares outstanding—basic and diluted

  $ 10,505      $ 10,345      $ 10,387      $ 10,051      $ 10,000      $ 10,000   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 



 

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(Dollars in thousands)   Successor     Predecessor     Predecessor  
    Six Months
Ended
June 30,
2015
    Six Months
Ended
June 30,
2014
    Year Ended
December 31,
2014
    March 23 to
December 31,
2013
    January 1 to
March 22,
2013
    Year Ended
December 31,
2012
 

Other Financial Data

           

Adjusted Revenue(1)

  $ 710,621      $ 691,283      $ 2,034,838      $ 1,758,299      $ 212,137      $ 1,978,112   

Adjusted EBITDA(1)

    8,557        7,988        472,366        498,126        (62,970     413,138   

Free Cash Flow From Operations(1)

    (189,957     (139,477     508,733        637,895        (16,632     324,095   

Capital expenditures

    23,517        5,615        40,500        7,379        2,461        20,983   

 

(Dollars in thousands)    Successor     Predecessor  
     As of
June 30,
2015
    As of
June 30,
2014
    As of
December 31,
2014
    As of
December 31,
2013
    As of
December 31,
2012
 

Balance Sheet data:

            

Cash and cash equivalents

   $ 79,435      $ 83,260      $ 413,963      $ 430,691      $ 98,188   

Working capital(2)

     68,292        118,110        200,298        363,651        339,321   

Total assets

     2,431,344        2,822,644        2,747,296        3,031,719        1,916,275   

Total debt(3)

     2,193,601        1,702,657        2,096,143        1,739,431        —     

Total net debt(3)

     2,114,166        1,619,397        1,682,180        1,308,740        —     

Stockholders’ equity (deficit)

     (734,611     321,589        (377,609     409,597        1,120,930   

 

(1) Adjusted Revenue, a measure used by management to assess operating performance, is defined as the total amount of revenue that would have been recognized in a period if all revenue were recognized immediately at the time of sale.

Adjusted Revenue is calculated as follows:

 

     Successor     Predecessor  
(Dollars in thousands)    Six Months
Ended
June 30,
2015
    Six Months
Ended
June 30,
2014
    Year Ended
December 31,
2014
    March 23,
2013 to
December 31,
2013
    January 1,
2013 to
March 22,
2013
    Year Ended
December 31,
2012
 

Revenue

   $ 670,143      $ 679,080      $ 1,855,779      $ 1,589,574      $ 229,441      $ 1,917,599   

Change in deferred revenue(a)

     40,478        12,203        179,059        168,725        (17,304     60,513   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted Revenue

   $ 710,621      $ 691,283      $ 2,034,838      $ 1,758,299      $ 212,137      $ 1,978,112   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

  (a) We receive cash up-front for most product sales but recognize revenue (primarily related to digital sales) over time recording a liability for deferred revenue when we receive the cash. This adjustment represents the net effect of converting deferred revenues (inclusive of deferred royalties) on digital sales to a cash basis assuming the collection of all receivable balances.

EBITDA, a measure used by management to assess operating performance, is defined as net income from continuing operations plus net interest, income taxes, depreciation and amortization, including amortization of pre-publication investment cash costs.

Adjusted EBITDA is defined as EBITDA adjusted to exclude unusual items and other adjustments required or permitted in calculating covenant compliance under our debt agreements.

Free Cash Flow From Operations is defined as Adjusted EBITDA as further adjusted to reflect changes in working capital from operations and capital expenditures.

Adjusted Revenue, Free Cash Flow From Operations and each of the above described EBITDA-based measures is not a recognized term under U.S. GAAP and does not purport to be an alternative to revenue or income from continuing operations as a measure of operating performance or to cash flows from operations as a measure of liquidity. Additionally, each such EBITDA-based measure is not intended to be a measure of free cash flows available for management’s discretionary use, as it does not consider certain cash requirements such as interest payments, tax payments and debt service requirements. Such measures have limitations as analytical tools, and you should not consider any of such measures in isolation or as substitutes for our results as reported under U.S. GAAP. Management compensates for the limitations of using non-GAAP financial measures by using them to supplement U.S. GAAP results to provide a more complete understanding of the factors and trends affecting the business than U.S. GAAP results alone. Because not all companies use identical calculations, these EBITDA-based measures may not be comparable to other similarly titled measures of other companies. See “Use of Non-GAAP Financial Information.”

Management believes that Adjusted Revenue is helpful in highlighting the sales performance from period to period because it reflects sales as they are made.

Management believes EBITDA is helpful in highlighting trends because EBITDA excludes the results of decisions that are outside the control of operating management and can differ significantly from company to company depending on long-term strategic decisions regarding capital structure, the tax jurisdictions in which companies operate and capital investments. In addition, EBITDA provides more comparability between the historical operating results and operating results that reflect purchase accounting and the new capital structure.

Management believes that the inclusion of supplementary adjustments to EBITDA applied in presenting Adjusted EBITDA are appropriate to provide additional information to investors about certain material non-cash items and about unusual items that we do not expect to continue at the same level in the future.

 



 

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For additional information related to these measures, please see “Non-GAAP Financial Information” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Non-GAAP Financial Measures—Adjusted Revenue and Adjusted EBITDA.”

Management believes that Free Cash Flow From Operations is useful in highlighting the cash available for use that is generated by our operations.

EBITDA, Adjusted EBITDA and Free Cash Flow From Operations are calculated as follows:

 

    Successor     Predecessor  
(Dollars in thousands)   Six
Months
Ended
June 30,
2015
    Six
Months
Ended
June 30,
2014
    Year Ended
December 31,
2014
    March 23 to
December 31,
2013
    January 1 to
March 22,
2013
    Year Ended
December 31,
2012
 

Net (loss) income from continuing operations

  $ (194,037   $ (144,430   $ (312,806   $ (186,126   $ (35,602   $ (275,672

Interest expense (income), net

    96,765        89,626        181,890        137,283        488        (1,688

Income tax (benefit) provision

    (2,527     (108,582     112,571        (130,158     (20,410     (19,704

Depreciation, amortization and pre-publication amortization

    89,293        96,590        205,831        163,883        25,434        228,565   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

EBITDA

    (10,506     (66,796     187,486        (15,118     (30,090     (68,499
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Change in deferred revenue(a)

    40,478        12,203        179,059        168,725        (17,304     60,513   

Restructuring and cost savings implementation fees(b)

    13,730        19,025        39,888        33,984        4,116        62,477   

Sponsor fees(c)

    1,750        1,750        3,500        875        —          —     

Elimination of corporate overhead(d)

    —          —          —          —          —          88,551   

Impairment charge(e)

    —          —          23,800        —          —          412,886   

Purchase accounting(f)

    —          41,585        41,585        312,615        —          —     

Transaction costs(g)

    —          3,421        3,932        56,820        —          —     

Acquisition costs(h)

    —          4,045        4,376        4,796        —          —     

Physical separation costs(i)

    —          21,607        46,716        8,100        —          —     

Other(j)

    7,707        8,762        29,109        23,944        5,627        (1,559

Pre-publication investment cash costs(k)

    (44,602     (37,614     (87,085     (96,615     (25,319     (168,623

Stand-alone cost savings(l)

    —          —          —          —          —          27,392   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted EBITDA

  $ 8,557      $ 7,988      $ 472,366      $ 498,126      $ (62,970   $ 413,138   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Change in working capital from operations(m)

    (174,997     (141,850     76,867        147,148        48,799        (68,060

Capital expenditures

    (23,517     (5,615     (40,500     (7,379     (2,461     (20,983
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Free Cash Flow From Operations

  $ (189,957   $ (139,477   $ 508,733      $ 637,895      $ (16,632   $ 324,095   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

  (a) We receive cash up-front for most product sales but recognize revenue (primarily related to digital sales) over time recording a liability for deferred revenue when we receive the cash. This adjustment represents the net effect of converting deferred revenues (inclusive of deferred royalties) on digital sales to a cash basis assuming the collection of all receivable balances.
  (b) Represents severance and other expenses associated with headcount reductions and other cost savings initiated as part of our formal restructuring initiatives to create a flatter and more agile organization.
  (c) Beginning in 2014, $3.5 million of annual management fees was recorded and payable to Apollo. The amount recorded in the Successor period from March 23, 2013 to December 31, 2013 was $0.9 million.
  (d) General corporate allocations for executive management costs incurred by MHC were allocated to the business prior to Q1 2013.
  (e) An impairment charge was recorded in 2014 to reduce the recorded value of an owned office building to its estimated fair value based upon an independent appraisal. In addition, a goodwill impairment charge was recorded in 2012 relating to the K-12 reporting unit.
  (f) Represents the effects of the application of purchase accounting associated with the Founding Acquisition, driven by the step-up of acquired inventory. The deferred revenue adjustment recorded as a result of purchase accounting has been considered in the deferred revenue adjustment.
  (g) The amount represents the transaction costs associated with the Founding Acquisition.
  (h) The amount represents costs incurred for acquisitions subsequent to the Founding Acquisition including ALEKS, LearnSmart and Engrade.
  (i) The amount represents costs incurred to physically separate our operations from MHC. These physical separation costs were incurred subsequent to the Founding Acquisition and concluded in 2014.
  (j) For six months ended June 30, 2015, the amount represents (i) non-cash incentive compensation expense; (ii) elimination of the gain of $4.8 million on the sale of an investment in an equity security and (iii) other adjustments permitted and/or required under the indentures governing the MHGE Senior Secured Notes, MHGE Facilities, MHSE Revolving Facility and MHSE Term Loan. For the six months ended June 30, 2014, the amount represents (i) cash distributions to noncontrolling interest holders of $0.1 million; (ii) non-cash incentive compensation expense; (iii) elimination of non-cash gain of $7.3 million relating to LearnSmart; and (iv) other adjustments required or permitted in calculating covenant compliance under our debt agreements.

For the year ended December 31, 2014, the amount represents (i) cash distributions to noncontrolling interest holders of $0.2 million; (ii) non-cash incentive compensation expense; (iii) elimination of non-cash gain of $7.3 million in LearnSmart; and (iv) other adjustments required or permitted in calculating covenant compliance under our debt agreements.

 



 

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For the periods from March 23, 2013 to December 31, 2013 (Successor) and from January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor), the amount represents (i) cash distributions to noncontrolling interest holders (excluding special dividends) of $0.5 million and $1.8 million and $5.5 million, respectively; (ii) the elimination of a $16.9 million benefit realized in 2012 as a result of a change in the Company’s vacation policy; (iii) non-cash incentive compensation expense recorded directly beginning in the first quarter of 2013; and (iv) other adjustments required or permitted in calculating covenant compliance under our debt agreements.

 

  (k) Represents the cash cost for pre-publication investment during the period excluding discontinued operations.
  (l) Represents stand-alone cost savings to reflect our expectation that costs incurred on a stand-alone basis will be lower than costs historically allocated to McGraw-Hill Education, LLC by MHC. These allocations were primarily related to services and expenses including (i) global technology operations and infrastructure; (ii) global real estate occupancy; (iii) employee benefits; and (iv) shared services such as tax, legal, treasury, and finance.
  (m) Working capital from operations is defined as accounts receivable, net, inventories, net and prepaid and other current assets less accounts payable, accrued royalties, accrued compensation and other current liabilities.
(2) Working capital is calculated as current assets less current liabilities.
(3) Total debt is presented as long-term debt plus current portion of long-term debt. Total net debt is total debt less cash and cash equivalents.

 



 

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RISK FACTORS

You should carefully consider the risk factors set forth below, as well as the other information contained in this prospectus, before participating in our initial public offering. Any of the following risks could materially and adversely affect our business, financial condition or results of operations. In addition, the risks described below are not the only risks that we face. Additional risks and uncertainties not currently known to us or those that we currently view to be immaterial could also materially and adversely affect our business, financial condition or results of operations. In any such case, you may lose all or a part of your investment in our common stock.

Risks Related to Our Business

We face competition from both large, established industry participants and new market entrants, the risks of which are enhanced due to rapid changes in our industry and market.

Our competitors in the market for education products include a few large, established industry participants. Some established competitors have greater resources and less debt than us and, therefore, may be able to adapt more quickly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sale of their products than we can. In addition, the market shift toward digital education solutions has induced both established technology companies and new start-up companies to enter certain segments of our market. These new competitors have the possible advantage of not needing to transition from a print business to a digital business. The risks of competition are intensified due to the rapid changes in the products our competitors are offering, the products our customers are seeking and our sales and distribution channels, which create increased opportunities for significant shifts in market share. Competition may require us to reduce the price of our products or make additional capital investments or result in reductions in our market share and sales.

Our investments in new products and distribution channels may not be profitable.

In order to maintain a competitive position, we must continue to invest in new products and new ways to deliver them. This is particularly true in the current environment where investment in new technology is ongoing and there are rapid changes in the products our competitors are offering, the products our customers are seeking and our sales and distribution channels. In some cases, our investments will take the form of internal development; in others, they may take the form of an acquisition. Our investments in new products or distribution channels, whether by internal development or acquisition, may be less profitable than what we have experienced historically, may consume substantial financial resources and/or may divert management’s attention from existing operations, all of which could materially and adversely affect our business, results of operations and financial condition.

Our failure to win state adoptions could adversely affect our revenue.

A significant portion of our revenue is derived from sales of K-12 instructional materials pursuant to pre-determined adoption schedules. 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. For example, over the next few years, adoptions are scheduled in one or more of the primary subjects of reading, language arts and literature, social studies and mathematics in, among others, the states of California, Texas and Florida, which are the three largest adoption states. In each adoption decision for each state, we face significant competition. Our failure to do well in state adoptions could materially and adversely affect our sales revenue for the year of adoption and subsequent years.

Reductions in anticipated levels of federal, state and local education funding available for the purchase of instructional materials could adversely affect demand for our K-12 products.

Most public school districts, which are the primary customers for K-12 products and services, depend largely on state and local funding programs to purchase materials. In addition, many school districts also receive

 

23


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substantial funding through Federal education programs. State, local or federal funding available to school districts may be reduced as a result of reduced tax revenues, efforts to reduce government spending or increased allocation of tax revenues to other uses. In addition, changes in the laws or regulations that give school districts flexibility in their use of funds previously dedicated exclusively to the purchase of instructional materials may reduce the share of district funds allocated to the purchase of instructional materials. Reductions in the amount of funding provided to school districts or reductions in the portion of those funds allocated to instructional materials could reduce demand for our K-12 products.

Increased difficulty in predicting the timing of customer purchases may adversely affect us.

Traditionally, when the majority of products sold to customers in the higher education market consisted of print textbooks, the timing of purchases was predictable because of the long lead time to order and receive printed books before the start of the semester. As the higher education market has shifted to digital products, there has been a tendency for purchases to occur closer to the beginning of the semester since less lead time is required for the purchase of a digital product. There is no assurance that the trend to more digital purchases will continue, but given the current mix of digital versus print purchasing it has become more difficult to predict when the majority of customer purchases will occur. Similar timing uncertainty exists in the K-12 business as it transitions to digital. In addition, in the K-12 market there has been increased uncertainty regarding the timing of state adoption decisions, with last minute delays or cancellations attributable to school funding considerations occurring with increased frequency. In addition, whereas in the past most school districts purchased educational materials in state adoptions up-front, many are now choosing to spend on educational materials over a multi-year period, and in some cases school districts are choosing to use available funds to purchase hardware, software and other instructional aids that are not produced by us. Taken together, it has become increasingly difficult for us to forecast the timing of customer purchases, causing us to have to wait until later in the buying season in order to assess our financial performance. The change in ordering patterns may impact the comparison of results between a quarter and the same quarter of the previous year, between a quarter and the consecutive quarter or between a fiscal year and the prior fiscal year.

State changes to Common Core State Standards or delays in their implementation may adversely affect our K-12 business.

There is considerable political controversy in many states surrounding the adoption and implementation of Common Core State Standards. Legislation has been introduced in a number of states to drop Common Core State Standards, and some states are considering revisions to and/or rebranding of the standards. These developments could disrupt local adoptions of instructional materials and require modifications to our programs offered for sale in those states that adopt such changes, which may delay or impair sales of our products or cause us to incur additional product development costs.

A change from up-front payment by school districts for multi-year licenses could adversely affect our cash flow and results of operation.

In keeping with the past practice of payment for printed materials, school districts typically pay up-front when buying multi-year licenses for digital products. If school districts changed to spreading their payments to us over the term of the licenses, our cash flow and results of operation could be adversely affected.

Increased availability of free or relatively inexpensive products may reduce demand for or negatively impact the pricing of our products.

Free or relatively inexpensive educational products are becoming increasingly available, particularly in digital formats and through the internet. For example, some governmental and regulatory agencies have increased the amount of information they make publicly available for free. In addition, in recent years there have been initiatives by not-for-profit organizations such as the Gates Foundation and the Hewlett Foundation to develop

 

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educational content that can be “open sourced” and made available to educational institutions for free or nominal cost. The increased availability of free or relatively inexpensive educational products may reduce demand for our products or require us to reduce pricing, thereby impacting our sales revenue.

Increased customer expectations for lower prices or free bundled products could reduce sales revenues.

As the market has shifted to digital products, customer expectations for lower priced products has increased due to customer awareness of reductions in marginal production costs and the availability of free or low-cost digital content and products. As a result, there has been pressure to sell digital versions of products at prices below their print versions and an increase in the amount of products and materials given away as part of bundled packs. Increased customer demand for lower prices or free bundled products could reduce our sales revenue.

Operational disruptions, including failure of our hosting facilities and electronic delivery systems, could adversely affect our ability to serve our customers and cause financial loss and reputational damage.

We depend on complex operational and logistical arrangements across our business to provide our products to our customers. In particular, the provision of our online products depends on the capacity, reliability and security of our hosting and electronic delivery systems. We maintain a backup facility for some, but not all, of our online products, and failures of our hosting and delivery systems (whether as a result of operational failures, tampering or hacking, human error, natural disasters, computer viruses or other factors) could cause our online products to operate slowly, interrupt their availability or result in loss of data. The occurrence of such problems or other operational disruptions could result in liability, loss of revenue or harm to our reputation.

Failure to comply with privacy laws and/or a data security breach may cause financial loss and reputational damage.

Across our businesses we hold large volumes of personal data, including that of employees, customers and students. We have policies, processes, internal controls and cybersecurity mechanisms in place intended to ensure the stability of our information technology, provide security from unauthorized access to our systems and maintain business continuity; however, no mechanisms are entirely free from the risk of failure, and we have no guarantee that our security mechanisms will be adequate to prevent all possible security threats. Failure to adequately protect such personal data could lead to penalties, significant remediation costs, reputational damage, potential cancellation of existing contracts and an impaired ability to compete for future business.

We are subject to a wide array of different privacy laws, regulations and standards in the United States and in foreign jurisdictions where we conduct business, including but not limited to (i) the Children’s Online Privacy Protection Act and state student data privacy laws in connection with access to, collection of, and use of personally identifiable information of students, (ii) the Health Insurance Portability and Accountability Act in connection with our self-insured health plan, (iii) the Payment Card Industry Data Security Standards in connection with collection of credit card information from customers, and (iv) various EU data protection laws resulting from the EU Privacy Directive. Our failure to comply with applicable privacy laws, regulations and standards could lead to significant reputational damage and other penalties and costs, including loss of revenue.

Our brand and customer trust are critical assets for our Company. In the event of negative publicity regarding the Company’s adherence to applicable privacy laws, regulations, and standards—whether valid or not valid—the resulting reputational damage could reduce demand for our products and adversely affect our relationship with teachers, educators and institutions. This reaction may have an immediate and/or long term impact on both new and renewed sales, and may lead to short and/or long term revenue loss.

Defects in our digital products could cause financial loss and reputational damage.

In the fast-changing digital marketplace, demand for innovative technology has generally resulted in short lead times for producing products that meet customer specifications. Growing demand for innovation and

 

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additional functionality in digital products increases the risk that our products may contain flaws or corrupted data, and these defects may only become apparent after product launch, particularly for new products and new features to existing products that are developed and brought to market under tight time constraints. Problems with the performance of our digital products could result in liability, loss of revenue or harm to our reputation.

An increase in unauthorized copying and distribution of our products could adversely affect our sales and competitive position.

Our products contain intellectual property delivered through a variety of media, including digital and print. We rely on a combination of copyrights, trademarks, patents, trade secrets and nondisclosure agreements to protect our intellectual property and proprietary rights. As we and our industry transition from providing print content to providing digital content and as the copying and distribution of content over the Internet proliferates, the risk of piracy, illegal downloading, file-sharing or other infringements of our intellectual property is likely to increase. Although the copying and redistribution of our products are restricted by copyright and other intellectual property laws, license agreements with customers, and other means, unauthorized copying and redistribution of our products does occur and reduces our product sales. In addition, while we use digital rights management features to protect our digital solutions, no digital rights management system is foolproof, and all such systems are subject to unauthorized tampering or modification. Our efforts to protect our intellectual property and proprietary rights may not be sufficient and we cannot make assurances that our proprietary rights will not be challenged, invalidated or circumvented. If there is an increase in the scale of unauthorized copying and redistribution of our products, or if we are unable to adequately protect and enforce our intellectual property and proprietary rights, it would adversely impact our product sales and reduce our revenue, thereby adversely affecting our results of operations and financial condition, as well as our competitive position.

Factors that reduce enrollment at colleges and universities could adversely affect demand for our higher education products.

Enrollment in U.S. colleges and universities can be adversely affected by many factors, including changes in government and private student loan and grant programs, uncertainty about current and future economic conditions, general decreases in family income and net worth and a perception of uncertain job prospects for recent graduates. In addition, enrollment levels at colleges and universities outside the United States are influenced by the global and local economic climate, local political conditions and other factors that make predicting foreign enrollment levels difficult. Reductions in expected levels of enrollment at colleges and universities both within and outside the United States could adversely affect demand for our higher education products.

Growth of the used and rental book markets could adversely affect our sales of printed higher education and professional books.

Active markets exist for the sale by third parties of used copies of our printed higher education and professional books and the rental by third parties of copies of those books. The internet has made the used and rental book markets more efficient and has significantly increased customer access to used and rental books. Further expansion of the used and rental book markets could further adversely affect our sales of new printed higher education and professional books and reduce our revenue, adversely affecting our results of operations and financial condition.

We are dependent on third-party distributors, representatives and retailers for a substantial portion of our sales.

In addition to our own sales force, we offer our products through a variety of third-party distributors, representatives and retailers. We do not ultimately control the performance of our third-party distributors, representatives and retailers to perform as required or to our expectations. Also, certain of our distributors, representatives or retailers may market other products that compete with our products. The loss of one or more of

 

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our distributors, representatives or retailers or their failure to effectively promote our products or otherwise perform in their functions in the expected manner could adversely affect our ability to bring our products to market and impact our revenues.

A significant portion of our sales is concentrated on a small number of customers. Our profitability and financial results may be impaired if our customers’ demand for our products is reduced or if their financial condition were to deteriorate.

Some of our distribution and retail channels have recently experienced significant consolidation and concentration. This concentration could potentially place us at a disadvantage with respect to negotiations regarding pricing and other terms. In addition, this concentration increases the risk that the loss of, or problems with, a single distribution or retail partner could have significant effect on our sales or profitability. As of December 31, 2014 and 2013, our two largest retail customers comprised approximately 25% and 24% of our gross accounts receivable, respectively. The loss of or any reduction in sales or collections from a significant customer could harm our business and financial results.

We may not be able to retain or attract the key authors and talented personnel that we need to remain competitive and grow.

Our success depends, in part, on our ability to continue to attract and retain key authors and talented management, creative, editorial, technology, sales and other personnel. We operate in a number of highly visible industry segments where there is intense competition for successful authors and other experienced, highly effective individuals. Our successful operations in these segments may increase the market visibility of our authors and personnel and result in their recruitment by other businesses. There can be no assurance that we can continue to attract and retain key authors and talented personnel and, if we fail to do so, it could adversely affect our business.

We may not be able to reduce our costs related to print-related products as fast as revenues from those products decline.

As the portion of our business that consists of print-related products declines, our need for certain facilities and arrangements, such as printing and warehousing, also declines. Some of the costs related to these facilities and arrangements are relatively fixed over the short term and, as a result, may not decline as quickly as the related revenues. If our print-related costs do not decline proportionately with our print-related revenues, our results of operations and financial condition would be adversely affected.

The shift to sales of multi-year licenses may affect the comparability of our GAAP revenue to prior periods and cause increases or decreases in our sales to be reflected in our results of operation on a delayed basis.

As our business transitions from printed products to digital products, an increasing percentage of our revenues are derived from the sale of multi-year licenses. Our customers typically pay for both printed products and multi-year licenses up-front; however, we recognize revenue from multi-year licenses over their respective terms, as required by GAAP, even if we are paid in full at the beginning of the license. As a result, an increase in the portion of our sales coming from multi-year licenses may cause our GAAP revenue, when compared to prior periods, to not provide a truly comparable perspective of our performance. Another effect of recognizing revenue from multi-year licenses over their respective terms is that any increases or decreases in sales during a particular period do not translate into proportional increases or decreases in revenue during that period. Consequently, deteriorating sales activity may be less immediately observable in our results of operations.

Unexpectedly large returns could adversely affect our financial results.

We generally permit our distributors to return products they purchase from us. When we record revenue, we record an allowance for sales returns, which is based on the historical rate of return and current market

 

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conditions. Should the estimate of the allowance for sales returns vary by one percentage point from the estimate we use in recording our allowance, the impact on operating income would be approximately $2 million.

The high degree of seasonality of our business can create cash flow difficulties.

Our business is seasonal. Purchases of Higher Education products have traditionally been made in the third and fourth quarters for the semesters starting classes in September and January. Purchases of K-12 products are typically made in the second and third quarters of the calendar year for the beginning of the school year. In 2014, we realized approximately 23%, 40% and 23% of net sales during the second, third and fourth quarters, respectively, making third-quarter results particularly material to our full-year performance. This sales seasonality affects operating cash flow from quarter to quarter. There are months when we operate at a net cash deficit from our activities. We cannot make assurances that our third quarter net sales will continue to be sufficient to meet our obligations or that they will be higher than net sales for our other quarters. In the event that we do not derive sufficient net sales in the third quarter, we may not be able to meet our debt service requirements and other obligations.

Our substantial indebtedness restricts our ability to react to changes in the economy or our industry and exposes us to interest rate risk and risk of default.

We are a leveraged company that has substantial indebtedness. As of June 30, 2015, we had $2,223.6 million face value of outstanding indebtedness (in addition to $240.0 million of commitments under the MHGE Revolving Facility and $150.0 million of commitments under the MHSE Revolving Facility, none of which was drawn (without giving effect to letters of credit)), and for the year ended December 31, 2014, we had total debt service of $187.6 million (including approximately $78.5 million of debt service relating to fixed rate obligations). Our substantial indebtedness could have important consequences. For example, it could:

 

    limit our ability to borrow money for our working capital, capital expenditures, debt service requirements, strategic initiatives or other purposes;

 

    make it more difficult for us to satisfy our obligations with respect to our indebtedness;

 

    require us to dedicate a substantial portion of our cash flow from operations to the repayment of our indebtedness, thereby reducing funds available to us for other purposes;

 

    require us to repatriate funds to the United States at substantial cost;

 

    limit our flexibility in planning for, or reacting to, changes in our operations or business;

 

    make us more vulnerable to downturns in our business or the economy;

 

    restrict us from making strategic acquisitions, engaging in development activities, introducing new technologies or exploiting business opportunities;

 

    cause us to make non-strategic divestitures; or

 

    expose us to the risk of increased interest rates, as certain of our borrowings, including borrowings under the MHGE Facilities, MHSE Revolving Facility and MHSE Term Loan, are at variable rates of interest.

In addition, the agreements governing our indebtedness contain restrictive covenants that will limit our ability to engage in activities that may be in our long-term best interest. Our failure to comply with those covenants could result in an event of default which, if not cured or waived, could result in the acceleration of substantially all of our indebtedness.

Despite our substantial indebtedness, we may still be able to incur significantly more debt, which could intensify the risks described above.

We and our subsidiaries may be able to incur additional indebtedness in the future. For example, as of June 30, 2015, we had approximately $240.0 million available for additional borrowing under the MHGE

 

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Revolving Facility portion of the MHGE Facilities (without giving effect to letters of credit), all of which would be secured, and approximately $150.0 million available for additional borrowing under the MHSE Revolving Facility (without giving effect to letters of credit or limitations to availability as a result of the MHSE Revolving Facility borrowing base calculation). In addition, although the terms of the agreements governing our indebtedness contain restrictions on our and our subsidiaries’ ability to incur additional indebtedness, these restrictions are subject to a number of important qualifications and exceptions, and the indebtedness incurred in compliance with these restrictions could be substantial. Further, these restrictions will not prevent us from incurring obligations that do not constitute indebtedness. The more leveraged we become, the more we, and in turn our security holders, will be exposed to certain risks described above under “Our substantial indebtedness restricts our ability to react to changes in the economy or our industry and exposes us to interest rate risk and risk of default.”

We may record future goodwill or indefinite-lived intangibles impairment charges related to our reporting units, which could materially adversely impact our results of operations.

We test our goodwill and indefinite-lived intangibles asset balances for impairment during the fourth quarter of each year or more frequently if indicators are present or changes in circumstances suggest that impairment may exist. We assess goodwill for impairment at the reporting unit level and, in evaluating the potential for impairment of goodwill, we make assumptions regarding estimated net sales projections, growth rates, cash flows and discount rates. Although we use consistent methodologies in developing the assumptions and estimates underlying the fair value calculations used in our impairment tests, these estimates are uncertain by nature and can vary from actual results. Declines in the future performance and cash flows of the reporting unit or small changes in other key assumptions may result future goodwill impairment charges, which could materially adversely impact our results of operations.

Failure to develop or maintain an effective system of internal controls could lead to sanctions, reduce investor confidence in our financial reporting and lower the price of our common stock.

As a public company, we will be required to meet these standards in the course of preparing our consolidated financial statements. Any failure to develop or maintain effective internal controls, or difficulties encountered in implementing or improving our internal controls, could make it impossible for us to issue reliable financial reports, prevent fraud or operate successfully as a public company. Failure to comply with Section 404 of the Sarbanes-Oxley Act could potentially subject us to sanctions or investigations by the SEC, the Financial Industry Regulatory Authority or other regulatory authorities. Sanctions by regulatory authorities or disclosure of inadequacies in our internal controls could cause investors to lose confidence in our reported financial information, which would likely have a negative effect on the trading price of our common stock.

Our management determined that there was a material weakness in our historical revenue recognition policies and practices in our K-12 business.

During 2014 we identified a material weakness in our internal control over financial reporting. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected on a timely basis. This material weakness related to our historical revenue recognition accounting in our K-12 business for multi-element revenue agreements and associated recognition of costs during the following subsidiary financial reporting periods: (i) year ended December 31, 2012 (Predecessor), (ii) from January 1, 2013 to March 22, 2013 (Predecessor), and (iii) from March 23, 2013 to December 31, 2013 (Successor). As a result of this material weakness, we restated our previously issued subsidiary balance sheet as of December 31, 2013 and our subsidiary statement of operations and comprehensive income (loss), cash flows and statement of shareholders’ equity for each of the above periods. We appropriately accounted for multi-element revenue agreements and associated recognition of costs during 2014 and in the financial statements included in this prospectus.

 

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If we suffer additional deficiencies or material weaknesses in our internal controls in the future, we may be unable to report financial information in a timely and accurate manner and it could result in a material misstatement of our annual or interim financial statements that would not be prevented or detected on a timely basis, which could cause investors to lose confidence in our financial reporting, cause a default under the agreements governing our indebtedness and/or have a negative effect on the trading price of our common stock.

Our ability to protect our intellectual property rights could impact our competitive position.

Our products contain intellectual property delivered through a variety of media, including digital and print. We rely on a combination of copyrights, trademarks, patents, trade secrets and nondisclosure agreements to protect our intellectual property and proprietary rights. However, our efforts to protect our intellectual property and proprietary rights may not be sufficient and we cannot make assurances that our proprietary rights will not be challenged, invalidated or circumvented. We may also be required to initiate expensive and time-consuming litigation to maintain, defend or enforce our intellectual property. Moreover, despite the existence of copyright and trademark protection under applicable laws, third parties may nonetheless violate our intellectual property rights, and our ability to remedy such violations, particularly in foreign countries, may be limited. In addition, the copying and distribution of content over the Internet creates additional challenges for us in protecting our proprietary rights. If we are unable to adequately protect and enforce our intellectual property and proprietary rights, our competitive position may be harmed and our business and financial results could be materially and adversely affected.

Legal actions against us, including intellectual property infringement claims, could be costly to defend and could result in significant damages.

In the ordinary course of business, we are occasionally involved in legal actions and claims against us arising from our business operations and therefore expect that we will likely be subject to additional actions and claims against us in the future. Litigation alleging infringement of copyrights and other intellectual property rights. particularly in relation to proprietary photographs and images, has become extensive in the educational publishing industry. At present, there are various suits pending or threatened which claim that we exceeded the print run limitation or other restrictions in licenses granted to us to reproduce photographs in our instructional materials. A number of similar claims against us have already been settled. A number of our competitors are defendants in similar lawsuits. We have liability insurance in such amounts and with such coverage and deductibles as management believes is reasonable. However, there can be no assurance that our liability insurance will cover all of our damages or that the limits of coverage will be sufficient to fully cover all potential liabilities and costs of litigation. While management does not expect any of the claims currently pending or threatened against us to have a material adverse effect on our results of operations, financial position or cash flows, due to the inherent uncertainty of the litigation process, the resolution of any particular legal proceeding or change in applicable legal standards could have a meaningful adverse effect on our financial position and results of operations.

We face risks of doing business abroad.

As we continue to invest in and expand our overseas business, we face increased exposure to the risks of doing business abroad, including, but not limited to:

 

    lack of local knowledge or acceptance of our products and services;

 

    entrenched competitors;

 

    the need to adapt our products to meet local requirements;

 

    longer customer payment cycles in certain countries;

 

    limitations on the ability to repatriate funds to the United States;

 

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    difficulties in protecting intellectual property, enforcing agreements and collecting receivables under certain foreign legal systems;

 

    compliance under the U.S. Foreign Corrupt Practices Act, the U.K. Bribery Act and other anti-corruption laws;

 

    the need to comply with local laws and regulations generally; and

 

    in some countries, a higher risk of political instability, economic volatility, terrorism, corruption, social and ethnic unrest.

Fluctuations between foreign currencies and the U.S. dollar could adversely affect our financial results.

We derived approximately 18% of our total revenue in the year ended December 31, 2014 from our international sales operations. The financial position and results of operations of our international operations are primarily measured using the foreign currency in the jurisdiction of operation of such business as the functional currency. As a result, we are exposed to currency fluctuations both in receiving cash from our international operations and in translating our financial results into U.S. dollars. For example, foreign exchange rates had an unfavorable impact on our revenue of $6.4 million for the year ended December 31, 2014. We have operations in various foreign countries where the functional currency is primarily the local currency. For international operations that are determined to be extensions of the parent company, the U.S. dollar is the functional currency. Our principal currency exposures relate to the Australian Dollar, British Pound, Canadian Dollar, Euro, Mexican Peso and Singapore Dollar. Assets and liabilities of our international operations are translated at the exchange rate in effect at each balance sheet date. Our income statement accounts are translated at the average rate of exchange during the period. A strengthening of the U.S. dollar against the relevant foreign currency reduces the amount of income we recognize from our international operations. In addition, certain of our international operations generate revenues in the applicable local currency or in currencies other than the U.S. dollar, but purchase inventory and incur costs primarily in U.S. dollars. While, from time to time, we may enter into hedging arrangements with respect to foreign currency exposures, variations in exchange rates may adversely impact our results of operations and profitability. The risks we face in foreign currency transactions and translation may continue to increase as we further develop and expand our international operations.

We are dependent on third-parties for the performance of many critical operational functions.

We rely on third-parties for many critical operational functions, including general financial shared services, accounts payable, accounts receivable, royalty processing, printing, warehousing, distribution, technology support, online product hosting and certain customer support functions. Since those functions are provided by third parties, our ability to supervise and support the performance of those functions is limited. The loss of one or more of these third-party partners, a material disruption in their business or their failure to otherwise perform their functions in the expected manner could cause disruptions in our business that would adversely affect our results of operations and financial condition.

A significant increase in operating costs and expenses could have a material adverse effect on our profitability.

Our major operating expenses include employee compensation, paper, technology and third-party provider fees and royalties. Any material increase in these or other operating costs and expenses that we are not able to pass on in the cost of our products and services could adversely affect our results of operations and financial condition.

We may not be able to continue to achieve cost savings in our operations.

We have achieved significant cost savings since we became an independent company in 2013. While we have additional cost saving initiatives planned and underway, it is likely that we will not be able to continue to achieve levels of cost savings that are similar to those we have achieved in the past. In addition, any cost savings

 

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that we realize from such efforts may differ materially from our estimates. We cannot assure you that these initiatives will be completed as anticipated or that the benefits we expect will be achieved on a timely basis or if they will be achieved at all. If we are unable to continue to reduce costs as expected, or at all, our competitive position and results of operations could be materially adversely affected.

Risks Related to this Offering and Ownership of Our Common Stock

We are a “controlled company” within the meaning of             rules and, as a result, qualify for and intend to rely on exemptions from certain corporate governance requirements.

Following this offering, Apollo will continue to control a majority of the voting power of our outstanding voting stock, and as a result we will be a controlled company within the meaning of the             ’s corporate governance standards. Under             rules, a company of which more than 50% of the voting power is held by another person or group of persons acting together is a controlled company and may elect not to comply with certain corporate governance requirements, including the requirements that:

 

    a majority of the board of directors consist of independent directors;

 

    the nominating and corporate governance committee be composed entirely of independent directors with a written charter addressing the committee’s purpose and responsibilities;

 

    the compensation committee be composed entirely of independent directors with a written charter addressing the committee’s purpose and responsibilities; and

 

    there be an annual performance evaluation of the nominating and governance and compensation committees.

These requirements will not apply to us as long as we remain a controlled company. Accordingly, you may not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of the             .

We continue to be controlled by Apollo, and Apollo’s interests may conflict with our interests and the interests of other stockholders.

Following this offering, Apollo will own     % of our common equity. In addition, representatives of Apollo comprise a majority of our directors. As a result, Apollo can control our ability to enter into significant corporate transactions such as mergers, tender offers and the sale of all or substantially all of our assets. The interests of Apollo and its affiliates could conflict with or differ from our interests or the interests of our other stockholders. For example, the concentration of ownership held by Apollo could delay, defer or prevent a change of control of our company or impede a merger, takeover or other business combination which may otherwise be favorable for us. Additionally, Apollo is 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 us. Apollo may also pursue acquisition opportunities that may be complementary to our business, and as a result, those acquisition opportunities may not be available to us. So long as Apollo continues to indirectly, own a significant amount of our equity, even if such amount is less than 50%, they will continue to be able to substantially influence or effectively control our ability to enter into corporate transactions.

Our amended and restated certificate of incorporation contains a provision renouncing our interest and expectancy in certain corporate opportunities.

Our amended and restated certificate of incorporation provides for the allocation of certain corporate opportunities between us and Apollo. Under these provisions, neither Apollo, its portfolio companies, funds or other affiliates, nor any of their officers, directors, agents, stockholders, members or partners will have any duty to refrain from engaging, directly or indirectly, in the same business activities, similar business activities or lines

 

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of business in which we operate. For instance, a director of our company who also serves as a director, officer or employee of Apollo or any of its portfolio companies, funds or other affiliates may pursue certain acquisitions or other opportunities that may be complementary to our business and, as a result, such acquisition or other opportunities may not be available to us. These potential conflicts of interest could have a material adverse effect on our business, financial condition, results of operations or prospects if attractive corporate opportunities are allocated by Apollo to itself or its portfolio companies, funds or other affiliates instead of to us. The terms of our amended and restated certificate of incorporation are more fully described in “Description of Capital Stock.”

Provisions in our organization documents and Delaware law may discourage our acquisition by a third party.

Our second amended and restated certificate of incorporation will authorize our board of directors to issue preferred stock without stockholder approval. If our Board of Directors elects to issue preferred stock, it could be more difficult for a third party to acquire us. In addition, some provisions of our amended and restated certificate of incorporation and amended and restated by-laws could make it more difficult for a third party to acquire control of us, even if the change of control would be beneficial to our stockholders.

Section 203 of the General Corporation Law of the State of Delaware (the “DGCL”) may affect the ability of an “interested stockholder” to engage in certain business combinations, for a period of three years following the time that the stockholder becomes an “interested stockholder.” We have elected in our amended and restated certificate of incorporation not to be subject to Section 203 of the DGCL. Nevertheless, our amended and restated certificate of incorporation will contain provisions that have the same effect as Section 203 of the DGCL, except that it will provide that affiliates of Apollo and their transferees will not be deemed to be “interested stockholders,” regardless of the percentage of our voting stock owned by them, and will therefore not be subject to such restrictions. These charter provisions may limit the ability of third parties to acquire control of our company.

Investors in this offering will experience immediate and substantial dilution of $         per share.

Based on an assumed initial public offering price of $         per share (the midpoint of the range set forth on the cover of this prospectus), purchasers of our common stock in this offering will experience an immediate and substantial dilution of $         per share in the as adjusted net tangible book value per share of common stock from the initial public offering price, and our as adjusted net tangible book value as of June 30, 2015 after giving effect to this offering would be $             per share. This dilution is due in large part to earlier investors having paid substantially less than the initial public offering price when they purchased their shares. Please see “Dilution.”

The sale of restricted shares of our common stock in the public market could reduce our stock price.

After the completion of this offering, we will have             outstanding shares of common stock. This number includes             shares that we are selling in this offering, which may be resold immediately in the public market. The number of outstanding shares of common stock also includes             shares, including shares controlled by Apollo, that are “restricted securities,” as defined under Rule 144 under the Securities Act, and eligible for sale in the public market subject to the requirements of Rule 144, all of which subject to the lock-up agreements with the underwriters described in “Underwriting,” but may be sold into the market following the expiration of such lock-up agreements beginning             days after the date of this prospectus or if the underwriters waive those agreements. Sales of significant amounts of restricted stock in the public market could adversely affect prevailing market prices of our common stock.

We may not pay dividends on our common stock.

As a holding company, our ability to pay dividends in the future depends on our subsidiaries’ making upstream distributions to us. There is no assurance that our subsidiaries will generate sufficient net income and cash flows to allow them to do so. Our subsidiaries’ ability to make distributions to us is also restricted by

 

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covenants in their debt instruments. As of June 30, 2015, the maximum amount MHGE would be permitted to distribute to us in compliance with its indebtedness was approximately $         million, and the maximum amount MHSE would be permitted to distribute to us in compliance with its indebtedness was approximately $         million, for an aggregate of $         million, distributable to us by MHGE and MHSE. Moreover, our subsidiaries are separate legal entities, and although they may be wholly owned or controlled by us, they have no obligation to make any funds available to us, whether in the form of loans, dividends or otherwise. Even if our subsidiaries are able and willing to distribute funds to us, we have no obligation to have them to do so and we have no obligation to declare a dividend if we have received funds that enable us to do so. The fact that we have paid dividends in the past is no assurance we will pay the same level of dividends, or any dividends at all, in the future.

The requirements of being a public company may increase our costs, divert management’s attention, and affect our ability to attract and retain qualified board members.

We will incur significant additional expenses as a result of having publicly traded common stock, including, but not limited to, increased costs related to auditor fees, legal fees, directors’ fees, directors and officers insurance, investor relations and various other costs. Moreover, the additional demands associated with being a public company may disrupt regular operations of our business by diverting the attention of some of our senior management team away from revenue producing activities. Being a public company could make it more difficult for us to attract and retain qualified persons to serve on our Board of Directors or as executive officers.

There can be no assurance that a viable public market for our common stock will develop.

Prior to this offering, our common stock was not traded on any market. An active, liquid and orderly trading market for our common stock may not develop or be maintained after this offering. Active, liquid and orderly trading markets usually result in less price volatility and more efficiency in carrying out investors’ purchase and sale orders. We cannot predict the extent to which investor interest in our common stock will lead to the development of an active trading market on the             or otherwise or how liquid that market might become. If an active public market for our common stock does not develop, or is not sustained, it may be difficult for you to sell your shares at a price that is attractive to you or at all.

The initial public offering price of our common stock may not be indicative of the market price of our common stock after this offering.

The initial public offering price was determined by negotiations between us and representatives of the underwriters, based on numerous factors which we discuss in “Underwriting,” and may not be indicative of the market price of our common stock after this offering. If you purchase our common stock, you may not be able to resell those shares at or above the initial public offering price.

Our stock price may be volatile.

The market price of our common stock could vary significantly as a result of a number of factors, some of which are beyond our control. In the event of a drop in the market price of our common stock, you could lose a substantial part or all of your investment in our common stock. The following factors could affect our stock price:

 

    our operating and financial performance,

 

    quarterly variations in the rate of growth (if any) of our financial indicators, such as net income per share, net income and revenues,

 

    the public reaction to our press releases, our other public announcements and our filings with the SEC,

 

    strategic actions by our competitors,

 

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    changes in operating performance and the stock market valuations of other companies,

 

    announcements related to litigation,

 

    our failure to meet revenue or earnings estimates made by research analysts or other investors,

 

    changes in the credit ratings of our debt,

 

    changes in revenue or earnings estimates, or changes in recommendations or withdrawal of research coverage, by equity research analysts,

 

    speculation in the press or investment community,

 

    sales of our common stock by us or our stockholders, or the perception that such sales may occur,

 

    changes in accounting principles, policies, guidance, interpretations or standards,

 

    additions or departures of key management personnel,

 

    actions by our stockholders,

 

    general market conditions,

 

    domestic and international economic, legal and regulatory factors unrelated to our performance, and

 

    the realization of any risks described under this “Risk Factors” section, or other risks that may materialize in the future.

The stock markets in general have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of our common stock. Securities class action litigation has often been instituted against companies following periods of volatility in the overall market and in the market price of a company’s securities. Such litigation, if instituted against us, could result in very substantial costs, divert our management’s attention and resources and harm our business, operating results and financial condition.

If securities or industry analysts do not publish research or reports about our business or publish negative reports, our stock price could decline.

The trading market for our common stock will be influenced by the research and reports that industry or securities analysts publish about us or our business. If one or more of these analysts cease coverage of our company or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline. Moreover, if one or more of the analysts who cover our company downgrades our common stock or if our operating results do not meet their expectations, our stock price could decline.

The issuance by us of additional shares of common stock or convertible securities may dilute your ownership of us and could adversely affect our stock price.

In connection with this offering, we intend to file a registration statement with the SEC on Form S-8 providing for the registration of         shares of our common stock issued or reserved for issuance under our long-term incentive plan. Subject to the satisfaction of vesting conditions and the expiration of lock-up agreements,             shares registered under the registration statement on Form S-8 will be available for resale immediately in the public market without restriction. From time to time in the future, we may also issue additional shares of our common stock or securities convertible into common stock pursuant to a variety of transactions, including acquisitions. The issuance by us of additional shares of our common stock or securities convertible into our common stock would dilute your ownership of us and the sale of a significant amount of such shares in the public market could adversely affect prevailing market prices of our common stock.

 

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We may issue preferred stock whose terms could adversely affect the voting power or value of our common stock.

Our amended and restated certificate of incorporation authorizes us to issue, without the approval of our stockholders, one or more classes or series of preferred stock having such designations, preferences, limitations and relative rights, including preferences over our common stock respecting dividends and distributions, as our board of directors may determine. The terms of one or more classes or series of preferred stock could adversely impact the voting power or value of our common stock. For example, we might grant holders of preferred stock the right to elect some number of our directors in all events or on the happening of specified events or the right to veto specified transactions. Similarly, the repurchase or redemption rights or liquidation preferences we might assign to holders of preferred stock could affect the residual value of the common stock.

Our designation of the Delaware Court of Chancery as the exclusive forum for certain types of stockholder legal proceedings could limit our stockholders’ ability to obtain a more favorable forum.

Our amended and restated certificate of incorporation will provide that unless we consent in writing to the selection of an alternative forum, the Court of Chancery of the State of Delaware will, to the fullest extent permitted by applicable law, be the sole and exclusive forum for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers, employees or agents to us or our stockholders, (iii) any action asserting a claim arising pursuant to any provision of the DGCL, our amended and restated certificate of incorporation or our by-laws or (iv) any action asserting a claim against us that is governed by the internal affairs doctrine, in each such case subject to such Court of Chancery having personal jurisdiction over the indispensable parties named as defendants therein. Any person or entity purchasing or otherwise acquiring any interest in shares of our capital stock will be deemed to have notice of, and consented to, the provisions of our amended and restated certificate of incorporation described in the preceding sentence. This choice of forum provision may limit a stockholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with us or our directors, officers, employees or agents, which may discourage such lawsuits against us and such persons.

Alternatively, if our exclusive forum provision is not enforceable, we may be subject to additional costs that we do not currently anticipate.

Alternatively, if a court were to find these provisions of our amended and restated certificate of incorporation inapplicable to, or unenforceable in respect of, one or more of the specified types of actions or proceedings, we may incur additional costs that we do not currently anticipate associated with resolving such matters in other jurisdictions, which could adversely affect our business, financial condition or results of operations.

 

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DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements, including without limitation statements relating to our businesses and our prospects, new products, sales, expenses, tax rates, cash flows, plate investment and operating and capital requirements. These forward-looking statements are intended to provide management’s current expectations or plans for our future operating and financial performance and are based on assumptions management believes are reasonable at the time they are made.

Forward-looking statements can be identified by the use of words such as “believe,” “expect,” “plan,” “estimate,” “project,” “target,” “anticipate,” “intend,” “may,” “will,” “continue,” “should” and other words of similar meaning in connection with a discussion of future operating or financial performance. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict; therefore, actual outcomes and results could differ materially from what is expected or forecasted. These risks and uncertainties include, among others:

 

    competition in our existing and future lines of business and the financial resources of competitors;

 

    the rapidly changing nature of and technological advancements in the education market;

 

    the level of success of new product development, global expansion, and strength of domestic and international markets;

 

    changes in government programs, laws or payment systems;

 

    the availability of free or relatively inexpensive educational information and materials;

 

    operational disruptions and failures in our information technology or electronic delivery systems;

 

    failure to comply with privacy laws and defects in, or security breaches relating to, our data security system or digital products;

 

    piracy, unauthorized copying, file-sharing, or other infringements on or claims against our intellectual property, including our digital content;

 

    enrollment and demographic trends;

 

    competition from used and rental markets for books and educational materials;

 

    the ability of our suppliers, distributors or service providers to meet their commitments to us, or the timing of purchases by our current and potential customers, and other general economic and business conditions;

 

    the loss of, or default by, one or more key customers;

 

    failure to retain or continue to attract senior management, key authors or skilled personnel;

 

    manufacturing, distribution, plate investment, amortization, depreciation, capital, technology, and other expenses related to our operations;

 

    the level of future cash flows;

 

    risks related to our substantial indebtedness;

 

    risks inherent in operating in foreign countries, including the impact of economic, political, legal, regulatory, compliance, cultural, foreign currency fluctuations and other conditions abroad.

 

    fluctuations between foreign currencies and the U.S. dollar;

 

    the uncertain economic climate in the U.S. and abroad or deterioration in the economy and its impact on the markets in general;

 

    adverse developments in general business, economic and political conditions or any outbreak or escalation of hostilities on a national, regional or international basis;

 

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    the health of debt and equity markets, including credit quality and spreads, the level of liquidity and future debt issuances;

 

    the state of the credit markets and regulatory environment and their impact on us and the economy in general;

 

    fluctuations in our operating results, unanticipated delays or accelerations in our sales cycles and the difficulty of accurately estimating revenues;

 

    income tax rates; and

 

    future legislative and regulatory developments, including any change in the integration or enforcement of existing laws or regulations.

You should consider the areas of risk described above, as well as those set forth in the section entitled “Risk Factors” in connection with considering any forward-looking statements that may be made by us and our businesses generally. We cannot assure you that projected results or events reflected in the forward-looking statements will be achieved or occur. The forward-looking statements included in this prospectus are made as of the date of this prospectus. We undertake no obligation to publicly release any revisions to any forward-looking statements, to report events or to report the occurrence of unanticipated events, except as otherwise required by law.

 

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USE OF PROCEEDS

We expect to receive approximately $         of net proceeds (based upon the assumed initial public offering price of $         per share, the midpoint of the range set forth on the cover page of this prospectus) from the sale of the common stock offered by us, after deducting underwriting discounts and commissions and estimated offering expenses payable by us. Each $1.00 increase (decrease) in the public offering would increase (decrease) our net proceeds by approximately $         million.

We intend to use approximately $         million of the net proceeds from this offering to pay related fees and expenses. The remaining net proceeds will be used for general corporate purposes.

 

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DIVIDEND POLICY

We currently intend to retain all future earnings, if any, for use in the operation of our business and to fund future growth. The decision whether to pay dividends in the future will be at the sole discretion of our board of directors after taking into account various factors, including legal requirements, our subsidiaries’ ability to make payments to us, our financial condition, operating results, cash flow from operating activities, available cash, business opportunities, restrictions in our debt agreements and other contracts, current and anticipated cash needs and other factors our board of directors deems relevant.

We are a holding company and have no direct operations. We will only be able to pay dividends from our available cash on hand and funds received from our subsidiaries. Their ability to make any payments to us will depend upon many factors, including our operating results, cash flows and the terms of the MHGE Facilities, the MHSE Revolving Facility, the MHSE Term Loan and the indentures governing the MHGE Senior Secured Notes and the MHGE PIK Toggle Notes. In addition, our ability to pay dividends on our common stock may be limited by restrictions on the ability of our subsidiaries and us to pay dividends and make distributions under the terms of our future indebtedness. Although we have sustained net losses in prior periods and cannot assure you that we will be able to pay dividends on a quarterly basis or at all, we believe that a number of recent positive developments in our business have improved our ability to pay dividends in compliance with applicable state corporate law once this offering has been completed. Also, because the DGCL permits corporations to pay dividends either out of surplus (generally, the excess of a corporation’s net assets (total assets minus total liabilities) over its stated capital, in each case as defined and calculated in the manner prescribed by the DGCL) or net profits, we may be able to pay dividends even if we report net losses in future periods.

The maximum amount that can be distributed to us by our subsidiaries for the purpose of paying dividends in compliance with the terms of our subsidiaries’ indebtedness was approximately $         million as of June 30, 2015 (assuming the number of shares offered by us are sold at the midpoint of the range set forth on the front cover of this prospectus).

 

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CAPITALIZATION

The following table sets forth our capitalization as of June 30, 2015:

 

    on an actual basis; and

 

    as adjusted to give effect to this offering and the use of proceeds therefrom as set forth under “Use of Proceeds.”

 

     As of June 30, 2015  
     Actual     As Adjusted  
     (in thousands,
except per share
and par value)
 

Cash and cash equivalents

   $ 79,435      $                
  

 

 

   

 

 

 

Long-term debt, including current maturities

    

MHGE Revolving Facility(1)

   $ —        $ —     

MHGE Term Loan(1)

     661,847     

MHGE Senior Secured Notes(2)

     791,334     

MHGE PIK Toggle Notes(3)

     496,029     

MHSE Revolving Facility(4)

     —       

MHSE Term Loan(4)

     244,391     
  

 

 

   

 

 

 

Total indebtedness, including current portion

   $ 2,193,601      $     

Stockholders’ equity (deficit):

    

Preferred stock, $0.01 par value; 1,000,000 shares authorized, 100,000 shares issued and 75,000 outstanding

     —       

Common stock—$0.01 par value; 100,000,000 shares authorized, 10,429,246 shares issued and 10,425,658 outstanding, actual;              shares authorized,              shares issued and outstanding, as adjusted

     201     

Additional paid-in capital

     62,455     

Treasury stock, 3,588 shares as of June 30, 2015

     (610  

Accumulated other comprehensive income (loss)

     (40,033  

Accumulated deficit

     (756,624  
  

 

 

   

 

 

 

Total stockholders’ equity (deficit)

     (734,611  
  

 

 

   

 

 

 

Total capitalization

   $ 1,458,990      $     
  

 

 

   

 

 

 

 

(1) As of June 30, 2015, the $240.0 million MHGE Revolving Facility had no borrowings outstanding. As of June 30, 2015, there were $661.8 million of loans outstanding under the MHGE Term Loan ($677.3 million face value less unamortized discount), which reflects a $81.0 million voluntary prepayment on December 31, 2013, a $35.0 million voluntary prepayment in connection with the repricing transaction that closed on March 24, 2014 and a $0.3 million voluntary prepayment in connection with the repricing transaction that closed on May 4, 2015. MHGE Intermediate Holdings, LLC guarantees the MHGE Facilities, and all of the material wholly owned domestic subsidiaries of MHGE Holdings have pledged their assets to secure the MHGE Facilities.
(2) MHGE Senior Secured Notes are presented at $791.3 million ($800.0 million face value less unamortized discount).
(3) MHGE PIK Toggle Notes are presented at $496.0 million ($500.0 million face value less unamortized discount).
(4) As of June 30, 2015, the $150.0 million MHSE Revolving Facility had no borrowings outstanding and $10 million in letters of credit outstanding and availability is subject to limitations of its borrowing base calculations. As of June 30, 2015, there were $244.4 million of loans outstanding under the MHSE Term Loan Facility ($246.3 million face value less unamortized discount).

 

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DILUTION

Purchasers of the common stock in this offering will experience immediate and substantial dilution to the extent of the difference between the initial public offering price per share of our common stock and the as adjusted net tangible book value per share of the common stock after this offering for accounting purposes. Dilution results from the fact that the per share offering price of our common stock is in excess of the net tangible book value per share attributable to new investors.

Historical net tangible book value as of                     , 2015 before this offering was $             per share and represents the amount of our total tangible assets (total assets less total intangible assets) less total liabilities, divided by the number of shares of common stock issued and outstanding. Assuming an initial public offering price of $             per share (which is the midpoint of the range set forth on the cover page of this prospectus), after giving effect to the sale of the shares in this offering and further assuming the receipt and application of the estimated net proceeds (after deducting estimated underwriting discounts and commissions and estimated offering expenses), our as adjusted net tangible book value as of                     , 2015 would have been approximately $             million, or $             per share. This represents an immediate increase in the net tangible book value of $             per share to our existing stockholders and an immediate dilution (i.e., the difference between the offering price and the as adjusted net tangible book value after this offering) to new investors purchasing shares in this offering of $             per share. The following table illustrates the per share dilution to new investors purchasing shares in this offering:

 

Assumed initial public offering price per share

      $                

Net tangible book value per share as of                     , 2015 before this offering

   $                   

Increase per share attributable to new investors in this offering

     
  

 

 

    

As adjusted net tangible book value per share after giving effect to this offering

     
     

 

 

 

Dilution in net tangible book value per share to new investors in this offering

      $     
     

 

 

 

A $1.00 increase (decrease) in the assumed initial public offering price of $             per share, which is the midpoint of the range set forth on the cover page of this prospectus, would increase (decrease) our as adjusted net tangible book value per share after the offering by $             and increase (decrease) the dilution to new investors in this offering by $             per share, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same, after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us.

If the underwriters were to fully exercise their option to purchase additional shares of our common stock, the as adjusted tangible book value per share as of                     , 2015 would be $             per share, and the dilution in net tangible book value per share to new investors in this offering would be $             per share.

The following table summarizes, on an adjusted basis as of                     , 2015, the total number of shares of common stock owned by existing stockholders and to be owned by new investors, the total consideration paid, and the average price per share paid by our existing stockholders and to be paid by new investors in this offering at the assumed initial public offering price of $             per share, calculated before deduction of estimated underwriting discounts and commissions:

 

     Shares Purchased     Total Consideration     Average
Price

per Share
 
     Number    Percent     Amount      Percent    

Existing stockholders

               $                             $                

Investors in the offering

                          
  

 

  

 

 

   

 

 

    

 

 

   

 

 

 

Total

        100   $           100   $     
  

 

  

 

 

   

 

 

    

 

 

   

 

 

 

 

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If the underwriters were to fully exercise their option to purchase              additional shares of our common stock, the percentage of common stock held by existing investors would be     %, and the percentage of shares of common stock held by new investors would be     %.

The information above excludes              shares of common stock reserved for issuance under our management equity plan. As of                     , 2015 there were a total of              shares of common stock underlying outstanding stock options issued under the management equity plan.

In addition, we may choose to raise additional capital due to market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. To the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of such securities could result in further dilution to our stockholders.

 

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SELECTED HISTORICAL COMBINED CONSOLIDATED FINANCIAL DATA

The following table presents our selected historical combined consolidated financial data and operating results. The combined statement of operations for the years ended December 31, 2011 and 2010 and the selected combined balance sheet data as of December 31, 2012 and 2011 have been derived from our audited combined financial statements of our Predecessor which are not included in this prospectus. The combined statement of operations for the year ended December 31, 2012 and the period from January 1, 2013 to March 22, 2013 is derived from our audited combined financial statements of our Predecessor included elsewhere in this prospectus. The consolidated statement of operations for the year ended December 31, 2014 and the period March 23, 2013 to December 31, 2013 and the selected consolidated balance sheet data as of December 31, 2014 and 2013 have been derived from the audited consolidated financial statements of the Company (Successor) included elsewhere in this prospectus. The selected consolidated balance sheet data as of June 30, 2014 has been derived from the unaudited consolidated financial statements of the Company (Successor), which are not included elsewhere in this prospectus. The selected combined balance sheet data as of December 31, 2012 have been derived from the unaudited combined financial statements of our Predecessor, which are not included in this prospectus. The consolidated statement of operations for the six months ended June 30, 2014 and 2015 and the selected consolidated balance sheet data as of June 30, 2015 have been derived from the unaudited consolidated financial statements of the Company (Successor) included elsewhere in this prospectus.

 

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The selected historical combined consolidated financial data and operating results presented below should be read in conjunction with our audited and unaudited combined consolidated financial statements and accompanying notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus. Our historical combined consolidated financial information may not be indicative of our future performance and does not necessarily reflect what our financial position and results of operations would have been had we operated as a separate, stand-alone entity during the periods presented, including changes that occurred in our operations and capitalization as a result of the Founding Acquisition.

 

    Successor     Predecessor  
(Dollars in thousands except per
share amounts)
  Six Months
Ended
June 30,
    Six Months
Ended
June 30,
    Year
Ended
December 31,
    March 23
to
December 31,
    January 1 to
March 22,
    Year Ended
December 31,
 
  2015     2014     2014     2013     2013     2012     2011     2010  

Statements of Operations

                 

Revenue

  $ 670,143      $ 679,080      $ 1,855,779      $ 1,589,574      $ 229,441      $ 1,917,599      $ 2,072,735      $ 2,261,840   

Cost of sales

    188,536        222,186        533,913        777,384        64,006        541,306        598,044        665,652   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross Profit

    481,607        456,894        1,321,866        812,190        165,435        1,376,293        1,474,691        1,596,188   

Operating expenses:

                 

Operating & administration expenses

    525,136        552,388        1,194,656        841,652        208,816        1,224,126        1,275,058        1,259,744   

Depreciation

    13,945        14,523        22,086        23,538        5,817        28,083        25,149        27,406   

Amortization of intangibles

    47,104        57,277        104,157        69,181        6,326        25,130        24,933        22,264   

Impairment charge

    —          —          23,800        —          —          412,886        —          —     

Transaction costs

    —          3,421        3,932        56,820        —          —          —          —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

    586,185        627,609        1,348,631        991,191        220,959        1,690,225        1,325,140        1,309,414   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating (loss) income

    (104,578     (170,715     (26,765     (179,001     (55,524     (313,932     149,551        286,774   

Interest expense (income), net

    96,765        89,626        181,890        137,283        488        (1,688     (4,205     (1,088

Other (income) expense

    (4,779     (7,329     (8,420     —          —          (16,868     —          —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

(Loss) Income from operations before taxes on income

    (196,564     (253,012     (200,235     (316,284     (56,012     (295,376     153,756        287,862   

Income tax (benefit) provision act

    (2,527     (108,582     112,571        (130,158     (20,410     (19,704     52,029        101,337   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income from continuing operations

    (194,037     (144,430     (312,806     (186,126     (35,602     (275,672     101,726        186,525   

Net (loss) income from discontinued operations, net of taxes

    (62,163     10,680        (18,157     18,617        4,058        23,897        24,543        20,900   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income

    (256,200     (133,750     (330,963     (167,509     (31,544     (251,775     126,269        207,425   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Less: net (income) loss attributable to non-controlling interests

    —          299        299        (2,251     631        (4,559     (4,320     (4,482
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income attributable to McGraw-Hill Education, Inc.

  $ (256,200   $ (133,451   $ (330,664   $ (169,760   $ (30,913   $ (256,334   $ 121,949      $ 202,943   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income per share from continuing operations—basic and diluted

  $ (18.47   $ (13.93   $ (30.09   $ (18.74   $ (3.50   $ (28.02   $ 9.74      $ 18.20   

Weighted average shares outstanding—basic and diluted

  $ 10,505      $ 10,345      $ 10,387      $ 10,051      $ 10,000      $ 10,000      $ 10,000      $ 10,000   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
               
    Successor     Predecessor  
    Six Months
Ended
June 30,

2015
    Six Months
Ended
June 30,

2014
    Year
Ended
December 31,

2014
    March 23
to
December 31,

2013
    January 1 to
March 22,

2013
    Year Ended
December 31,
 
(Dollars in thousands)             2012     2011     2010  

Other Financial Data

                 

Adjusted Revenue(1)

  $ 710,621      $ 691,283      $ 2,034,838      $ 1,758,299      $ 212,137      $ 1,978,112      $ 2,164,218      $ 2,297,044   

Adjusted EBITDA(1)

    8,557        7,988        472,366        498,126        (62,970     413,138        471,932        527,883   

Capital expenditures

    23,517        5,615        40,500        7,379        2,461        20,983        17,905        18,455   

 

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     Successor     Predecessor  
(Dollars in thousands)    As of
June 30,
    As of
December 31,
    As of
December 31,
 
   2015     2014     2014     2013     2012      2011      2010  

Balance Sheet data:

                  

Cash and cash equivalents

   $ 79,435      $ 83,260      $ 413,963      $ 430,691      $ 98,188       $ 110,267       $ 104,897   

Working capital(2)

     68,292        118,110        200,298        363,651        339,321         339,673         254,445   

Total assets

     2,431,344        2,822,644        2,747,296        3,031,719        1,916,275         2,454,111         2,476,582   

Total debt(3)

     2,193,601        1,702,657        2,096,143        1,739,431        —           —           —     

Total net debt(3)

     2,114,166        1,619,397        1,682,180        1,308,740        —           —           —     

Stockholders’ equity (deficit)

     (734,611     321,589        (377,609     409,597        1,120,930         1,563,547         1,650,748   

 

(1) Adjusted Revenue, a measure used by management to assess operating performance, is defined as the total amount of revenue that would have been recognized in a period if all revenue were recognized immediately at the time of sale.

Adjusted Revenue is calculated as follows:

 

    Successor     Predecessor  
(Dollars in thousands)   Six Months
Ended
June 30,
2015
    Six Months
Ended
June 30,
2014
    Year Ended
December 31,
2014
    March 23,
2013 to
December 31,
2013
    January 1,
2013 to
March 22,
2013
    Year Ended
December 31,
2012
    Year Ended
December 31,
2011
    Year Ended
December 31,
2010
 

Revenue

  $ 670,143      $ 679,080      $ 1,855,779      $ 1,589,574      $ 229,441      $ 1,917,599      $ 2,072,735      $ 2,261,840   

Change in deferred revenue

    40,478        12,203        179,059        168,725        (17,304     60,513        91,483        35,204   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted Revenue

  $ 710,621      $ 691,283      $ 2,034,838      $ 1,758,299      $ 212,137      $ 1,978,112      $ 2,164,218      $ 2,297,044   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

EBITDA, a measure used by management to assess operating performance, is defined as net income from continuing operations plus net interest, income taxes, depreciation and amortization, including amortization of pre-publication investment cash costs.

Adjusted EBITDA is defined as EBITDA adjusted to exclude unusual items and other adjustments required or permitted in calculating covenant compliance under our debt agreements.

Adjusted Revenue and each of the above described EBITDA-based measures is not a recognized term under U.S. GAAP and does not purport to be an alternative to revenue or income from continuing operations as a measure of operating performance or to cash flows from operations as a measure of liquidity. Additionally, each such EBITDA-based measure is not intended to be a measure of free cash flows available for management’s discretionary use, as it does not consider certain cash requirements such as interest payments, tax payments and debt service requirements. Such measures have limitations as analytical tools, and you should not consider any of such measures in isolation or as substitutes for our results as reported under U.S. GAAP. Management compensates for the limitations of using non-GAAP financial measures by using them to supplement U.S. GAAP results to provide a more complete understanding of the factors and trends affecting the business than U.S. GAAP results alone. Because not all companies use identical calculations, these EBITDA-based measures may not be comparable to other similarly titled measures of other companies. See “Use of Non-GAAP Financial Information.”

Management believes that Adjusted Revenue is helpful in highlighting the sales performance from period to period because it reflects sales as they are made.

Management believes EBITDA is helpful in highlighting trends because EBITDA excludes the results of decisions that are outside the control of operating management and can differ significantly from company to company depending on long-term strategic decisions regarding capital structure, the tax jurisdictions in which companies operate and capital investments. In addition, EBITDA provides more comparability between the historical operating results and operating results that reflect purchase accounting and the new capital structure.

Management believes that the inclusion of supplementary adjustments to EBITDA applied in presenting Adjusted EBITDA are appropriate to provide additional information to investors about certain material non-cash items and about unusual items that we do not expect to continue at the same level in the future.

For additional information related to these measures, please see “Prospectus Summary—Our Key Metrics” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Non-GAAP Financial Measures—Adjusted Revenue and Adjusted EBITDA.”

 

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EBITDA and Adjusted EBITDA are calculated as follows:

 

    Successor     Predecessor  
(Dollars in thousands)   Six
Months
Ended
June 30,
2015
    Six
Months
Ended
June 30,
2014
    Year
Ended
December 31,
2014
    March 23
to
December 31,
2013
    January 1
to
March 22,
2013
    Year
Ended
December 31,
2012
    Year
Ended
December 31,
2011
    Year
Ended
December 31,
2010
 

Net (loss) income from continuing operations

  $ (194,037   $ (144,430   $ (312,806   $ (186,126   $ (35,602   $ (275,672   $ 101,726      $ 186,525   

Interest expense (income), net

    96,765        89,626        181,890        137,283        488        (1,688     (4,205     (1,088

Income tax (benefit) provision

    (2,527     (108,582     112,571        (130,158     (20,410     (19,704     52,029        101,337   

Depreciation, amortization and pre-publication amortization

    89,293        96,590        205,831        163,883        25,434        228,565        245,576        290,031   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

EBITDA

    (10,506     (66,796     187,486        (15,118     (30,090     (68,499     395,126        576,805   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Change in deferred revenue(a)

    40,478        12,203        179,059        168,725        (17,304     60,513        91,483        35,204   

Restructuring and cost savings implementation fees(b)

    13,730        19,025        39,888        33,984        4,116        62,477        29,741        —     

Sponsor fees(c)

    1,750        1,750        3,500        875        —          —          —          —     

Elimination of corporate overhead(d)

    —          —          —          —          —          88,551        59,506        47,824   

Impairment charge(e)

    —          —          23,800        —          —          412,886        —          —     

Purchase accounting(f)

    —          41,585        41,585        312,615        —          —          —          —     

Transaction costs(g)

    —          3,421        3,932        56,820        —          —          —          —     

Acquisition costs(h)

    —          4,045        4,376        4,796        —          —          —          —     

Physical separation
costs(i)

    —          21,607        46,716        8,100        —          —          —          —     

Other(j)

    7,707        8,762        29,109        23,944        5,627        (1,559     (5,930     (7,721

Pre-publication investment cash costs(k)

    (44,602     (37,614     (87,085     (96,615     (25,319     (168,623     (145,727     (145,108

Stand-alone cost
savings(l)

    —          —          —          —          —          27,392        47,733        20,879   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted EBITDA

  $ 8,557      $ 7,988      $ 472,366      $ 498,126      $ (62,970   $ 413,138      $ 471,932      $ 527,883   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

  (a) We receive cash up-front for most product sales but recognize revenue (primarily related to digital sales) over time recording a liability for deferred revenue at the time of sale. This adjustment represents the net offer of converting deferred revenues (inclusive of deferred royalties) to a cash basis assuming the collection of all receivable balances.
  (b) Represents severance and other expenses associated with headcount reductions and other cost savings initiated as part of our formal restructuring initiatives to create a flatter and more agile organization.
  (c) Beginning in 2014, $3.5 million of annual management fees was recorded and payable to Apollo. The amount recorded in the Successor period from March 23, 2013 to December 31, 2013 was $0.9 million.
  (d) General corporate allocations for executive management costs incurred by MHC were allocated to the business prior to Q1 2013.
  (e) An impairment charge was recorded in 2014 to reduce the recorded value of an owned office building to its estimated fair value based upon an independent appraisal. In addition, a goodwill impairment charge was recorded in 2012 relating to the K-12 reporting unit.
  (f) Represents the effects of the application of purchase accounting associated with the Founding Acquisition, driven by the step-up of acquired inventory. The deferred revenue adjustment recorded as a result of purchase accounting has been considered in the deferred revenue adjustment.
  (g) The amount represents the transaction costs associated with the Founding Acquisition.
  (h) The amount represents costs incurred for acquisitions subsequent to the Founding Acquisition including ALEKS, LearnSmart and Engrade.
  (i) The amount represents costs incurred to physically separate our operations from MHC. These physical separation costs were incurred subsequent to the Founding Acquisition and concluded in 2014.
  (j) For six months ended June 30, 2015, the amount represents (i) non-cash incentive compensation expense; (ii) elimination of the gain of $4.8 million on the sale of an investment in an equity security and (iii) other adjustments required or permitted in calculating covenant compliance under our debt agreements. For the six months ended June 30, 2014, the amount represents (i) cash distributions to noncontrolling interest holders of $0.2 million; (ii) non-cash incentive compensation expense; (iii) elimination of non-cash gain of $7.3 million relating to LearnSmart; and (iv) other adjustments required or permitted in calculating covenant compliance under our debt agreements.

 

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For the year ended December 31, 2014, the amount represents (i) cash distributions to noncontrolling interest holders of $0.2 million; (ii) non-cash incentive compensation expense; (iii) elimination of non-cash gain of $7.3 million in LearnSmart; and (iv) other adjustments required or permitted in calculating covenant compliance under our debt agreements.

For the periods from March 23, 2013 to December 31, 2013 (Successor) and from January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor), the amount represents (i) cash distributions to noncontrolling interest holders (excluding special dividends) of $0.5 million and $1.8 million and $5.5 million, respectively; (ii) the elimination of a $16.9 million benefit realized in 2012 as a result of a change in the Company’s vacation policy; (iii) non-cash incentive compensation expense recorded directly beginning in the first quarter of 2013; and (iv) other adjustments required or permitted in calculating covenant compliance under our debt agreements.

  (k) Represents the cash cost for pre-publication investment during the period excluding discontinued operations.
  (l) Represents stand-alone cost savings to reflect our expectation that costs incurred on a stand-alone basis will be lower than costs historically allocated to McGraw-Hill Education, LLC by MHC. These allocations were primarily related to services and expenses including (i) global technology operations and infrastructure; (ii) global real estate occupancy; (iii) employee benefits; and (iv) shared services such as tax, legal, treasury, and finance.
(2) Working capital is calculated as current assets less current liabilities.
(3) Total debt is presented as long-term debt plus current portion of long-term debt. Total net debt is total debt less cash and cash equivalents.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion provides a narrative of our results of operations and financial condition for the year ended December 31, 2014, the periods from March 23, 2013 to December 31, 2013 and January 1, 2013 to March 22, 2013 and the year ended December 31, 2012 and the six months ended June 30, 2015 and 2014, which covers periods prior to the consummation of the Founding Acquisition. Accordingly, the discussion and analysis of historical periods prior to the consummation of the Founding Acquisition do not reflect the impact of the Founding Acquisition. Except as otherwise specified, the results of operations and other financial information included in this section present the Company on a stand-alone basis, after giving effect to the restructuring and related financing completed in connection with the Founding Acquisition.

You should read the following discussion of our results of operations and financial condition in conjunction with the accompanying audited and unaudited financial statements and notes thereto and “Selected Historical Combined Financial Data” of the Company, appearing elsewhere in this prospectus. This discussion contains forward looking statements and involves numerous risks and uncertainties, including, but not limited to, those described in the “Risk Factors” section of this prospectus. Actual results may differ materially from those contained in any forward looking statements.

Overview

We are a leading provider of outcome-focused learning solutions, delivering both curated content and digital learning tools and platforms to the students in the classrooms of approximately 250,000 higher education instructors, 13,000 K-12 school districts and a wide variety of academic institutions, professionals and companies in over 135 countries. We have evolved our business from a print-centric producer of textbooks and instructional materials to a leader in the development of digital content and technology-enabled adaptive learning solutions that are delivered anywhere, anytime.

Company History

On March 22, 2013, MHE Acquisition, LLC completed the Founding Acquisition, pursuant to which a wholly-owned subsidiary of the Company acquired all of the outstanding equity interests of certain subsidiaries of McGraw Hill Financial, Inc. (“MHC”) pursuant to a Purchase and Sale Agreement, dated November 26, 2012 and as amended March 4, 2013 (the “Acquired Business”). The Acquired Business included all of MHC’s educational materials and learning solutions business, which is comprised of (i) the Higher Education, Professional, and International Group (the “HPI business”), which includes post-secondary education and professional products both in the United States and internationally and (ii) the School Education Group business (the “SEG business”), which includes school and formative assessment products targeting students in the pre-kindergarten through secondary school market. We refer to the purchase of the Acquired Business and the related financing transactions as the “Founding Acquisition.” Following the Founding Acquisition, MHC has been known as McGraw Hill Financial, Inc.

In connection with the Founding Acquisition, a restructuring was completed, the result of which was that the HPI business and the SEG business became held by separate wholly owned subsidiaries of MHE US Holdings LLC. The HPI business became held by MHGE Parent, LLC (“MHGE”) and its wholly owned subsidiaries, while the SEG business became held by McGraw-Hill School Education Intermediate Holdings, LLC (“MHSE”) and its wholly owned subsidiaries. In addition, concurrent with the closing of the Founding Acquisition, subsidiaries of each of MHGE and MHSE entered into certain credit facilities. Neither MHGE nor its subsidiary companies guarantee or provide collateral to the financing of MHSE, and MHSE does not guarantee or provide collateral to the financing of MHGE or its subsidiary companies.

The term “Predecessor” refers to McGraw-Hill Education, Inc. prior to giving effect to the consummation of the Founding Acquisition, but after giving effect to the Restructuring. The term “Successor” refers to McGraw-Hill Education, Inc. after giving effect to the consummation of the Founding Acquisition.

 

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Business Segments

We have four operating business segments: Higher Education, K-12, International and Professional. Higher Education is our largest segment, representing 45%, 42% and 47%, and 40% of total revenue for the year ended December 31, 2014 (Successor), the periods from March 23, 2013 to December 31, 2013 (Successor), and January 1, 2013 to March 22, 2013 (Predecessor), and the year ended December 31, 2012 (Predecessor), respectively. Our K-12 segment generated 31%, 34% and 19% and 34% of total revenue for the year ended December 31, 2014 (Successor), the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor), and the year ended December 31, 2012 (Predecessor), respectively. Our International segment generated 18%, 19% and 23% and 19% of total revenue for the years ended December 31, 2014 (Successor), the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor), and the year ended December 31, 2012 (Predecessor), respectively. Our Professional segment represents 6%, 6% and 10% and 6% of total revenue for the year ended December 31, 2014 (Successor), the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor), and the year ended December 31, 2012 (Predecessor), respectively. The remaining total revenue relates to adjustments made for in-transit product sales.

Higher Education

In the higher education market in the United States, we provide students, instructors and institutions with adaptive digital learning tools, digital platforms, custom publishing solutions and traditional printed textbook products with capabilities in adaptive learning, homework tools, lecture capture and Learning Management System (“LMS”) integration for post-secondary markets. Although we cover all major academic disciplines, our content portfolio is organized into three key disciplines: (i) Business, Economics & Career; (ii) Science, Engineering & Math; and (iii) Humanities, Social Science & Languages. Our top selling products include Economics: Principles, Problems, and Policies (McConnell/Brue/Flynn), ALEKS, Managerial Accounting (Garrison) and The Art of Public Speaking (Lucas). The primary users of our solutions are students enrolled in two- and four-year non-profit colleges and universities, and to a lesser extent, for-profit institutions. We sell our Higher Education solutions to well-known online retailers, distribution partners and college bookstores, who subsequently sell to students. Our own direct-to-student sales channel is increasing via our proprietary e-Commerce platform, which currently represents our third largest distribution channel in this segment. Although we sell our products to the students as end users, it is the instructor that makes the ultimate decision regarding new materials for the course. We have longstanding and exclusive relationships with many authors and nearly all of our products are covered by copyright in major markets, providing us the exclusive right to produce and distribute such content in those markets during the applicable copyright terms.

K-12

In the K-12 market in the United States, we primarily sell curriculum and learning solutions, which include core basal programs, intervention and supplemental products, formative assessment tools, teaching resources and professional development programs. We sell our learning solutions directly to school districts across the United States. The process through which products are selected and procured for classroom use varies throughout the United States. Nineteen states, known as adoption states, approve and procure new basal programs, usually every five to eight years on a state-wide basis for each major area of study, before individual schools or school districts are permitted to schedule the purchase of materials. In all remaining states, known as open territories, each individual school or school district can procure materials at any time, though they usually do so on a five to eight year cycle. The student population in adoption states represents approximately 50% of the U.S. elementary and secondary school-age population. Many adoption states provide “categorical funding” for instructional materials, which means that state funds cannot be used for any other purpose. While we offer all of our curriculum and learning solutions in digital format, given the varying degrees of availability and maturity of our customers’ technological infrastructure, a majority of our sales are derived from blended print and digital solutions. Our top selling programs are Reading Wonders, McGraw-Hill My Math, Everyday Mathematics, Glencoe Math, and the Networks Social Studies Series.

 

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International

Our International segment, defined as sales outside the United States, serves students in the higher education, K-12 and professional markets in over 135 countries. Our products and solutions for the International segment are produced in nearly 60 languages and primarily originate from our offerings for the United States market, which are later adapted to meet the needs of individual geographies. Sales of our digital offerings are growing significantly in the international market, and we are continuously increasing our inventory of digital programs. The growth in the use of the English language is also a driver of demand for digital learning solutions and printed educational instructional materials.

Professional

In the Professional market in the United States, we provide medical, technical and engineering content for the professional, education and test prep communities. Our digital subscription products are sold to over 2,700 customers including corporations, academic institutions, libraries and hospitals. Our digital subscription products have averaged approximately 93% annual retention rates over the last three years.

Other

Other represents certain transactions or adjustments that are unusual or non-operational. In addition, adjustments made for in-transit product sales, timing related corporate cost allocations and other costs not attributed to a single operating segment are recorded within Other.

Factors Affecting Our Performance

Impact of Our Digital Transformation

The acceptance and adoption of digital learning solutions is driving a substantial transformation in the education market. We believe we are well positioned to take advantage of this transformation given our ability to offer embedded assessments, adaptive learning, real-time interaction and feedback and student specific personalization based on our core curated educational content in a platform- and device-agnostic manner.

The demand for our digital solutions has increased substantially over the last five years though the rate of transformation differs by business segment. In the higher education market, our customers’ technology infrastructures are sufficiently advanced to support full adoption of digital learning solutions. During the six months ended June 30, 2015, more than half of our Higher Education Adjusted Revenue was derived from digital learning solutions. In the K-12 market, varying degrees of broadband internet connectivity, adequacy of technical support staff, and teacher training across our customer base have limited the rate of broad-based adoption of digital solutions. Recent public policy and funding initiatives have increased emphasis on removing these limitations. Professional markets have the greatest digital readiness, and a majority of our Professional revenues are derived from digital product sales. Internationally, the receptivity to digital solutions is also strong, particularly in developing economies. According to Juniper Networks, people in developing countries are nearly twice as likely to use connected devices for educational purposes on a regular basis as those in developed markets.

Our revenue models across each of our business segments are transforming along with our customers’ increasing adoption of digital learning solutions. In general, our digital solutions are sold on a subscription basis with high renewal rates, which provides a more stable and predictable long term revenue model. We believe that the digital transformation will provide new opportunities for revenue growth. For example, our digital learning solutions provide an opportunity for us to increase the size of our addressable market as our digital products are not available in a format that can be utilized for sale in the used and rental market. In addition, the reserve that we maintain for product returns has declined over time due to the shift from traditional print products to digital learning solutions, which experience a much lower return rate.

 

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We closely monitor our digital sales given the significant investment being made across our business and the increasing adoption of digital in the marketplace. Our digital offerings are sold on a standalone basis and as part of bundled or hybrid offerings. In instances where we sell digital with a print component, it is our policy to bifurcate the sale between the digital and print components and attribute value to each of the components in accordance with U.S. GAAP. When we discuss or present digital revenues, such information is based upon the attribution of value in accordance with U.S. GAAP and does not include print revenues.

The transition from traditional print to digital solutions also improves our cost structure as we tag and leverage content across the entire business instead of duplicating development efforts in each segment. We also expect to reduce raw material, warehouse and delivery costs as a result of the shift to digital solutions, as well as reducing sampling costs that are incurred to provide traditional print products to purchasing decision makers at no cost to them.

The development cycle for traditional print products involves periodic revisions, which give rise to significant pre-publication costs that are capitalized and recognized through amortization expense over time. Our pre-publication costs have been declining as we sell more digital solutions. With our digital solutions, we employ a continuous revision cycle that permits smaller and more frequent investment over the lifecycle of a product to maintain the product’s relevancy by quickly incorporating feedback and enhancement opportunities. The cost of the smaller and more frequent investment is expensed and not capitalized, a shift from the historical accounting for pre-publication costs.

Our digital learning solutions are supported by our in-house Digital Platform Group (“DPG”), which was formed in 2013 to drive innovation and to develop, maintain and leverage our digital learning solutions and technology tools and platforms across our entire business. To maintain and grow our leading digital position, we have increased our annual digital learning solutions spending, including operating and capital expenditures, from less than $90 million in 2012 to approximately $150 million in 2014. We expect to invest in excess of $175 million in digital learning solutions in 2015. While our investment has increased significantly since 2012, we believe that our annual expenditures will stabilize in the near future as our major initiatives and the build-out of certain foundational capabilities near completion.

Revenue

Higher Education

We derive revenue primarily from the sale of digital learning solutions and content, traditional and custom print content and instructional materials. Our digital and print revenues are a function of sales volume and, to a lesser extent, changes in unit pricing. Our revenues are comprised of product and services sales less an allowance for product returns and revenue that is required to be deferred in accordance with U.S. GAAP.

Sales volumes are primarily influenced and the use of used or rental alternatives to our learning solutions by student enrollment figures. Our business is driven by our ability to maintain and win instructor adoptions and purchasing decisions made by students. Higher education enrollment, which was approximately 20 million in the fall of 2013, has grown at a 2.0% CAGR since 1970, according to NCES. Growth in enrollment impacts the number of students requiring our digital and print solutions in any given year. Because instructors are the ultimate decision makers for content and instructional materials to be used in their courses, we compete for instructor adoptions of our products. After an instructor has adopted our products for use in his or her course, students have the option to purchase new content and instructional materials, purchase used versions of printed materials, rent printed materials from a number of outlets, or forego the acquisition of course content and materials altogether. Our sales depend heavily on the volume of new content and instructional materials sold and we do not benefit from sales in the used and rental markets. As digital solutions are adopted by more instructors, and increasingly become part of the instructors’ graded curriculum, more students are purchasing our digital solutions. This trend has increased sales of our digital solutions and is resulting in more predictable and recurring revenues as sales volumes begin to more closely align with trends in student enrollment.

 

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Our product pricing is typically set at the beginning of each new academic year, and unit pricing has increased annually at a low-single digits percentage, on average, over the last several years. Digital products are typically priced at a discount to print products. However, given the integration of our digital solutions into course instruction, our solutions increasingly becoming part of instructors’ graded curriculum and the lack of used and rental alternatives, we tend to generate more revenue per edition from a digital product than from a comparable print product covering the same subject area.

For our print products, we recognize revenue at the time of shipment to our distribution partners, who typically order products several weeks before the beginning of an academic semester to ensure sufficient physical product inventory. Digital products are generally sold as subscriptions, which are paid for at the time of sale or shortly thereafter, and we recognize revenues derived from these products over the life of the subscription. In most cases, students purchase digital products at the beginning of the academic semester, or shortly thereafter, which has tended to shift the timing of revenues to later in the academic year as we sell more digital products and fewer print products. In addition, the difference in our revenue recognition policies between print and digital products has caused comparisons of current and historical revenues to less accurately reflect the actual sales performance of our business during this time of transition. As a result, we use the non-GAAP measure Adjusted Revenue to provide a consistent comparison of sales performance from period to period. See “—Non-GAAP Measures” for a description of Adjusted Revenue.

Revenues are also impacted by our reserve for product returns. Our distribution partners are permitted to return products at any time, though they primarily do so following the heavy student purchasing period at the beginning of each academic semester. To more accurately reflect the economic impact of returns on our operating performance, we reserve a percentage of our gross sales in anticipation of these returns when calculating our net revenues. This reserve has declined in recent years as we shift from sales of traditional print products to digital learning solutions, which experience a much lower return rate.

K-12

We derive revenue primarily from the sale of digital learning solutions, traditional print offerings and other instructional materials. Our revenues are driven primarily by sales volume and, to a lesser extent, changes in unit pricing. Our revenues are comprised of product and services sales less an allowance for product returns and revenue that is required to be deferred in accordance with U.S. GAAP. The required revenue deferral for digital solutions in K-12 is significantly greater than in Higher Education due to the longer, multi-year contractual terms of our customer arrangements in K-12 (typically, five to eight years).

Sales volumes are driven primarily by the availability of funding for instructional materials. Most public school districts are largely dependent on state and local funding for the purchase of instructional materials, which correlate with state and local receipts from income, sales and property taxes. Nationally, total state funding for public schools has been trending upward as state income and sales tax revenues recover from the lows of the 2008-2009 economic recession. The improving economy has driven a recovery in housing, which has led to higher property tax revenues for local governments and increased budgets for public schools.

The purchasing cycles of adoption states also have a significant impact on our sales volumes. We monitor the purchasing cycles for specific disciplines in adoption states in order to manage our product development and to plan sales campaigns. Our sales may be materially impacted by the purchasing schedules of major adoption states such as Florida, California and Texas. For example, Florida implemented a language arts adoption in 2014 and is scheduled to adopt social studies materials in 2015 that will be purchased beginning in 2016. Texas school districts purchased mathematics and science materials in 2014, and adopted social studies and high school math materials in 2014 for purchase in 2015. California adopted math materials in 2013, with purchases spread over 2014 and 2015, and is scheduled to adopt English language arts materials in 2015 for purchase beginning in 2016. Florida, Texas and other adoption states provide dedicated state funding for instructional materials and classroom technology, with funding typically appropriated by the legislature in the first half of the year in which materials are to be purchased. Texas, which has a two-year budget cycle, will appropriate funds for purchases in

 

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2015 and 2016. In the 2015 legislative session, California funded instructional materials in part with a dedicated portion of state lottery proceeds and in part out of general formula funds, with the minimum overall level of school funding determined according to the Proposition 98 funding guarantee.

Sales volume in the United States K-12 market is also affected by changes in state curriculum standards and by student enrollment. Changes in state curriculum standards require that instructional materials be revised or replaced to align to the new standards, which historically has driven demand for basal programs. School enrollment is highly predictable, as they correlate with the overall growth in birth rates in the United States, and are expected to continue trending upward over the long term. According to NCES, K-12 enrollment in the United States as of 2011 was nearly 55 million and enrollment is projected to grow at a compound annual growth rate of 0.4% from 2013 through 2023.

Our product pricing is generally determined at the time our products are adopted by a state or district. Price has historically been of lesser importance than curriculum quality and service levels in state and district purchasing decisions. The vast majority of our program offerings is hybrid, incorporating both print and digital elements.

Revenue from traditional print products is typically recognized at the time of shipment, which closely aligns with when a school district takes possession of the required number of products at the outset of a multi-year adoption. Traditional print products are typically re-used by students over the term of the adoption, and school districts will occasionally purchase replacement products due to wear or increasing enrollment over the life of the adoption. Sales of these replacement products are known as residual sales, from which we derive a significant portion of our revenue. Our online and digital solutions are sold as a subscription, which states and districts pay for at the beginning of a multi-year adoption. We typically defer revenue related to online and digital solutions for the entirety of the contract upfront and recognize it ratably over the term of the contract. Because they are consumable products, revenue for workbooks is deferred when we enter into a multi-year contract and is recognized when delivery takes place, often at the beginning of each academic year over the contract term. As our customers purchase more of our digital and hybrid learning solutions, the percentage of our revenue that is deferred continues to increase. The total amount of the sale and the cash received upfront for a fully-digital or hybrid program is comparable to a fully print program; however, the time period over which the revenue is recognized increases with the shift to digital. The difference in our revenue recognition policies between print and digital solutions has caused comparisons of current and historical revenues to less accurately reflect the actual sales performance of our business during this time of transition. As a result, we use the non-GAAP measure Adjusted Revenue to provide a consistent comparison of sales performance from period to period. See “Non-GAAP Measures” for a description of how we define Adjusted Revenue.

Unlike our Higher Education segment, product returns in our K-12 segment have an immaterial impact on net revenues because we sell directly to school districts, which rarely return products.

International

We derive revenue primarily from the sale of digital learning solutions and content, traditional print content and instructional materials to the higher education, K-12 and professional markets in over 135 countries worldwide. Our revenues are a function of the market conditions in the countries in which we operate and our ability to expand our sales to customers in these countries and to new countries. A majority of our international revenue is generated by selling our unmodified English language products, which were originally created for the United States market, internationally. Our revenues are comprised of product and services sales less an allowance for product returns and revenue that is required to be deferred in accordance with U.S. GAAP.

Our International business covers five major regions. Each of these regions and the underlying country performance can be impacted by the economy, government policy and competitive situations. These regions and the general revenue drivers for each are as follows:

 

   

EMEA: the majority of our business is driven by Higher Education, followed by K-12 (including English Language Learning) and Professional. The majority of our Higher Education revenues come

 

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from the sale of original United States product translations and adaptations of those products. Our K-12 business in Spain is primarily driven by the development and sale of local original publications and is subject to the cyclical nature of renewals and government funding. Our K-12 business in the Middle East is primarily driven by orders for United States product as well as translations and adaptations.

 

    Asia Pacific: our business is driven primarily by Higher Education, followed by K-12 (including English Language Learning) and Professional. The majority of the business is derived from Southeast Asia, where we operate in over 15 countries, some of which are subject to volatile political and economic conditions. Our Australian business is primarily driven by the sale of original United States Higher Education product as well as translations and adaptations.

 

    India: Higher Education is a major driver of our business, followed by Professional and K-12. Our product portfolio in India primarily consists of local publishing programs, followed by adaptations of United States product.

 

    Latin America: this region is primarily driven by K-12 (including English Language Learning), followed by Higher Education and Professional. From a regional perspective, our largest market is Mexico, followed by Colombia, Chile and Venezuela. Latin America’s business is exposed to volatile political and economic conditions. The majority of our Higher Education revenues are derived from the sale of original United States products that have been translated and / or adapted. Our K-12 business is primarily driven by the development and sale of local/original publications and is subject to the cyclical nature of renewals and government funding.

 

    Canada: Higher Education is the largest driver of our Canadian business, followed by K-12 and Professional. Higher Education sales consist primarily of original United States Higher Education product as well as translations and adaptations. Our Canadian K-12 business is primarily driven by the development and sale of local/original publications and is subject to the cyclical nature of renewals and government funding.

Product pricing varies by region and country with pricing comparable to equivalent products sold in the United States in some instances. Within developing economies, price growth is lower than in the United States market, dictated by the economic conditions prevalent in that country.

Foreign exchange rates also impact our international revenues as the functional currency is often the foreign currency of the countries in which we operate. As a result, we are exposed to currency fluctuations in translating our financial results into U.S. dollars. In 2014, approximately 70% of our sales were denominated in currencies other than the U.S. dollar. Recent strengthening of the dollar has resulted in unfavorable foreign exchange impacts. We monitor the impact of foreign currency movements and the correlation between local currencies and the U.S. dollar. We also periodically review our hedging strategy and may enter into other arrangements as appropriate.

Revenue recognition for international products is similar to products sold in the United States. Revenue for traditional print products is typically recognized upon shipment, while digital revenues are recognized over the contractual term of the product. The difference in our revenue recognition policies between print and digital solutions has caused comparisons of current and historical revenues to less accurately reflect the actual sales performance of our business during this time of transition. As a result, we use the non-GAAP measure Adjusted Revenue to provide a consistent comparison of sales performance from period to period. See “—Non-GAAP Measures” for a description of how we define Adjusted Revenue.

Professional

We derive revenue primarily from the sale of digital subscription services and content, both digital and print. Our digital and print revenues are a function of sales volume and, to a lesser extent, changes in unit pricing. Our revenues are comprised of product and services sales less an allowance for product returns and revenue that is required to be deferred in accordance with U.S. GAAP.

 

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Sales volume is driven by demand for subscription based, professional academic content and by growth in knowledge-based industries, especially in the medical, business, technical and engineering fields. As the United States economy continues to recover, we expect the market for professional education resources to grow, particularly among professions that are experiencing more rapid job growth. The Professional and Business Services and Healthcare and Social Assistance industry sectors are expected to add 8 million jobs by 2022, more than all other United States industries combined, according to the Bureau of Labor Statistics (“BLS”). We derive a substantial portion of our Professional revenue from these two industries.

Sales of our digital subscription services provide a stable and highly recurring revenue stream, with a retention rate across major platforms of approximately 93% over the last three years. Our digital subscription services are sold as annual contracts, and prices for new subscriptions typically increase by low single-digits each year. Our other digital and traditional print products are also priced competitively and increase in the low single digits each year.

Revenue for traditional print products is typically recognized upon shipment, while digital revenues are recognized over the contractual term. The continued shift from print to digital will increase the percentage of our sales that are deferred and recognized over the contractual term. The difference in our revenue recognition policies between print and digital solutions has caused comparisons of current and historical revenues to less accurately reflect the actual sales performance of our business during this time of transition. As a result, we use the non-GAAP measure Adjusted Revenue to provide a consistent comparison of sales performance from period to period. See “Non-GAAP Measures” for a description of Adjusted Revenue.

Cost of Sales

Cost of sales includes expenses directly attributable to the production of our products and delivery of our services. Costs associated with our printed products include variable costs such as paper, printing and binding, content related royalty expenses, gratis costs (products provided at no charge as part of the sales transaction) and certain transportation and freight costs. Gratis costs are predominately incurred in our K-12 business and tend to be higher for adoption state sales as compared to open territory sales. As such, these costs will vary based upon the level of adoption state sales during a given period. Cost of sales also includes royalty expense where author developed content is used, primarily in our Higher Education and Professional segments.

Operating and Administration Expenses

Our operating and administration expenses include the expenses of our employees and outside vendors engaged in our marketing, selling, editorial and administrative activities as well as pre-publication cost amortization. A significant component of our total operating and administration expense relates to our ongoing investment in DPG. These costs are both fixed and variable in nature and our investment is expected to increase given our increasingly digital revenues; however, we expect the rate of increase to moderate over time as our major initiatives and the build-out of certain foundational capabilities near completion.

Outside of costs directly associated with DPG, we incur additional digital related costs, including content tagging and digital solutions hosting, which are also included in our operating and administrative expenses and have increased as the digital transformation continues.

We incur expense for products provided to decision makers in the educational materials purchasing process as part of our sampling program, primarily in our K-12 business. Annual samples expense can vary significantly depending upon the adoption calendar and the mix of programs being considered for adoption. As our revenues continue to shift from traditional print offerings to digital solutions, we expect the expense incurred for sampling to decline.

In the United States, our products are sold in over 5,000 higher education institutions and 13,000 K-12 school districts across all 50 states. Our sales force of nearly 1,450 persons maintains close relationships with the

 

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individual instructors who are the primary decision makers in the higher education market, as well as the states, school districts, and individual schools. We incur significant selling and market expense to maintain and support our extensive sales force. Subsequent to the Founding Acquisition, we invested in sales and marketing to drive future revenue opportunities and enhance our product branding. As revenues grow in the future, we expect to see modest increases in selling and marketing expense that will vary with the K-12 adoption cycle.

Since the Founding Acquisition, we have incurred significant non-recurring restructuring and separation costs to establish the standalone operations of our business and facilitate cost saving opportunities. The physical separation costs incurred to establish our standalone operations ceased in 2014 upon the completion of the separation from our former parent. Excluding the impact of restructuring and separation costs, we expect our operating and administration expense to increase nominally as we continue to invest in the business and drive our digital transformation.

Transaction and Acquisition Costs

In connection with the Founding Acquisition, we incurred significant transaction costs including external legal and consulting expenses that are separately identified in the statement of operations. Subsequent to the Founding Acquisition, we incurred additional acquisition costs in connection with our acquisitions of ALEKS, LearnSmart and Engrade, which are included in operating and administration expenses. To the extent we acquire and divest of businesses in the future, we may incur transaction costs that will vary based upon the size and complexity of the transaction.

Interest Expense

Our interest expense includes interest related primarily to the MHGE Senior Secured Notes, the MHGE Term Loan, the MHGE PIK Toggle Notes and the MHSE Term Loan.

Interest expense varies based on the amount of indebtedness outstanding and the rates at which we were able to secure the indebtedness. The interest rate on certain tranches of indebtedness is based on London InterBank Offered Rate (LIBOR) or the prime lending rate (Prime), plus an applicable margin. As a result, changes in the LIBOR or Prime rate can impact interest expense. As applicable, interest expense may also include costs associated with our revolving credit facility and the amortization of deferred financing fees and loan discounts. Interest expense for the year ending December 31, 2014 (Successor) was $181.9 million.

Intangible Amortization

Our intangible asset amortization expense primarily includes the amortization of acquired intangible assets consisting of customer relationships, content rights, trade names, non-compete rights and technology. The largest component of our intangibles asset balance is related to content acquired as part of the Founding Acquisition and is being amortized over a period of 8-14 years. The remaining balances will be amortized over varying periods of time from 4 to 14 years from the date of acquisition. Intangible asset amortization expense for the year ending December 31, 2014 (Successor) was $104.2 million.

Pre-publication Expenditures and Amortization

Pre-publication expenditures are capitalized costs incurred and principally consist of design and content creation. Costs incurred prior to the publication date of a title or release date of a product represent activities associated with product development. These may be performed internally or outsourced to subject matter specialists and include, but are not limited to, editorial review and fact verification, graphic art design and layout and the process of conversion from print to digital media or within various formats of digital media. These costs are capitalized when the costs can be directly attributable to a project or title and the title is expected to generate probable future economic benefits. Capitalized costs are amortized upon publication of the title over its estimated useful life of up to six years, with a higher proportion of the amortization typically taken in the earlier years.

 

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Over the last several years, we have optimized our pre-publication expenditures to emphasize investment in content that can be leveraged across our full range of products, which maximizes our long-term returns on this investment. This has been accomplished, in part, by the creation of our Digital Platform Group, which supports ongoing innovation, development and maintenance of our technology platforms. We have also experienced a decline in pre-publication expenditures as our business shifts from a periodic revision cycle for print products, which gives rise to significant pre-publication expenditures, to a continuous revision cycle for digital learning solutions.

Pre-publication expenditure demands differ by business segment for a variety of reasons, including the speed with which the digital transformation has occurred. In Higher Education, pre-publication expenditures are highest for the first edition of a new title, and lower for subsequent revisions. Our pre-publication investment to create content used in our adaptive tools, such as the assessment questions in the LearnSmart, product is increasing. This foundational investment is expected to reduce the variability of pre-publication expenditures in the future as we are able to leverage the content across the business.

Higher Education

Pre-publication expenditures in the Higher Education segment relate to the development of product across all disciplines, since the content is created by authors on a royalty basis. We develop “first editions,” which are new titles or programs that can be revised over time based on market acceptance. As we continue our digital transformation, our pre-publication expenditure is increasingly related to content used in our adaptive tools, such as the assessment questions in the LearnSmart product. Development of the technology underlying our digital products is either supported by DPG with costs recorded in operating expenses, or capitalized if a new capability is developed (i.e., new product). Pre-publication expenditures are typically incurred in the year before the copyright is acquired on a printed textbook. The cash spend in the year ended December 31, 2014 (Successor), the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor) was $30.2 million, $34.3 million and $9.7 million and $51.6 million, respectively.

K-12

Pre-publication expenditures in the K-12 segment relate to content development and are the highest in the company, representing approximately 45% of total spend in 2014. Unlike the Higher Education segment, most content is developed by our K-12 product development teams. Pre-publication expenditures are incurred for external content development (work for hire), permissions, artwork and the physical design and layout of the printed books. Created content is used in our digital offerings as well. New basal programs such as reading, math, social studies or science are published around the adoption cycles for large adoption states such as California, Texas and Florida. Pre-publication is typically spent up to three years prior to an adoption sales year. The cash spend in the year ended December 31, 2014 (Successor), the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor) was $38.0 million, $44.0 million and $11.7 million and $90.4 million, respectively.

International

Pre-publication expenditures in the international segment relate to locally developed products or adaptations and translations of existing Higher Education, K-12 and Professional products in both digital and print format. Similar to our Higher Education and Professional segments, pre-publication is typically spent in the year before the copyright is established. The cash spend in the year ended December 31, 2014 (Successor), the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 was $10.0 million, $9.1 million and $2.5 million and $13.6 million, respectively.

Professional

Pre-publication expenditures in the Professional segment relate to new titles and revisions, similar to the Higher Education segment, and include activities related to the creation of the actual product, since the content is

 

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created by authors on a royalty basis. Pre-publication expenditures are typically incurred in the year before the copyright is established. For our Access platforms, any additional content needed to supplement the print product will be funded through pre-publication expenditures. The cash spend in the year ended December 31, 2014 (Successor), the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor) was $10.1 million, $9.1 million and $1.9 million and $13.1 million, respectively.

Capital Expenditures

Capital expenditures relate to expenditures for fixed assets, leasehold improvements and software development. The expense related to these purchases is recorded as depreciation in our statement of operations over the useful life of the asset. Our capital expenditures as a percentage of revenue have historically averaged less than 2.0% per annum. Our capital expenditures vary based upon the level of digital investment being made, which was significant in 2014 and 2015, as well as the timing of periodic asset refreshes. For the year ended December 31, 2014 (Successor), the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor), our capital expenditures were $40.5 million, $7.4 million and $2.5 million and $21.0 million, respectively.

Combined Consolidated Operating Results

The following tables sets forth certain historical combined consolidated financial information for the six months ended June 30, 2015 and 2014 (Successor), the year ended December 31, 2014 (Successor), the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor). The following tables and discussion should be read in conjunction with the information contained in our historical combined consolidated financial statements and the notes thereto included elsewhere in this prospectus. However, our historical predecessor results of operations set forth below and elsewhere in this prospectus may not necessarily reflect what would have occurred if we had been a separate, stand-alone entity during the periods presented or what will occur in the future.

Consolidated Operating Results for the Six Months Ended June 30, 2015 and 2014

 

    Six Months Ended              
    June 30, 2015     June 30, 2014     $ Change     % Change  
(Dollars in thousands)                        

Revenue

  $ 670,143      $ 679,080      $ (8,937     (1.3 )% 

Cost of sales

    188,536        222,186        (33,650     (15.1 )% 
 

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

    481,607        456,894        24,713        5.4

Operating expenses

       

Operating and administration expenses

    525,136        552,388        (27,252     (4.9 )% 

Depreciation

    13,945        14,523        (578     (4.0 )% 

Amortization of intangibles

    47,104        57,277        (10,173     (17.8 )% 

Transaction costs

    —          3,421        (3,421     (100.0 )% 
 

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

    586,185        627,609        (41,424     (6.6 )% 
 

 

 

   

 

 

   

 

 

   

 

 

 

Operating (loss) income

    (104,578     (170,715     66,137        (38.7 )% 

Interest expense (income), net

    96,765        89,626        7,139        8.0

Other (income) expense

    (4,779     (7,329     2,550        (34.8 )% 
 

 

 

   

 

 

   

 

 

   

 

 

 

(Loss) income from operations before taxes on income

    (196,564     (253,012     56,448        (22.3 )% 

Income tax (benefit) provision

    (2,527     (108,582     106,055        (97.7 )% 
 

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income from continuing operations

    (194,037     (144,430     (49,607     34.3

Net (loss) income from discontinued operations, net of taxes

    (62,163     10,680        (72,843     (682.1 )% 
 

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income

  $ (256,200   $ (133,750   $ (122,450     91.6
 

 

 

   

 

 

   

 

 

   

 

 

 

Less: Net (income) loss attributable to non-controlling interests

    —          299        (299     (100.0 )% 
 

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income attributable to McGraw-Hill Education, Inc.

  $ (256,200   $ (133,451   $ (122,749     92.0
 

 

 

   

 

 

   

 

 

   

 

 

 

 

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Revenue

 

     Six Months Ended         
     June 30, 2015      June 30, 2014      $ Change      % Change  
(Dollars in thousands)                            

Revenue, as reported

           

Higher Education

   $ 275,281       $ 272,819       $ 2,462         0.9

K-12

     219,403         222,764         (3,361      (1.5 )% 

International

     118,748         128,862         (10,114      (7.8 )% 

Professional

     53,668         53,152         516         1.0

Other

     3,043         1,483         1,560         105.2
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Revenue

   $ 670,143       $ 679,080       $ (8,937      (1.3 )% 
  

 

 

    

 

 

    

 

 

    

 

 

 

Revenue for the six months ended June 30, 2015 and June 30, 2014 was $670.1 million and $679.1 million, respectively, a decrease of $8.9 million or 1.3%. Excluding the impact of purchase accounting (which negatively impacted revenue as a result of the adjustment recorded to reduce the carrying value of deferred revenue on the opening balance sheet), revenue for the six months ended June 30, 2015 and June 30, 2014 was $683.3 million and $695.6 million, respectively, a decrease of $12.3 million or 1.8%. This decrease was driven by the segment factors described below.

Higher Education

Higher Education revenue for the six months ended June 30, 2015 and June 30, 2014 was $275.3 million and $272.8 million, respectively, an increase of $2.5 million or 0.9%. Excluding the impact of purchase accounting, revenue for the six months ended June 30, 2015 and June 30, 2014 was $275.9 million and $267.6 million, respectively, an increase of $8.3 million or 3.1%. The increase was primarily due to:

 

    increased revenue from the sale of our digital learning solutions, primarily our Connect, LearnSmart and ALEKS offerings driven by growth in unique users for our digital learning solutions (unique users of Connect grew 13% to 1.9 million, unique users of LearnSmart grew 33% to 1.2 million, and unique users of ALEKS grew 17% to 0.6 million); partially offset by

 

    decreased print revenues, due primarily to market demand for digital learning solutions as opposed to print products.

K-12

K-12 revenue for the six months ended June 30, 2015 and June 30, 2014 was $219.4 million and $222.8 million respectively, a decrease of $3.4 million or 1.5%. Excluding the impact of purchase accounting, revenue for the six months ended June 30, 2015 and June 30, 2014 was $231.9 million and $240.9 million, respectively, a decrease of $9.0 million or 3.7%. The decrease was primarily due to:

 

    net deferred revenue growth of $28.4 million driven by increased sales of our digital learning solutions (which are required to be deferred and recognized to income over time (5 – 8 years) in accordance with U.S. GAAP); and

 

    a decline in open territory revenue due to a smaller market opportunity; partially offset by

 

    strong performance in California math adoptions as well as Texas math and social studies adoptions.

 

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International

International revenue for the six months ended June 30, 2015 and June 30, 2014 was $118.7 million and $128.9 million respectively, a decrease of $10.2 million or 7.8%. Excluding the impact of purchase accounting, revenue for the six months ended June 30, 2015 and June 30, 2014 was $118.7 million and $129.5 million, respectively, a decrease of $10.8 million or 8.3%. The decrease was primarily due to:

 

    unfavorable foreign exchange impact of $9.5 million (estimated by re-calculating current year results of foreign operations using the average exchange rate from the prior year); and

 

    a decline in print revenue; partially offset by

 

    digital growth of approximately 10%, with the majority of digital sales attributable to Higher Education sales.

U.S. exports and higher education sales continue to account for the majority of total revenue. Non-U.S. performance was driven by Middle East funded orders, 18% sales growth in Australia relative to the prior year period, driven by higher education sales, and increased sales in India as a result of the release of the 19th edition of Harrison’s Principles of Internal Medicine, offset by a decline in Latin America driven by lower K-12 and professional sales.

Professional

Professional revenue for the six months ended June 30, 2015 and June 30, 2014 was $53.7 million and $53.2 million, respectively, an increase of $0.5 million or 1.0%. Excluding the impact of purchase accounting, revenue for the six months ended June 30, 2015 and June 30, 2014 was $53.8 million and $56.1 million, respectively, a decrease of $2.3 million or 4.2%. The decrease was primarily due to:

 

    anticipated print decline due, in part, to portfolio rationalization in late 2014;

 

    decline in eBook revenues; and

 

    unfavorable timing associated with subscription renewals; partially offset by

 

    digital subscription revenue growth due, in part, to renewal rates in excess of 90%.

Cost of Sales

 

     Six Months Ended        
     June 30, 2015     June 30, 2014     $ Change     % Change  
(Dollars in thousands)                         

Cost of sales, as reported

   $ 188,536      $ 222,186      $ (33,650     (15.1 )% 

Impact of purchase accounting

     —          41,585        (41,585     (100.0 %) 
  

 

 

   

 

 

   

 

 

   

 

 

 

Cost of sales, excluding the impact of purchase accounting

   $ 188,536      $ 180,601      $ 7,935        4.4
  

 

 

   

 

 

   

 

 

   

 

 

 

Excluding purchase accounting—% of revenue

     27.6     26.0    

Cost of sales for the six months ended June 30, 2015 and June 30, 2014 was $188.5 million and $222.2 million, respectively. Excluding the impact of purchase accounting (which negatively impacted cost of sales as a result of the step-up in the carrying value of inventory on the opening balance sheet), cost of sales for the six months ended June 30, 2015 and June 30, 2014 was $188.5 million and $180.6 million, respectively, an increase of $7.9 million or 4.4%. This net increase was driven by:

 

    Higher royalty expense due to increased sales of our digital learning solutions in our K-12 business which, in accordance with U.S. GAAP, are deferred while royalty costs are generally expensed as incurred; and

 

    Increased freight charges for unreimbursed K-12 shipments.

 

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Operating and Administration Expenses

Operating and administration expenses for the six months ended June 30, 2015 and June 30, 2014 were $525.1 million and $552.4 million, respectively, a decrease of $27.3 million or 4.9%. Included within operating and administration expense is the amortization of pre-publication costs which decreased by $4.7 million or 18.4% as a result of more effective and efficient capital deployment. The remaining decrease was driven by:

 

    a $6.3 million reduction in samples expense as we continue to emphasize our digital learning solutions over traditional print offerings and leverage digital for sampling purposes;

 

    a $5.3 million decrease in restructuring and cost savings implementation charges;

 

    a $21.6 million cost reduction due to the completion of physical separation from MHC, our former parent company, in 2014;

 

    the realization of cost savings associated with restructuring and cost savings initiatives implemented in late 2014 and early 2015; and

 

    a $7.5 million decline in acquisition costs; partially offset by

 

    continued investment in DPG, a year-over-year increase of $12.5 million.

Depreciation & Amortization of Intangibles

Depreciation and amortization expenses for the six months ended June 30, 2015 and June 30, 2014 were $61.0 million and $71.8 million, respectively, a decrease of $10.8 million or 15.0%. This decrease was the result of having finalized the valuation of intangible assets acquired at the time of the Founding Acquisition.

Interest expense, net

Interest expense, net, for the six months ended June 30, 2015 and 2014 was $96.8 million and $89.6 million, respectively, an increase of $7.2 million or 8.0%. The increase was the result of the following:

 

    the original issuance of the $400.0 million in MHGE PIK Toggle Notes on July 17, 2014 and subsequent issuance of an additional $100.0 million of MHGE PIK Toggle Notes in April 2015; partially offset by

 

    the refinancing of the MHGE Term Loan on March 24, 2014, which reduced the applicable LIBOR margin from 7.75% to 4.75% and voluntary principal payment of $35.0 million; and

 

    the refinancing of the MHGE Term Loan in May 2015, which further reduced the applicable LIBOR margin of 4.75% to 3.75%, and voluntary principal payment of $0.3 million.

Other (income) expense

Other (income) expense for the six months ended June 30, 2015 and 2014 was $(4.8) million and $(7.3) million, respectively related to the following:

 

    a gain of $4.8 million relating to the sale of an investment in an equity security; and

 

    a $7.3 million gain recognized on the original 20% equity interest in LearnSmart held at the time the remaining 80% was acquired on February 6, 2014.

Provision for Taxes on Income

Taxes on income from continuing operations for the six months ended June 30, 2015 and 2014 were a benefit of $2.5 million and $108.6 million, respectively, a decrease of $106.1 million. As of December 31, 2014, a full valuation allowance was recorded against federal and state deferred tax assets due to negative evidence of

 

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cumulative book losses incurred in the Successor period. In assessing the need for a valuation allowance, we considered both positive and negative evidence related to the likelihood of realization of the deferred tax assets. The weight given to the positive and negative evidence is commensurate with the extent to which the evidence can be objectively verified. A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome in determining that a valuation allowance is not needed against deferred tax assets. As such, it is generally difficult for positive evidence regarding projected future taxable income exclusive of reversing taxable temporary differences to outweigh objective negative evidence of recent financial reporting losses. Because the valuation allowance was recorded as of December 31, 2014, no deferred income tax benefit was recognized for domestic loss on operations for the six months ended June 30, 2015, while a deferred income tax benefit was recognized for domestic loss on operations for the six months ended June 30, 2014.

Discontinued Operations

The Company sold substantially all of the assets and certain liabilities of the Company’s wholly owned CTB business to Data Recognition Corporation in June 2015. The net loss attributable to discontinued operations was $62.2 million for the six months ended June 30, 2015 as compared to net income of $10.7 million for the six months ended June 30, 2014. The difference of $72.9 million is primarily due to a $38.8 million loss on sale recognized in 2015 in addition to material contract expirations and non-renewal attributable, in part, to slow and uneven state adoptions of Common Core assessment tests which negatively impacted the market and the number of new business opportunities.

 

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Combined Consolidated Operating Results for the Year Ended December 31, 2014 (Successor) and the Periods Ended March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor)

 

     Successor           Predecessor              
     Year Ended
December 31,
2014
    March 23,
2013 to
December 31,
2013
          January 1,
2013 to
March 22,
2013
    $ Change     % Change  
(Dollars in thousands)                                     

Revenue

   $ 1,855,779      $ 1,589,574           $ 229,441      $ 36,764        2.0

Cost of sales

     533,913        777,384             64,006        (307,477     (36.5 )% 
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Gross profit

     1,321,866        812,190             165,435        344,241        35.2

Operating expenses

               

Operating and administration expenses

     1,194,656        841,652             208,816        144,188        13.7

Depreciation

     22,086        23,538             5,817        (7,269     (24.8 )% 

Amortization of intangibles

     104,157        69,181             6,326        28,650        37.9

Impairment charge

     23,800        —               —          23,800        100.0

Transaction costs

     3,932        56,820             —          (52,888     (93.1 )% 
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Total operating expenses

     1,348,631        991,191             220,959        136,481        11.3
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Operating (loss) income

     (26,765     (179,001          (55,524     207,760        (88.6 )% 

Interest expense (income), net

     181,890        137,283             488        44,119        32.0

Other (income) expense

     (8,420     —               —          (8,420     100.0
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

(Loss) income from operations before taxes on income

     (200,235     (316,284          (56,012     172,061        (46.2 )% 

Income tax (benefit) provision

     112,571        (130,158          (20,410     263,139        (174.8 )% 
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Net (loss) income from continuing operations

     (312,806     (186,126          (35,602     (91,078     41.1

Net (loss) income from discontinued operations, net of taxes

     (18,157     18,617             4,058        (40,832     (180.1 )% 
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Net (loss) income

   $ (330,963   $ (167,509        $ (31,544   $ (131,910     66.3
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Less: Net (income) loss attributable to non-controlling interests

     299        (2,251          631        1,919        (118.5 )% 
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Net (loss) income attributable to McGraw-Hill Education, Inc.

   $ (330,664   $ (169,760        $ (30,913   $ (129,991     64.8
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Revenue

 

     Successor            Predecessor               
     Year Ended
December 31,
2014
    March 23,
2013 to
December 31,
2013
    

 

   January 1,
2013 to
March 22,
2013
     $ Change     % Change  
(Dollars in thousands)                                       

Revenue, as reported

                 

Higher Education

   $ 840,549      $ 664,698            $ 107,717       $ 68,134        8.8

K-12

     565,301        533,769              43,199         (11,667     (2.0 )% 

International

     333,764        296,353              53,009         (15,598     (4.5 )% 

Professional

     116,774        93,988              23,139         (353     (0.3 )% 

Other

     (609     766              2,377         (3,752     (119.4 )% 
  

 

 

   

 

 

         

 

 

    

 

 

   

 

 

 

Total Revenue

   $ 1,855,779      $ 1,589,574            $ 229,441       $ 36,764        2.0
  

 

 

   

 

 

         

 

 

    

 

 

   

 

 

 

 

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Revenue for the year ended December 31, 2014 (Successor) and the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $1,855.8 million and $1,589.6 million and $229.4 million, respectively, an increase of $36.8 million or 2.0%. Excluding the impact of purchase accounting (which negatively impacted revenue as a result of the adjustment recorded to reduce the carrying value of deferred revenue on the opening balance sheet), revenue for the year ended December 31, 2014 (Successor) and the periods ended March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $1,886.4 million and $1,651.4 million and $229.4 million, respectively, an increase of $5.6 million or 0.3%. This net increase was driven by the segment factors discussed below.

Higher Education

Higher Education revenue for the year ended December 31, 2014 (Successor) and the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $840.5 million and $664.7 million and $107.7 million, respectively, an increase of $68.1 million or 8.8%. Excluding the impact of purchase accounting, revenue for the year ended December 31, 2014 (Successor) and the periods ended March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $834.8 million and $690.0 million and $107.7 million, respectively, an increase of $37.1 million or 4.7%. The increase was primarily due to:

 

    digital revenue growth of nearly $60.0 million driven by our Connect and LearnSmart offerings, eBooks and a full year of incremental ALEKS revenues (acquired in August 2013) driven by continued growth in unique users of and engagement with our digital learning solutions (unique users of Connect grew 17% to 3.0 million; unique users of LearnSmart grew 33% to 2.0 million; unique users of ALEKS grew 25% to 0.9 million); partially offset by

 

    a decline in print revenue of $22.0 million or 4% as customers migrate from traditional print to digital learning solutions.

K-12

K-12 revenue for the year ended December 31, 2014 (Successor) and the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $565.3 million and $533.8 million and $43.2 million, respectively, a decrease of $11.7 million or 2.0%. Excluding the impact of purchase accounting, revenue for the year ended December 31, 2014 (Successor) and the periods ended March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $597.3 million and $566.5 million and $43.2 million, respectively, a decrease of $12.4 million or 2.0%. The decrease was primarily due to:

 

    net deferred revenue growth of $68.7 million driven by increased sales of our digital learning solutions (which are required to be deferred and recognized to income over time (five to eight years) in accordance with U.S. GAAP);

 

    a decline in Everyday Math revenues in anticipation of the new product release; partially offset by

 

    strong adoption state sales (both print and digital) in secondary math and science in Texas and secondary math in California;

 

    strong open territory sales, most notably Hawaii and Pennsylvania; and

 

    the full year results of ALEKS, which was acquired in August 2013.

 

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International

International revenue for the year ended December 31, 2014 (Successor) and the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $333.8 million and $296.4 million and $53.0 million, respectively, a decrease of $15.6 million or 4.5%. Excluding the impact of purchase accounting, revenue for the year ended December 31, 2014 (Successor) and the periods ended March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $334.4 million and $297.5 million and $53.0 million, respectively, a decrease of $16.1 million or 4.6%. The decrease was primarily due to the following:

 

    unfavorable foreign exchange impact of $6.4 million (estimated by re-calculating current year results of foreign operations using the average exchange rate from the prior year); and

 

    a decline in print revenues; partially offset by

 

    an increase in digital revenues to approximately 10% of total revenues.

Geographic performance was affected by growth in the Asia Pacific region, driven by higher education market share gains in Australia; a decline in performance in the EMEA, driven partially by cyclical nature of K-12 renewals and pressure on government funding; and lower performance in Latin America across all segments.

Professional

Professional revenue for the year ended December 31, 2014 (Successor) and the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $116.8 million and $94.0 million and $23.1 million, respectively, a decrease of $0.4 million or 0.3%. Excluding the impact of purchase accounting, revenue for the year ended December 31, 2014 (Successor) and the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $120.5 million and $96.7 million and $23.1 million, respectively, an increase of $0.7 million or 0.6%. The increase was primarily due to the following:

 

    a digital revenue increase of 8%, net of eBook revenue declines, to approximately 40% of total revenues with digital subscription renewal rates continuing to exceed 90%; partially offset by

 

    expected print revenue declines.

Cost of Sales

 

     Successor           Predecessor              
     Year Ended
December 31,
2014
    March 23,
2013 to
December 31,
2013
          January 1,
2013 to
March 22,
2013
    $ Change     % Change  
(Dollars in thousands)                                     

Cost of sales, as reported

   $ 533,913      $ 777,384           $ 64,006      $ (307,477     (36.5 )% 

Impact of purchase accounting

     41,585        312,615             —          (271,030     (86.7 )% 
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Cost of sales, excluding the impact of purchase accounting

   $ 492,328      $ 464,769           $ 64,006      $ (36,447     (6.9 )% 
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Excluding purchase accounting—% of revenue

     26.1     28.1          27.9  

Cost of sales for the year ended December 31, 2014 (Successor) and the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $533.9 million and $777.4 million and $64.0 million, respectively. Excluding the impact of purchase accounting (which negatively

 

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impacted cost of sales as a result of the step-up in the carrying value of inventory on the opening balance sheet), cost of sales for the year ended December 31, 2014 (Successor) and the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $492.3 million and $464.8 million and $64.0 million, respectively, a decrease of $36.5 million or 6.9%. The net decrease was driven by:

 

    royalty savings as a result of the ALEKS acquisition in August 2013 and LearnSmart acquisition in February 2014; and

 

    decreased manufacturing and gratis product costs during the period due to the continued migration from print to digital solutions.

Operating and Administration Expenses

Operating and administration expenses for the year ended December 31, 2014 (Successor) and periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) were $1,194.7 million and $841.7 million and $208.8 million, respectively, an increase of $144.2 million or 13.7%. Included within operating and administration expense is the amortization of pre-publication costs which decreased by $5.1 million or 5.9% as a result of more efficient capital deployment and the impact of transitioning from a print to digital operating model. The remaining variance was due to:

 

    an increase in digital related expenditures associated with the formal establishment and build-out of DPG (approximately $60.0 million) subsequent to the separation of the business from MHC;

 

    physical separation cost increase of $38.6 million related to the carve-out of MHE operations from MHC;

 

    investment in selling and marketing of approximately $30.8 million in advance of sales opportunities in 2014 and future periods for both K-12 and Higher Education; and

 

    increased technology costs as a standalone entity; partially offset by

 

    the realization of cost savings associated with actions taken subsequent to the Founding Acquisition, including headcount reduction, facilities rationalization, technology optimization and outsourcing as part of our comprehensive cost savings program.

Depreciation & Amortization of Intangibles

Depreciation and amortization expenses for the year ended December 31, 2014 (Successor) and periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) were $126.2 million and $92.7 million and $12.1 million, respectively. This was primarily due to the definite-lived intangible assets associated with the following acquisitions:

 

    Founding Acquisition: $998 million (completed March 2013; full year impact in 2014);

 

    LearnSmart: $44.8 million (acquired February 2014; partial year impact in 2014);

 

    ALEKS: $40.7 million (acquired August 2013; full year impact in 2014); and

 

    Engrade: $5.8 million (acquired February 2014; partial year impact in 2014).

Transaction related expenses

The transaction related expenses for the year ended December 31, 2014 (Successor) and period from March 23, 2013 to December 31, 2013 (Successor) were $3.9 million and $56.8 million, respectively. These amounts represent the transaction costs associated with the Founding Acquisition, which include legal and consulting expenses. There were no transaction related expenses recorded in the Predecessor period.

 

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Interest expense, net

Interest expense, net, for the year ended December 31, 2014 (Successor) and periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $181.9 million and $137.3 million and $0.5 million, respectively. The net change was the result of the following:

 

    the debt incurred to finance the Founding Acquisition, including an initial $810 million 6-year MHGE Term Loan, all of which was drawn at closing, $240.0 million 5-year MHGE Revolving Facility, of which $35.0 million was drawn at closing, the issuance of $800.0 million MHGE Senior Secured Notes and a $150 million 5-year MHSE Revolving Facility, which was undrawn at closing;

 

    the $250.0 million First-Lien Credit Agreement Term Loan entered into by MHSE on December 18, 2013; and

 

    the $400.0 million issuance of the MHGE PIK Toggle Notes on July 17, 2014.

During the year ended December 31, 2014 (Successor), the interest expense, net was favorably impacted by the voluntary principal payments of the MHGE Term Loan of $35.0 million and $81.0 million on March 24, 2014 and December 31, 2013, respectively, as well as the refinancing of the MHGE Term Loan on March 24, 2014, which reduced the applicable LIBOR margin from 7.75% to 4.75%. This interest expense reduction was partially offset by the additional debt incurred by MHSE on December 18, 2013.

Other (income) expense

Other (income) expense for the year ended December 31, 2014 (Successor) and periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) was $(8.4) million and none and none, respectively, related to the following:

 

    a $7.3 million gain recognized on the original 20% equity interest in LearnSmart held at the time the remaining 80% was acquired on February 6, 2014; and

 

    the sale of two parcels of land in November 2014 for a gain of $1.1 million.

Provision for Taxes on Income

Taxes on income for the year ended December 31, 2014 (Successor) and periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor), were a provision of $112.6 million and benefits of $130.2 million and $20.4 million, respectively. For the year ended December 31, 2014 (Successor) and the periods March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor), the effective tax rate was (56.2)% and 41.2% and 36.4%, respectively. The Predecessor tax provisions and related deferred tax assets and liabilities were determined as if the Company were a separate taxpayer.

The taxes on income for the year ended December 31, 2014 (Successor) were negatively impacted by a full valuation allowance recorded by the Company against federal and state deferred tax assets due to negative evidence of cumulative book losses incurred in the Successor period. In assessing the need for a valuation allowance, the Company considered both positive and negative evidence related to the likelihood of realization of the deferred tax assets. The weight given to the positive and negative evidence is commensurate with the extent to which the evidence can be objectively verified. A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome in determining that a valuation allowance is not needed against deferred tax assets. As such, it is generally difficult for positive evidence regarding projected future taxable income exclusive of reversing taxable temporary differences to outweigh objective negative evidence of recent financial reporting losses.

 

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Discontinued Operations

The Company sold substantially all of the assets and certain liabilities of the Company’s wholly-owned CTB business to Data Recognition Corporation in June 2015. For the year ended December 31, 2014 (Successor) and periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor), there was a net loss of $18.2 million and net income of $18.6 million and net income of $4.1 million attributable to discontinued operations. The net loss in 2014 was the result of a $32.5 million impairment of goodwill, material contract expirations and non-renewal as well as slow and uneven state adoptions of Common Core assessment tests which negatively impacted the market and the number of new business opportunities.

Combined Consolidated Operating Results for the Periods Ended March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the Year Ended December 31, 2012 (Predecessor)

 

     Successor           Predecessor              
     March 23,
2013 to
December 31,
2013
          January 1,
2013 to
March 22,
2013
    December 31,
2012
    $ Change     % Change  
(Dollars in thousands)                                     

Revenue

   $ 1,589,574           $ 229,441      $ 1,917,599      $ (98,584     (5.1 )% 

Cost of sales

     777,384             64,006        541,306        300,084        55.4
  

 

 

        

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     812,190             165,435        1,376,293        (398,668     (29.0 )% 

Operating expenses

           

Operating and administration expenses

     841,652             208,816        1,224,126        (173,658     (14.2 )% 

Depreciation

     23,538             5,817        28,083        1,272        4.5

Amortization of intangibles

     69,181             6,326        25,130        50,377        200.5

Impairment charge

     —               —          412,886        (412,886     (100.0 )% 

Transaction costs

     56,820             —          —          56,820        100.0
  

 

 

        

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     991,191             220,959        1,690,225        (478,075     (28.3 )% 
  

 

 

        

 

 

   

 

 

   

 

 

   

 

 

 

Operating (loss) income

     (179,001          (55,524     (313,932     79,407        (25.3 )% 

Interest expense (income), net

     137,283             488        (1,688     139,459        (8,261.8 )% 

Other (income) expense

     —               —          (16,868     16,868        (100.0 )% 
  

 

 

        

 

 

   

 

 

   

 

 

   

 

 

 

(Loss) income from operations before taxes on income

     (316,284          (56,012     (295,376     (76,920     26.0

Income tax (benefit) provision

     (130,158          (20,410     (19,704     (130,864     664.1
  

 

 

        

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income from continuing operations

     (186,126          (35,602     (275,672     53,944        (19.6 )% 

Net (loss) income from discontinued operations, net of taxes

     18,617             4,058        23,897        (1,222     (5.1 )% 
  

 

 

        

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income

   $ (167,509        $ (31,544   $ (251,775   $ 52,722        (20.9 )% 
  

 

 

        

 

 

   

 

 

   

 

 

   

 

 

 

Less: Net (income) loss attributable to non-controlling interests

     (2,251          631        (4,559     2,939        (64.5 )% 
  

 

 

        

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income attributable to McGraw-Hill Education, Inc.

   $ (169,760        $ (30,913   $ (256,334   $ 55,661        (21.7 )% 
  

 

 

        

 

 

   

 

 

   

 

 

   

 

 

 

 

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Revenue

 

     Successor            Predecessor              
     March 23,
2013 to
December 31,
2013
           January 1,
2013 to
March 22,
2013
     December 31,
2012
    $ Change     % Change  
(Dollars in thousands)                                      

Revenue, as reported

                 

Higher Education

   $ 664,698            $ 107,717       $ 766,803      $ 5,612        0.7

K-12

     533,769              43,199         658,652        (81,684     (12.4 )% 

International

     296,353              53,009         370,830        (21,468     (5.8 )% 

Professional

     93,988              23,139         121,601        (4,474     (3.7 )% 

Other

     766              2,377         (287     3,430        (1,195.1 )% 
  

 

 

         

 

 

    

 

 

   

 

 

   

 

 

 

Total Revenue

   $ 1,589,574            $ 229,441       $ 1,917,599      $ (98,584     (5.1 )% 
  

 

 

         

 

 

    

 

 

   

 

 

   

 

 

 

Revenue for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor) was $1,589.6 million and $229.4 million and $1,917.6 million, respectively, a decrease of $98.6 million or 5.1%. Excluding the impact of purchase accounting (which negatively impacted revenue as a result of the adjustment recorded to reduce the carrying value of deferred revenue on the opening balance sheet), revenue for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor) was $1,651.4 million and $229.4 million and $1,917.6 million, respectively, a decrease of $36.8 million or 1.9%. This net decrease was driven by the following segment factors.

Higher Education

Higher Education revenue for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and for the year ended December 31, 2012 (Predecessor) was $664.7 million and $107.7 million and $766.8 million, respectively, an increase of $5.6 million or 0.7%. Excluding the impact of purchase accounting, revenue for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor) was $690.0 million and $107.7 million and $766.8 million, respectively, an increase of $30.9 million or 4.0%. This increase was primarily due to:

 

    digital revenue growth of more than $40.0 million driven by Connect, LearnSmart, eBooks and a full year of incremental ALEKS revenues (acquired in August 2013); offset by

 

    net print decline of approximately $13.0 million or 2% due to migration from traditional print to digital learning solutions offset by custom print growth.

K-12

K-12 revenue for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and for the year ended December 31, 2012 (Predecessor) was $533.8 million and $43.2 million and $658.7 million, respectively. Excluding the impact of purchase accounting, revenue for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor) was $566.5 million and $43.2 million and $658.7 million, respectively, a decrease of $49.0 million or 7.4%. This decrease was primarily due to:

 

    decline in open territory revenues;

 

    net deferred revenue growth of $28.2 million driven by increased sales of our digital learning solutions (which are required to be deferred and recognized to income over time (5 – 8 years) in accordance with U.S. GAAP); partially offset by

 

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    strong adoption revenues for Florida social studies and Alabama math in 2012 in addition to the strategic decision to focus on fewer, more profitable curriculum opportunities; and

 

    the partial year impact of the ALEKS acquisition.

International

International revenue for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and for the year ended December 31, 2012 (Predecessor) was $296.4 million and $53.0 million and $370.8 million, respectively, a decrease of $21.5 million or 5.8%. Excluding the impact of purchase accounting, revenue for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor) was $297.5 million and $53.0 million and $370.8 million, respectively, a decrease of $20.3 million or 5.5%. The decrease was primarily due to the following:

 

    decline in traditional print revenues;

 

    unfavorable foreign exchange impact of $4.9 million (estimated by re-calculating current year results of foreign operations using the average exchange rate from the prior year); partially offset by

 

    digital revenue growth during the period; and

 

    strong higher education revenues, which accounted for the majority of sales in each period.

Geographic performance was driven by higher education market share gains in Australia, which drove Asia Pacific region growth; a decline in Spain sales due, in part, to reduced government spending, which negatively impacted EMEA performance; and a sales decline in India due to the impact of the 18th edition release of Harrison’s Principles of Internal Medicine in the prior year.

Professional

Professional revenue for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and for the year ended December 31, 2012 (Predecessor) was $94.0 million and $23.1 million and $121.6 million, respectively, a decrease of $4.5 million or 3.7%. Excluding the impact of purchase accounting, revenue for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor) was $96.7 million and $23.1 million and $121.6 million, respectively, a decrease of $1.8 million or 1.5%. The decrease was primarily due to the following:

 

    print revenue declines driven, in part, by a shift in customer buying patterns to eBook offerings; partially offset by

 

    a 15% increase in digital revenue to nearly 40% of total revenue, driven by digital subscription revenue and eBook sales.

Cost of sales

 

    Successor          Predecessor              
    March 23, 2013
to December 31,
2013
         January 1,
2013 to March 22,
2013
    Year Ended
December 31,
2012
    $ Change     % Change  
(Dollars in thousands)                                   

Cost of sales, as reported

  $ 777,384          $ 64,006      $ 541,306      $ 300,084        55.4

Impact of purchase accounting

    312,615            —          —          312,615        100.0
 

 

 

       

 

 

   

 

 

   

 

 

   

 

 

 

Cost of sales, excluding the impact of purchase accounting

  $ 464,769          $ 64,006      $ 541,306      $ (12,531     (2.3 )% 
 

 

 

       

 

 

   

 

 

   

 

 

   

 

 

 

Excluding purchase accounting—% of revenue

    28.1         27.9     28.2    

 

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Cost of sales for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and for the year ended December 31, 2012 (Predecessor) was $777.4 million and $64.0 million and $541 million, respectively. Excluding the impact of purchase accounting (which negatively impacted cost of sales as a result of the step-up in the carrying value of inventory on the opening balance sheet), cost of sales for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and for the year ended December 31, 2012 (Predecessor) was $464.8 million and $64.0 million and $541.3 million, respectively, a decrease of $12.5 million or 2.3%. The cost decrease was driven by:

 

    manufacturing cost savings of nearly $10 million due to the migration to digital; and

 

    a slight reduction in royalty expense due, in part, to the acquisition of ALEKS in August 2013; partially offset by

 

    increased gratis product costs associated with our K-12 business.

Operating and Administration Expenses

Operating and administration expenses for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and for the year ended December 31, 2012 (Predecessor) were $841.7 million and $208.8 million and $1,224.1 million, respectively, a decrease of $173.6 or 14.2%. The decrease was driven by:

 

    a $93.8 million decrease in pre-publication amortization expense due to the impact of purchase accounting in conjunction with the Founding Acquisition;

 

    elimination of $88.6 million of MHC corporate overheads in 2012; and

 

    a $24.4 million reduction in restructuring and cost savings implementation charges; partially offset by

 

    an increase in digital related expenditures associated with the formalization and build-out of DPG subsequent to the separation of the business from MHC;

 

    $4.8 million of acquisition costs incurred in 2013 associated with acquisitions other than the Founding Acquisition; and

 

    $8.1 million of physical separation costs incurred post the Founding Acquisition.

Depreciation & Amortization of Intangibles

Depreciation and amortization expenses for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and for the year ended December 31, 2012 (Predecessor) were $92.7 million and $12.1 million and $53.2 million, respectively, an increase of $51.6 million. This increase was primarily due to the definite-lived intangible assets associated with the following acquisitions:

 

    Founding Acquisition: $998.0 million (completed March 2013; partial year impact in 2013); and

 

    ALEKS: $41 million (acquired August 2013; partial year impact in 2013).

Transaction related expenses

The transaction related expenses for the period from March 23, 2013 to December 31, 2013 (Successor) were $56.8 million. This amount represents the transaction costs associated with the Founding Acquisition, which include external legal and consulting expenses. There were no transaction related expenses in the Predecessor period.

 

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Interest expense, net

Interest expense, net, for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor) were $137.3 million and $0.5 million and income of $1.7 million, respectively. This increase is primarily a result of the debt incurred to finance the Founding Acquisition.

The Founding Acquisition was financed by borrowings consisting of an initial $810.0 million 6-year MHGE Term Loan, all of which was drawn at closing, $240.0 million 5-year MHGE Revolving Facility, of which $35.0 million was drawn at closing, an issuance of $800.0 million MHGE Senior Secured Notes and a $150.0 million 5-year MHSE Revolving Facility, which was undrawn at closing.

Other (income) expense

Other (income) expense for March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor) was none and none and $(16.9) million, respectively related to a $16.9 million gain recognized in the fourth quarter of 2012 due to a change in our vacation policy.

Provision for Taxes on Income

Taxes on income for the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor), were benefits of $130.2 million and $20.4 million and $19.7 million, respectively. For the periods March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor), the effective tax rate was 41.2% and 36.4% and 6.7%, respectively. The tax provision for the year ended December 31, 2012 (Predecessor) was negatively impacted by the non-deductible impairment of K-12 business goodwill. The Predecessor tax provisions and related deferred tax assets and liabilities were determined as if the Company were a separate taxpayer.

Discontinued Operations

The Company sold substantially all of the assets and certain liabilities of the Company’s wholly-owned CTB business to Data Recognition Corporation in June 2015. For the periods from March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor), net income from discontinued operations was $18.6 million and $4.1 million and $23.9 million, respectively. The variance from 2012 to 2013 was the result of a mix shift to lower margin custom products, increased product investment in 2013 and contract remediation costs incurred.

Non-GAAP Measures

Adjusted Revenue, EBITDA and Adjusted EBITDA

The SEC has adopted rules to regulate the use in filings with the SEC and in public disclosures of “non-GAAP financial measures,” such as Adjusted Revenue, EBITDA and Adjusted EBITDA and the ratios related thereto. These measures are derived on the basis of methodologies other than in accordance with U.S. GAAP.

Adjusted Revenue is a non-GAAP financial measure that we define as the total amount of revenue that would have been recognized in a period if we recognized all revenue immediately at the time of sale. We use Adjusted Revenue as a performance measure given that we typically collect full payment for our digital and print solutions at the time of sale or shortly thereafter, but recognize revenue from digital solutions and multi-year deliverables ratably over the term of our customer contracts. Adjusted Revenue is a key metric we use to manage our business as it reflects the sales activity in a given period, particularly in the K-12 market, in which customers typically pay for five to eight year contracts upfront. Adjusted Revenue is U.S. GAAP revenue plus the net change in deferred revenue.

 

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EBITDA, a measure used by management to assess operating performance, is defined as net income from continuing operations plus net interest, income taxes, depreciation and amortization (including amortization of pre-publication investment cash costs). Adjusted EBITDA is defined as EBITDA adjusted to exclude unusual items and other adjustments required or permitted under our debt agreements. Adjusted EBITDA is the fundamental profitability metric we use to manage our business as it reflects the sales activity in a given period, as well as the impact of our continuing investment in pre-publication activities, which are important to the ongoing success of our business.

Each of the above described measures is not a recognized term under U.S. GAAP and does not purport to be an alternative to revenue, income from continuing operations, income from operations or any other measure derived in accordance with U.S. GAAP as a measure of operating performance or to cash flows from operations as a measure of liquidity. Additionally, each such measure is not intended to be a measure of free cash flows available for management’s discretionary use, as it does not consider certain cash requirements such as interest payments, tax payments and debt service requirements. Such measures have limitations as analytical tools, and you should not consider any of such measures in isolation or as substitutes for our results as reported under U.S. GAAP. Management compensates for the limitations of using non-GAAP financial measures by using them to supplement U.S. GAAP results to provide a more complete understanding of the factors and trends affecting the business than U.S. GAAP results alone. Because not all companies use identical calculations, our measures may not be comparable to other similarly titled measures of other companies. See “Use of Non-GAAP Financial Information” and “Prospectus Summary—Our Key Metrics.”

Management believes Adjusted EBITDA is helpful in highlighting trends because Adjusted EBITDA excludes the results of decisions that are outside the control of operating management and can differ significantly from company to company depending on long-term strategic decisions regarding capital structure, the tax rules in the jurisdictions in which companies operate, and capital investments. In addition, Adjusted Revenue and Adjusted EBITDA provides more comparability between the historical operating results and operating results that reflect purchase accounting and the new capital structure post the Founding Acquisition as well as the digital transformation that we are undertaking which requires different accounting treatment for digital and print solutions in accordance with U.S. GAAP.

Management believes that the inclusion of supplementary adjustments to Adjusted EBITDA applied in presenting Adjusted EBITDA are appropriate to provide additional information to investors about certain material non-cash items and about unusual items that we do not expect to continue at the same level in the future.

 

     Six Months Ended  
     June 30, 2015     June 30, 2014  
(Dollars in thousands)             

Higher Education

   $ 243,849      $ 229,441   

K-12

     295,725        276,336   

International

     116,572        127,280   

Professional

     52,075        56,994   

Other

     2,400        1,232   
  

 

 

   

 

 

 

Adjusted Revenue

   $ 710,621      $ 691,283   
  

 

 

   

 

 

 

Change in deferred revenue

     (40,478     (12,203
  

 

 

   

 

 

 

Reported Revenue

   $ 670,143      $ 679,080   
  

 

 

   

 

 

 

Net income (loss) from continuing operations

   $ (194,037   $ (144,430

Interest (income) expense, net

     96,765        89,626   

Provision for (benefit from) taxes on income

     (2,527     (108,582

Depreciation, amortization and pre-publication investment amortization

     89,293        96,590   
  

 

 

   

 

 

 

EBITDA

   $ (10,506   $ (66,796
  

 

 

   

 

 

 

 

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Table of Contents
     Six Months Ended  
     June 30, 2015     June 30, 2014  
(Dollars in thousands)             

Change in deferred revenue(a)

     40,478        12,203   

Restructuring and cost savings implementation charges(b)

     13,730        19,025   

Sponsor fees(c)

     1,750        1,750   

Purchase accounting(f)

     —          41,585   

Transaction costs(g)

     —          3,421   

Acquisition costs(h)

     —          4,045   

Physical separation costs(i)

     —          21,607   

Other(j)

     7,707        8,762   

Pre-publication investment cash costs(k)

     (44,602     (37,614
  

 

 

   

 

 

 

Adjusted EBITDA

   $ 8,557      $ 7,988   
  

 

 

   

 

 

 

 

     Successor           Predecessor  
     Year Ended
December 31,
2014
    March 23, 2013
to December 31,
2013
          January 1, 2013
to March 22,
2013
    Year Ended
December 31,
2012
 
(Dollars in thousands)                               

Higher Education

   $ 838,310      $ 718,076           $ 93,289      $ 779,785   

K-12

     734,417        638,197             38,942        697,932   

International

     335,809        300,487             54,289        372,354   

Professional

     127,299        99,429             25,738        128,041   

Other

     (997     2,110             (121     —     
  

 

 

   

 

 

        

 

 

   

 

 

 

Adjusted Revenue

   $ 2,034,838      $ 1,758,299           $ 212,137      $ 1,978,112   
  

 

 

   

 

 

        

 

 

   

 

 

 

Change in deferred revenue

     (179,059     (168,725          17,304        (60,513
  

 

 

   

 

 

        

 

 

   

 

 

 

Reported Revenue

   $ 1,855,779      $ 1,589,574           $ 229,441      $ 1,917,599   
  

 

 

   

 

 

        

 

 

   

 

 

 

Net income (loss) from continuing operations

   $ (312,806   $ (186,126        $ (35,602   $ (275,672

Interest (income) expense, net

     181,890        137,283             488        (1,688

Provision for (benefit from) taxes on income

     112,571        (130,158          (20,410     (19,704

Depreciation, amortization and pre-publication investment amortization

     205,831        163,883             25,434        228,565   
  

 

 

   

 

 

        

 

 

   

 

 

 

EBITDA

   $ 187,486      $ (15,118        $ (30,090   $ (68,499
  

 

 

   

 

 

        

 

 

   

 

 

 

Change in deferred revenue(a)

     179,059        168,725             (17,304     60,513   

Restructuring and cost savings implementation charges(b)

     39,888        33,984             4,116        62,477   

Sponsor fees(c)

     3,500        875             —          —     

Elimination of corporate overhead(d)

     —          —               —          88,551   

Impairment charge(e)

     23,800        —               —          412,886   

Purchase accounting(f)

     41,585        312,615             —          —     

Transaction costs(g)

     3,932        56,820             —          —     

Acquisition costs(h)

     4,376        4,796             —          —     

Physical separation costs(i)

     46,716        8,100             —          —     

Other(j)

     29,109        23,944             5,627        (1,559

Pre-publication investment cash costs(k)

     (87,085     (96,615          (25,319     (168,623

Stand-alone cost savings(l)

     —          —               —          27,392   
  

 

 

   

 

 

        

 

 

   

 

 

 

Adjusted EBITDA

   $ 472,366      $ 498,126           $ (62,970   $ 413,138   
  

 

 

   

 

 

        

 

 

   

 

 

 

 

(a) We receive cash up-front for most product sales but recognize revenue (primarily related to digital sales) over time recording a liability for deferred revenue at the time of sale. This adjustment represents the net effect of converting deferred revenues (inclusive of deferred royalties) to a cash basis assuming the collection of all receivable balances.

 

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(b) Represents severance and other expenses associated with headcount reductions and other cost savings initiated as part of our formal restructuring initiatives to create a flatter and more agile organization.
(c) Beginning in 2014, $3.5 million of annual management fees was recorded and payable to Apollo. The amount recorded in the Successor period from March 23, 2013 to December 31, 2013 was $0.9 million.
(d) General corporate allocations for executive management costs incurred by MHC were allocated to the business prior to Q1 2013.
(e) An impairment charge was recorded in 2014 to reduce the recorded value of an owned office building to its estimated fair value based upon an independent appraisal. In addition, a goodwill impairment charge was recorded in 2012 relating to the K-12 reporting unit.
(f) Represents the effects of the application of purchase accounting associated with the Founding Acquisition, driven by the step-up of acquired inventory. The deferred revenue adjustment recorded as a result of purchase accounting has been considered in the deferred revenue adjustment.
(g) The amount represents the transaction costs associated with the Founding Acquisition.
(h) The amount represents costs incurred for acquisitions subsequent to the Founding Acquisition including ALEKS, LearnSmart and Engrade.
(i) The amount represents costs incurred to physically separate our operations from MHC. These physical separation costs were incurred subsequent to the Founding Acquisition and concluded in 2014.
(j) For six months ended June 30, 2015, the amount represents (i) non-cash incentive compensation expense; (ii) elimination of the gain of $4.8 million on the sale of an investment in an equity security and (iii) other adjustments required or permitted in calculating covenant compliance under our debt agreements. For the six months ended June 30, 2014, the amount represents (i) cash distributions to noncontrolling interest holders of $0.1 million; (ii) non-cash incentive compensation expense; (iii) elimination of non-cash gain of $7.3 million relating to LearnSmart; and (iv) other adjustments required or permitted in calculating covenant compliance under our debt agreements.

For the year ended December 31, 2014, the amount represents (i) cash distributions to noncontrolling interest holders of $0.2 million; (ii) non-cash incentive compensation expense; (iii) elimination of non-cash gain of $7.3 million in LearnSmart; and (iv) other adjustments required or permitted in calculating covenant compliance under our debt agreements.

For the periods from March 23, 2013 to December 31, 2013 (Successor) and from January 1, 2013 to March 22, 2013 (Predecessor) and the year ended December 31, 2012 (Predecessor), the amount represents (i) cash distributions to noncontrolling interest holders (excluding special dividends) of $0.5 million and $1.8 million and $5.5 million, respectively; (ii) the elimination of a $16.9 million benefit realized in 2012 as a result of a change in the Company’s vacation policy; (iii) non-cash incentive compensation expense recorded directly beginning in the first quarter of 2013; and (iv) other adjustments required or permitted in calculating covenant compliance under our debt agreements.

 

(k) Represents the cash cost for pre-publication investment during the period excluding discontinued operations.
(l) Represents stand-alone cost savings to reflect our expectation that costs incurred on a stand-alone basis will be lower than costs historically allocated to McGraw-Hill Education, LLC by MHC. These allocations were primarily related to services and expenses including (i) global technology operations and infrastructure; (ii) global real estate occupancy; (iii) employee benefits; and (iv) shared services such as tax, legal, treasury, and finance.

 

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Operating Results Based on Non-GAAP Measures for the Six Months Ended June 30, 2015 and 2014

 

     Six Months Ended      $ Change      % Change  
     June 30,
2015
     June 30,
2014
       
(Dollars in thousands)                            

Higher Education

   $ 243,849       $ 229,441       $ 14,408         6.3

K-12

     295,725         276,336         19,389         7.0

International

     116,572         127,280         (10,708      (8.4 )% 

Professional

     52,075         56,994         (4,919      (8.6 )% 

Other

     2,400         1,232         1,168         94.8
  

 

 

    

 

 

    

 

 

    

 

 

 

Adjusted Revenue

   $ 710,621       $ 691,283       $ 19,338         2.8
  

 

 

    

 

 

    

 

 

    

 

 

 

Change in deferred revenue

     (40,478      (12,203      (28,275      231.7
  

 

 

    

 

 

    

 

 

    

 

 

 

Reported Revenue

   $ 670,143       $ 679,080       $ (8,937      (1.3 )% 
  

 

 

    

 

 

    

 

 

    

 

 

 

Higher Education

   $ 11,350       $ (3,449    $ 14,799         (429.1 )% 

K-12

     (9,239      3,391         (12,630      (372.5 )% 

International

     (3,936      (3,752      (184      4.9

Professional

     8,841         13,036         (4,195      (32.2 )% 

Other

     1,541         (1,238      2,779         (224.5 )% 
  

 

 

    

 

 

    

 

 

    

 

 

 

Adjusted EBITDA

   $ 8,557       $ 7,988       $ 569         7.1
  

 

 

    

 

 

    

 

 

    

 

 

 

Adjusted Revenue for the six months ended June 30, 2015 and June 30, 2014 was $710.6 million and $691.3 million, respectively, an increase of $19.3 million or 2.8%.

Adjusted EBITDA for the six months ended June 30, 2015 and June 30, 2014 was $8.6 million and $8.0 million, respectively, an increase of $0.6 million or 7.1%.

These variances were driven by the segment factors described below.

Higher Education

Adjusted Revenue. Adjusted Revenue for the six months ended June 30, 2015 and June 30, 2014 was $243.8 million and $229.4 million, respectively, an increase of $14.4 million or 6.3%. The increase was due to:

 

    strong digital growth of 25% or $25.5 million, driven predominately by our Connect, LearnSmart and ALEKS offerings driven by growth in unique users and engagement for our digital learning solutions (unique users of Connect grew 13% to 1.9 million; unique users of LearnSmart grew 33% to 1.2 million; unique users of ALEKS grew 17% to 0.6 million); partially offset by

 

    an $11.1 million decrease in print revenues, due primarily to market demand for digital learning solutions as opposed to print products.

Adjusted EBITDA. Adjusted EBITDA for the six months ended June 30, 2015 and June 30, 2014 was $11.4 million and $(3.4) million, respectively, an increase of $14.8 million. The increase was due to:

 

    the profit impact of aforementioned Adjusted Revenue variance;

 

    the realization of cost savings associated with actions taken subsequent to the Founding Acquisition;

 

    reduced samples expense due to efforts to drive digital learning solution sales and digital sampling; partially offset by

 

    continued investment in digital capabilities, primarily through DPG; and

 

    higher commission and bonus expense during the prior year due, in part, to timing.

 

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K-12

Adjusted Revenue. Adjusted Revenue for the six months ended June 30, 2015 and June 30, 2014 was $295.7 million and $276.3 million, respectively, an increase of $19.4 million or 7.0%. The increase was due to:

 

    an increase in total adoption Adjusted Revenue of 33% or approximately $46.0 million due to:

 

  º   K-5 math adoptions in California, including a large Los Angeles Unified School District shipment;

 

  º   6-12 social studies and 9-12 math adoptions in Texas; partially offset by

 

  º   Lower 6-8 math and 6-12 science adoptions in Texas as compared to 2014; partially offset by

 

    a 20% or approximately $23.0 million decline in total open territory Adjusted Revenue due to a smaller market opportunity.

Adjusted EBITDA. Adjusted EBITDA for the six months ended June 30, 2015 and June 30, 2014 was $(9.2) million and $3.4 million, respectively, a decrease of $12.6 million. The decrease was due to:

 

    continued investment in DPG; and

 

    increased pre-publication investment cash costs in advance of future sales opportunities; partially offset by

 

    the profit impact of aforementioned Adjusted Revenue variance; and

 

    reduced samples expense due to a push towards digital sampling.

International

Adjusted Revenue. Adjusted Revenue for the six months ended June 30, 2015 and June 30, 2014 was $116.6 million and $127.3 million, respectively, a decrease of $10.7 million or (8.4)%. The decrease was due to:

 

    a $9.5 million unfavorable foreign exchange rate impact (estimated by re-calculating current year results of foreign operations using the average exchange rate from the prior year); and

 

    print revenue declines; partially offset by

 

    digital growth in excess of 10%, with the majority of digital sales attributable to the Higher Education market.

Geographic performance was driven by Middle East funded orders in the EMEA region; 18% sales growth in Australia, primarily in Higher Education; increased sales in India due to the release of the 19th edition of Harrison’s Principles of Internal Medicine; offset by a sales decline in Latin America, primarily due to lower K-12 and Professional sales.

Adjusted EBITDA. Adjusted EBITDA for the six months ended June 30, 2015 and June 30, 2014 was $(3.9) million and $(3.8) million, respectively. The decrease was due to:

 

    a $1.0 million unfavorable foreign exchange rate impact (estimated by re-calculating current year results of foreign operations using the average exchange rate from the prior year); and

 

    the profit impact of aforementioned Adjusted Revenue variance and slightly lower gross margins due to sales mix; partially offset by

 

    the realization of cost savings associated with restructuring and cost savings initiatives implemented in late 2014; and

 

    more efficient capital deployment and timing related to pre-publication investment cash costs.

 

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Professional

Adjusted Revenue. Adjusted Revenue for the six months ended June 30, 2015 and June 30, 2014 was $52.1 million and $57.0 million, respectively, a decrease of $4.9 million or 8.6%. The decrease was due to:

 

    print decline due, in part, to a portfolio rationalization in late 2014;

 

    unfavorable timing associated with subscription renewals; and

 

    decline in eBook revenues partially; partially offset by

 

    subscription revenue growth with renewal rates in excess of 90%.

Adjusted EBITDA. Adjusted EBITDA for the six months ended June 30, 2015 and June 30, 2014 was $8.8 million and $13.0 million, respectively, a decrease of $4.2 million or 32.2%. The decrease was due to:

 

    the profit impact of the aforementioned Adjusted Revenue variance; and

 

    increase in digital related investment; partially offset by

 

    the realization of cost savings related to a print portfolio and operating model rationalization project undertaken in 2014, which contributed to a reduction in compensation related costs.

Other

Adjusted EBITDA. Adjusted EBITDA for the six months ended June 30, 2015 and June 30, 2014 was $1.5 million and $(1.2) million, respectively, an increase of $2.7 million. The change was driven by:

 

    impact of adjustments made for in-transit product sales in accordance with U.S. GAAP;

 

    timing related corporate adjustments; and

 

    various costs not attributable to a single operating segment.

Combined Consolidated Operating Results Based on Non-GAAP Measures for the Year Ended December 31, 2014 and the Periods Ended March 23, 2013 to December 31, 2013 (Successor) and January 1, 2013 to March 22, 2013 (Predecessor)

 

     Successor           Predecessor              
     Year Ended
December 31,
2014
    March 23,
2013
to
December 31,
2013
          January 1,
2013
to
March 22,
2013
    $ Change     % Change  
(Dollars in thousands)                                     

Higher Education

   $ 838,310      $ 718,076           $ 93,289      $ 26,945        3.3

K-12

     734,417        638,197             38,942        57,278        8.5

International

     335,809        300,487             54,289        (18,967     (5.3 )% 

Professional

     127,299        99,429             25,738        2,132        1.7

Other

     (997     2,110             (121     (2,985     (150.1 )% 
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Adjusted Revenue

   $ 2,034,838      $ 1,758,299           $ 212,137      $ 64,402        3.3
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Change in deferred revenue

     (179,059     (168,725          17,304        (27,638     18.3
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Reported Revenue

   $ 1,855,779      $ 1,589,574           $ 229,441      $ 36,764        2.0
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Higher Education

   $ 293,100      $ 280,950           $ (6,045   $ 18,195        6.6

K-12

     115,627        126,095             (51,255     40,787        54.5

International

     37,603        50,958             (8,630     (4,725     (11.2 )% 

Professional

     37,882        29,249             2,932        5,701        17.7

Other

     (11,846     10,874             28        (22,748     (208.7 )% 
  

 

 

   

 

 

        

 

 

   

 

 

   

 

 

 

Adjusted EBITDA

   $ 472,366      $ 498,126           $ (62,970   $ 37,210        8.6