McGraw-Hill Companies, Inc. (“MHP”) is a leading global information services provider serving the financial services (Standard & Poor’s, or S&P), education, and business information markets with information products and services. Like its counterpartMoody’s, S&P has been making headlines recently due to its alleged role in the recent credit crisis. An examination of the underlying business model and relevant regulatory and legal frameworks however, suggest that while the ratings agencies face increased regulation, their businesses should revert to historical trends once the credit freeze thaws over.
The profitability of McGraw-Hill is driven largely by its Financial Services segment, which constitutes in excess of 70% of the company’s operating profit and maintains operating margins in excess of 40%.The majority of the Financial Services segment’s revenues are derived from its S&P credit ratings business.The Financial Services business, and the S&P credit ratings business in particular, is a high quality business with a natural moat consisting of several elements including regulation (for example, to operate in the U.S., credit rating agencies must receive NRSRO designation from the SEC), deep analytical resources (S&P employs over 1,200 analysts in 25 countries), brand (despite the recent criticism pertaining to their ratings of structured finance products, S&P and Moody’s are viewed as the preeminent ratings agencies in the world), and a networking effect (based on long-term relationships).S&P maintains a virtual duopoly with Moody’s, receives a consistent and predictable stream of recurring revenues (due to its annual surveillance fees of issues), and has consistently demonstrated pricing power.
By way of comparison, outside of Moody's, S&P and Fitch, the next largest competitor has a staff of 135 analysts and offices in only one country.S&P's moat is extremely wide and deep, and it is impractical to see how a competitor could scale-up in a rapid fashion.In fact, even if a competitor could build the infrastructure in an attempt to compete, S&P has formed inextricable relationships (both informal and contractual) with thousands of corporations and issuers worldwide over the past 100 years, encompassing everything from firm term contracts to the sharing of material, non-public information.Accordingly, believe this ultimate networking effect appears to be an insurmountable competitive advantage.
All of these combined characteristics have enabled McGraw-Hill’s Financial Services division to grow revenues at 11.5%/year from 1988-2007 and operating income by 16.5%/year over that same time period.While growth will certainly slow in the near-term due to the recent credit-freeze, from a long-term perspective, the business will continue to grow and thrive.
McGraw-Hill’s Education Publishing and Information & Media businesses are solid, free-cash flow generating businesses with opportunities for margin expansion and growth.McGraw-Hill Education serves both the elementary/high school markets as well as the college, professional and adult education markets.Although the growth rate of textbook spending has declined due to the economic slowdown, the movement towards digitization will provide McGraw-Hill Education an opportunity to steadily grow its profits going forward.
McGraw-Hill’s Information & Media business consists of B2B publications and the ownership and operation of nine television stations.In total, this segment is responsible for less than 10% of the total company’s EBITDA.
From a valuation perspective, at a recent price of $24 per share, MHP is trading near an all-time low, at 9.1x 2008e EPS and 8.0-11.5x 2009e EPS (depending on sensitivity to new issuances).On an EV/EBITDA basis, MHP is trading at approximately 4.9 x 2008 EBITDA, also a historical low.By way of comparison, over the last ten years, McGraw-Hill has traded at an average P/E of approximately 22-24x.At the same time, its publicly-traded comparable, Moody’s Corporation, has traded at an average EV/EBITDA multiple of 15.2x (Admittedly, MHP’s Education and Information & Media business should have a lower multiple; however, this still would be relevant for a sum of the parts analysis if one chose to approach valuation this way)
The main “bear case” pertaining to MHP is predicated on perceived regulatory and legal risk with regards to S&P.Given the recent global financial crisis, and efforts to address the actual or perceived cause, there will be more regulation pertaining to the credit ratings industry.However, given the structure of the industry, the critical role that the credit ratings agencies play in the functioning of the capital markets, and the ultimate reliance on the ratings agencies by the vast majority of financial institutions, it is likely that the regulation will not significantly impair the profitability/business model of S&P. Though competitors such as Egan-Jones have called for a reexamination of the “issuer pay” model, the alternative – investor pay – is replete with even more conflicts than the current model.
While legal liability is a dynamic and difficult risk to assess, an examination of legal precedents suggest that such risks are overstated. Specifically, an in-depth and comprehensive review of the relevant case law indicates that U.S. courts have consistently found that ratings are opinions protected by the First Amendment to the U.S. Constitution.Although there will most likely be more lawsuits in this environment, ultimately the ratings agencies should prevail due to this absolute protection.
In summary, it is likely that once the unprecedented freeze of the world's credit markets subside, and the heightened regulatory and legal uncertainties either dissipate or resolve themselves, McGraw-Hill should be able to return to its historical, long-term revenue and EPS growth rates.In such an instance, it is not inconceivable that the Company could earn in excess of $3.50 per share in 2010, which, combined with a discounted, conservative multiple of 18x would suggest a stock price in excess of $60.
Bounceback in new issuances
Resolution of regulatory issues