The decision to abandon their merger because of the divestitures required by the Department of Justice (DOJ) has left the companies with a more complicated future. In a call with investors in the aftermath of the decision to scrap the deal, Cengage’s management indicated that they have embarked on a cost reduction program and formulated a number of scenarios about the impact of COVID-19 in 2021; the pessimistic one is based on a 25% decline in revenues, equal to about $300/310 million.1 Since the cash costs of goods sold would also decline because of lower variable costs (print and warehousing, royalties, some selling costs), in this scenario, the cash flow of Cengage could decline by about $180 million (variable cash costs were 44% of revenues in FY 2019).
The decline in Cengage’s cash flow would be roughly equal to the cash flow generated by its operations in FY 2019 (after paying interest on its debt). In this scenario, Cengage would likely be forced to cut costs substantially and to close to zero its investments in new technology and content in order to avoid further increasing its debt (in FY 2019, investments totaled about $150 million). In summary, a 25% decline in revenues would leave Cengage roughly in a position to continue servicing its debt, but it would make it difficult to continue investing adequately in content and technology just at the moment in time when the transition from print to digital is accelerating.
With no immediate prospect of launching cost-cutting programs of the magnitude expected as a result of the failed merger with McGraw-Hill, such a steep decline in revenues would force management to make tough decisions on how to balance financial survival with future growth programs.
This assumes that revenues for FY 2020 (which ended in March 2020) were on a -7% trajectory,aggravated by a further $30 million decline in Q4 (i.e. the quarter that ended in March 2020) because of the COVID-19 crisis. ↩