Donald Rubin – Sr. VP IR
Harold McGraw – President & CEO
Robert Bahash – EVP & CFO
Craig Huber – Barclay’s Capital
Michael Meltz – JP Morgan
Catriona Fallon – Citigroup
Edward Atorino - The Benchmark Co.
Peter Appert – Goldman Sachs
The McGraw-Hill Companies (MHP) Q3 2008 Earnings Call October 28, 2008 8:30 PM ET
Welcome to McGraw-Hill Companies third quarter 2008 earnings call. (Operator Instructions) I will now turn the call over to Donald Rubin, Senior Vice President of Investor Relations for the McGraw-Hill Companies.
Good morning and thank everyone for joining us for the McGraw-Hill Companies third quarter earnings call. I’m Donald Rubin, Senior Vice President of Investor Relations for the McGraw-Hill Companies. With me today are Harold McGraw III, Chairman, President and CEO, and Robert Bahash, Executive Vice President and Chief Financial Officer of the corporation.
This morning we issued a news release with our third quarter 2008 results. We trust you have all had a chance to review the release. If you need a copy of the release and financial schedules, they can be downloaded at www.mcgraw-hill.com. Before we begin this morning I need to provide certain cautionary remarks about forward-looking statements.
Except for historical information, the matters discussed in this teleconference may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including projections, estimates, and descriptions of future events. Any such statements are based on current expectations and current economic conditions and are subject to risks and uncertainties that may cause actual results to differ materially from results anticipated in these forward-looking statements.
In this regard we direct listeners to the cautionary statements contained in our Form 10-Ks, 10-Qs, and other periodic reports filed with the US Securities and Exchange Commission. We are aware that we do have some media representatives with us today on the call, however this call is for investors, and we would ask that questions from the media be directed to Mr. Steve Weiss in our New York office subsequent to this call.
Today's update will last approximately an hour. After the presentations we will open the meeting to questions and answers. It's now my pleasure to introduce the Chairman, President, and CEO of the McGraw-Hill Companies, Harold McGraw.
Thank you very much Donald, good morning everyone and welcome to our review of the McGraw-Hill Companies third quarter results and the outlook for the remainder of 2008 and as Donald mentioned joining me today on this call is Robert Bahash, Executive Vice President and Chief Financial Officer.
On today’s call we will be reviewing the third quarter earnings and our guidance for 2008 and then Robert will provide an in depth look at our financial condition which is strong, and we aim to keep it that way. At the conclusion of Robert’s presentation as always we will be pleased to take any comments or questions that you may have about the companies.
Earlier this morning we announced third quarter results; let’s get started with a quick recap on that. We took a pre-tax restructuring charge of $23.4 million for a workforce reduction of approximately 270 positions. That’s a $14.6 million after-tax or $0.05 per share.
Including the restructuring charge then, earnings per share was $1.23 and revenue declined 6.4% to $2 billion. Restructuring charges in the second and third quarter represent pre-tax charges of $47.1 million or $29.4 million after-tax and a workforce reduction of approximately 670 positions this year.
We have been taking action since late last year, including the staff reductions announced in the fourth quarter of 2007 we have eliminated approximately 1,275 positions. In this environment we will continue to monitor our situation very carefully and I can assure you that we will take more steps if warranted.
In the face of continued economic weakness we have seen more efforts by the US government to support the financial sector and restore confidence in credit markets. US Treasury Secretary Hank Poulson recently provided more details on the bank recapitalization measures and Fed Chairman Ben Bernanki, is supporting another stimulus package.
Additional rate cuts with the Fed Funds going down to 1% later this year now seem very likely and that’s according to our economists. The rate cuts by the Federal Reserve and other major central banks have already set the stage for further stimulus. Another Fed rate cut could come this week.
Housing has been in recession for three years now. David Weiss our chief economist doesn’t expect housing prices to hit bottom until late in 2009 so we have a little bit more to go there. The housing recession and the credit crunch in the financial markets continue to have an impact on our results.
In the face of challenging conditions we are now forecasting earnings per share of $2.63 to $2.65 for this year. The projection for 2008 excludes the restructuring charges but includes the associated benefits. The forecast assumes earnings per share of $0.40 to $0.42 in the fourth quarter.
Alright, with this as background let’s examine in more detail the performance and the outlook for our three operating segments and let’s begin because of the third quarter and the education quarter, let’s begin with McGraw-Hill education which in the third quarter produced some expected successes and also experienced some unexpected softness.
In the third quarter revenue declined by 3.8% as an increase of 3.7% for higher education, professional and international group partially offset a decrease of 9.1% at the school education group.
Including a pre-tax restructuring charge of $5.4 million operating profit was off 14.5% and the operating margin was 31.1%. After nine months this year revenue is off 1% including restructuring, operating profit is 17.5% and the operating margin is 15.5%.
To contain costs we took pre-tax restructuring charges in the second and third quarters. For McGraw-Hill education that totaled $13.9 million and represented the reduction of approximately 240 positions.
The most important 60 days of the sales year in the education market normally occur in July and August. Through July the industry was off to a pretty good start. According to reports from the Association of American Publishers industry sales in July were up 5% but as we cautioned investors at a conference in September, the situation suddenly began to change in early August.
Our concern was validated when the Association of American Publishers, AAP, subsequently released sales figures for August and September. Industry sales in August dropped by 16.6%, results that turned the markets 3.9% gain after seven months into a 1.7% decline after eight months.
In September industry sales fell by 17.6% and the market is down 3.3% after nine months. The reversal of the positive trend that we saw earlier in the year has led us to conclude that sales for the elementary/high school market will now decline about 3% to 4% in 2008 however we expect to gain share in this very difficult market.
Historically residual sales are heaviest in the third quarter, but in August we witnessed and unprecedented slow down in residual sales and as many of you know residual sales are sales of previously adopted materials. These include hardbound text that are needed by the schools for new enrollments, or to replace lost of damaged books.
More importantly residuals include workbooks, lab manuals and other consumable softbound materials that support texts. These are designed for students to write in so they are normally replaced every year. Residual sales represent a significant percentage of all publishers’ revenues in any given year.
Along with the decline in residual sales, we also a decrease in the volume of new textbook business. The decrease was most pronounced in the open territory states which are mainly in the northern and central regions. Open territory school districts are more dependent on local property tax revenues and more likely to face higher fuel costs for bus transportation, heating in the new school year and so forth.
When it comes to purchasing new textbook programs, open territory districts are also more independent then adoption state districts where there are directives on how budget allocations must be spent but all school districts face increased costs for personnel including salaries, health care and pensions which are frequently indexed to the rate of inflation.
On average the state education budgets that went into the effect for the fiscal year starting on July 1 were not sufficient to cover these inflationary increases. As a result all expenses that might be considered discretionary became low priority items.
Unfortunately in many districts the purchase of instructional materials fell into this category. For many large urban districts this situation was aggravated by the cutback in this year’s Federal Reading First bonds which dropped from more then $1 billion last year to only $383 million this year.
The supplemental market has always been very sensitive to discretionary funding constraints because most purchases are made at the school building or classroom level. It is disappointing but not surprising that this market has been slow all year.
To reduce costs some districts are buying newly adopted programs for only a few grades intending to add more grades in the future. We have also seen more buying of classroom sets that are used by successive classes throughout the day as opposed to purchases that would provide one book per student.
As schools have reduced their orders for consumable materials we have also seen more copying of workbooks particularly in grades K through two. These short-term measures are not sustainable. Enrollments in many places are growing and schools will face shortages as standards align materials which are so important in preparing students to meet the accountability requirements of No Child Left Behind which remain in force and which have actually become more stringent in the current academic year.
Photocopying workbooks which many financially strapped districts are doing, is an illusionary savings. It happens because the expense of photocopying is spread over several months and is charged to a different cost center. In reality it is more cost effective to order new workbooks then to copy old ones but for the time being the cost of copying shows up in somebody else’s budget and so therefore there is an appearance of savings.
In the state new adoption market we have delivered on our forecast. As we had expected the school education group captured approximately 31% of the total available dollars in the state new adoption market and it was propelled by strong performances in K-5 reading and mathematics.
These programs also produced sales gains in the open territory. In the Florida K-5 reading adoption we expect to capture more than 70% of the market; an outstanding achievement. We also expect to take about 40% of the K-12 reading literature state new adoption market. In mathematics we project that 31% capture rate in the Texas K-market, a state specific version of Math Connects has also done very well in the first year of the California math adoption and Everyday Mathematics has also won some good adoptions in California.
We led the first year science adoption in California in 2007 and a second year sales are following that positive trend and our music, fine arts, health, business and vocational lines have also performed very well in all states adopting in these categories.
In assessment and reporting the third quarter is typically a seasonally slow period. Revenue for custom tests declined due to reductions in the volume of work performed for Indiana and Missouri and the expiration of contracts in Mississippi and Tennessee.
But we continue to make progress with acuity which is our new formative testing program Lost Links, our assessment for English language learners and TABE which is our suite of assessments and structural resources for adult students.
In the higher education, professional, and international group we also saw a shift this year in historical ordering patterns. In the US college and university market the peak ordering period normally occurs in July and August. This year we experienced a surge in September as college and retail stores waited to gauge student demand. We still expect the total market to grow 4% to 6% this year but our own higher education group will underperform the industry in 2008.
All our main academic higher education imprints achieved good growth in the third quarter, that’s in business and economics, science, engineering and mathematics, and humanities, social sciences, and languages.
But 2008 is also a low point or an off cycle year for revisions of our traditional best sellers in these disciplines and that will dampen our performance a little bit in 2008.
Our career education product line produced a very strong gain. We have strengthened our position in the allied health market and the computer information technology markets with products like Computers in the Medical Office.
This innovative program combines software and print to give medical assistance students practical, hands-on experience as well as permanent on the job reference materials.
Digital products grew rapidly in the third quarter with study guide products like homework manager leading the way. Students are embracing this generation of digital products because they provide course critical content that helps them study and prepare for exams more efficiently.
We continued to make headway, good headway with ebooks. Currently our higher education group has 618 titles on Course Smart and that’s the industry’s ebook website. New functionality permits sales representatives to provide samples to instructors directly from Course Smart. Sampling instructors electronically not only offers some cost savings but it also represents a cost effective strategy for increasing awareness of ebook availability among student customers.
To facilitate the sale of ebooks to students, Course Smart now has partnerships with about 50 campuses in conjunction with a Nebraska book company, a textbook retailer and wholesaler, and a significant new agreement the university system of Ohio will link to Course Smart through its own textbook site which is available to all students enrolled in the state’s private as well as public colleges.
Digital subscriptions and licensing also had a favorable impact in our professional market but could not offset softness at retail as bookstores cut back on orders and reduced inventory in face of economic conditions.
In international markets Harrison’s Principals of Internal Medicine continued to perform well in both the English and Spanish editions released in recent months. Higher education products sold well in Europe, The Middle East, and India. In the third quarter we also benefited from back to school sales in Spain, and in Mexico.
So let’s sum up for the McGraw-Hill education, growth in higher education markets here and abroad here in the third quarter, digital revenue that continued to grow rapidly in higher education and professional markets, a strong performance in the state new adoption market with a 31% capture rate, a slowdown in the elementary/high school market in August and September that signals a 3% to 4% decline in industry sales for the full year.
Growth in the college market of 4% to 6% and an expectation to increase share in the elementary/high school market and to underperform slightly in the US college and university market.
As we enter a seasonally slow fourth quarter for education we are adjusting the 2008 outlook for this segment. We now expect revenue in 2008 to decrease 1% to 2% with an operating margin decline of 300 to 350 basis points.
Okay let’s turn now to financial services, in a challenging period for credit markets the diversity of our portfolio helped cushion the downturn at Standard & Poor's Credit Market Services, that’s the rating portion of Standard & Poor's.
For the financial services segment in the third quarter revenue declined by 14.2% as an increase of 13.5% for Standard & Poor's investment services, helped offset a fall off of 24.2% for the S&P credit market services including a pre-tax restructuring charge of $4.1 million operating profit decreased by 18.8% and the operating margin was 43.2%.
After nine months this year revenue is off 12% including restructuring charges, operating profit is down 23.3% and the operating margin is 41.4%. We continue to watch costs closely and we took restructuring charges in the second and the third quarters to contain costs and to mitigate the impact of economic conditions.
For financial services that totaled $19.3 million and represented the reduction of approximately 290 positions. The reduction climbs to 460 positions when you include the cutbacks announced for the fourth quarter of 2007.
The restructuring charges taken this year reduced the operating margin by 64 basis points and that’s in the third quarter and by 95 basis points for the nine months.
As we all know turbulence in the credit markets continued into the third quarter. The charts illustrate quarterly new issuance dollar volume this year for residential mortgage-backed securities, commercial mortgage-backed securities, and collateralized debt obligations and asset-backed securities in the US market.
In looking at these bar charts its readily apparent that the third quarter is the weakest of the year for new issuance. You can also see that in most cases the structured finance market volume continued to decline in the fourth quarter of 2007.
Structured finance dollar volume issuance in the United States was off 78.3% in the third quarter. In this environment a 2.6% decline for asset backed securities issuance is as good as it gets. US public finance dollar volume issuance was off 1.8% and corporate declined by 65.8%.
But new issue volume is not the whole story in financial services, as this next chart shows global new issuance dollar volume declined 44.2% in the third quarter but revenue was off 14.2% for financial services and 24.2% at credit market services.
International revenue for S&P credit market services declined 11.6% in the third quarter while non-US issuance fell 21.0%. Domestic revenue for S&P credit market services was off 33% but total US new issuance fell 61.6%.
Clearly steps we have taken to diversify our portfolio in both S&P credit market services and in S&P’s investment services is providing some shelter in this storm. Reducing S&P credit market services dependence on the new issue market and expanding internationally were important initiative that continue to benefit us in turbulent times and those will continue.
International ratings accounted for 47.9% of S&P’s credit market services revenue in the third quarter, up from 41% of the comparable quarter last year. In Europe we saw a substantial drop in structured finance issuance resulting from widening spreads and a decline in fundamentals. There was also some issuance softness in the Asia Pacific region, [Cresol] our ratings operation in India continues to post solid gains.
We are actively exploring more opportunities to expand our international footprint and we’ll be back to you with more on that. The continued growth of non-transaction revenue is another measure of our diversification strategy. Non-transaction revenue grew by 2.3% in the third quarter and up 8.9% after nine months.
Non-transaction revenue includes surveillance fees, annual contracts, subscriptions, all three categories grew in the third quarter. Deferred revenue for this segment also increased in the third quarter. It grew by 7.2% to just over $8.5 million at the end of the third quarter. Sequentially that represents a decline from the second quarter. The slower growth reflects the seasonality of our revenue as well as a decline in ratings activity.
We are pleased with another quarter of double-digit growth from S&P’s investment services. Our non-ratings businesses, Capital IQ, and Index services were key contributors to this performance. Capital IQ has added new customers all year, now with more than 2,500 customers. Capital IQ’s base has grown by 22.2% in the past 12 months. Capital IQ also continues to expand its product offering and improve the functionality.
To accelerate Capital IQ’s own estimates database project, and launch into an alternative research marketplace we recently acquired a copy of Reuter’s estimates and the Reuter’s research on demand databases. The acquisition adds another piece to the comprehensive global analytical solutions offered by Capital IQ.
In index services we benefited from higher volume for exchange-traded derivatives, an increase in assets under management and exchange traded funds based on S&P indices and growth in our data and custom indices. Assets under management and exchanged traded funds grew to $223.5 billion and that was by the end of the third quarter.
That’s a gain of 6.7%. We believe the increase is in part due to the use of exchange-traded funds for hedging as well as the asset class mix acting as a natural hedge. Daily volume for major exchange traded derivatives based on S&P indices averaged 3.7 million contracts, a year-over-year increase of 27%.
We also continue to expand in index services, in the past nine months of this year S&P has launched 45 new exchange traded funds based on its indices compared to 46 for all of 2007. There are now 189 new exchange traded funds based on S&P indices around the world.
Building on its family of fixed income indices, S&P in October launched the S&P LSTA US levered loan 100 index. It is a market value weighted index designed to measure the performance of the US levered loan market.
LSTA is short for Loan Syndications and Trading Association. Earlier this month S&P introduced the S&P US commercial paper index. It consists of commercial paper with one to three month maturities issued by financial and non-financial corporate issuers.
In September S&P signed an agreement with a Korean exchange to develop a new set of indices to meet the needs of Asian investors. S&P already signed its first exchange partnership in the year 2000 with the Australian stock exchange. Today we have partnerships with primary exchanges in Tokyo, Milan, Toronto, Moscow, Hong Kong, India, and so forth and there is more in the pipeline this year from index services.
Earlier in this presentation we showed charts indicating that new issue market for most asset classes continued to soften in 2007. That means that S&P faces the easiest comparisons of the year in the fourth quarter of 2008. But some improvement obviously hinges on the start of a market recovery in the fourth quarter.
At this point visibility on the extent and speed of the recovery remains low. There is growing concern about the economy and the markets are assessing the new rescue program from the Federal government and how to respond to various fiscal stimulus packages.
The infusion of capital into the banks should help return confidence and credit to the market. Recently we’ve seen a decline in the key London inter bank offer rate or LIBOR, a sign that credit markets may be on the mend. There are indications that investors now are on the sidelines and they are ready to move once markets begin to stabilize.
When investors do return it will be back to basics, less leverage, less risk, and more plain vanilla securities. Our assessment of the outlook for financial services this year assumed that the level of activity in the structured finance market would remain at low levels.
For 2008 we now anticipate revenue for the financial services segment will decrease by approximately 11% to 12%. We have also changed our forecast on the operating margin, originally we expected a decline of 500 to 600 basis points, now we anticipate only a 425 to 475 basis point decline in the operating margin for this year.
Now obviously no discussion of financial services would be complete these days without a review of the regulatory and legal situations. We’ve now embarked on another round of new congressional hearings on the rating agencies.
Last week as many of you know Deven Sharma our President of Standard & Poor's, testified before the US House of Representatives Committee on over side and government reform, these are Congressman [Waxman’s] committee.
It was a long day but there seemed to be three basic charges against the rating agencies that came out of that. One was structured finance ratings were not objective, another one was that S&P’s only concern was for profit, the business model, the third one, is prone to conflict.
Those seemed to be the three pieces that came out of that. In a rush to judgment it can be difficult to be heard. But Deven refuted these charges and we don’t have time this morning to go through all of it but I do urge you to read his complete testimony and that you can get at www.standardandpoors.com. I think you’ll get a good sense of how he positioned it and how we feel about it.
He pointed out in his remarks that S&P’s ratings business has strong policies against analysts structuring transaction that S&P rates and that it does not provide consulting services to issuers, that it does not give higher ratings based on how its paid but it does make its ratings criteria and methodologies available and open to market comment.
But let’s be clear, no business model is without potential for conflict but a reasonable organization like S&P has policies and procedures in place to manage them. Our professionals have never been compensated upon the amount of revenue they generate. Credit analysts do not negotiate fees. Rating decisions are always made by a committee and not by individuals. And we have a team of quality officers to promote analytical rigor and the safeguard of the ratings process. The compliance process is very strong and very clear.
A thorough examination by the SEC recently found “there is no evidence that decisions about rating methodology or models we attracting or losing market share.” Under the issuer pays model S&P makes all its ratings public, free of charge in real time, higher transparency which is the order of the day.
Credit ratings are not investment advice or recommendations to buy, sell, or hold a security. Credit ratings primarily address the likelihood that an obligation will be repaid on time with interest. Ratings are also not static. S&P recognizes the seriousness of the current dislocation in the capital markets and that not all of the forecasts used in its ratings analysis have been borne out, even though historical events going back 75 years to the Great Depression were included in our stress tests.
S&P is committed to constant improvement, greater transparency, and independence. That’s why earlier this year after consulting with policy makers and regulators both here and abroad, around the world, S&P announced 27 actions on its own to enhance the ratings process and promote confidence.
And you can get an update on the S&P’s 27 leadership actions in four categories by visiting S&P’s website. And you can get some additional perspective by looking at S&P’s record in rating AAA US structured finance securities. The default rate on US structured finance securities rated AAA by S&P between January of 1978 and October 13, 2008 is only one-quarter of 1%; 0.28%.
We expect to learn more about regulatory initiatives next month, sometime in November the SEC could issue new rules for rating agencies. As we now know on November 12 the European commission is expected to issue its proposals on rating agencies and those will be out for public comment and we will work through that process.
There is a little doubt that more regulation is coming but we will continue to work with policy makers, regulators and others to assure some global consistency. We believe global consistency should be based on IOSCOs, those are the security commissioners out of Madrid recently revised Code of Conduct for rating agencies.
Basically not a lot has changed on the legal front since we reviewed the situation at an Investor Conference on September 18. A new lawsuit was filed at the end of September against the Federal National Mortgage Association and a number of defendants, class action suit, and included in that was the McGraw-Hill Companies. The central allegation is that the company issued inappropriate credit ratings on certain securities issued by the Federal National Mortgage Association.
We believe strongly that the litigation is without bearing. We continue to believe that any pending legal, governmental, or self-regulatory proceedings or investigation, will not result in a material adverse effect on the financial condition or results of our operations.
Let’s sum up for financial services, revenue will decline 11% to 12% in 2008, the operating margin will decline 425 t0 475 basis points this year, better then we thought, low visibility in credit markets and double-digit growth for S&P investment services in 2008.
Now let’s review our third segment, information, and media, where business-to-business products and services again drove the results. In the third quarter revenue increased 5.3% as the business-to-business group grew by 5.4% and broadcasting was up 4.4% including a pre-tax restructuring charge of $13.9 million, operating profit increased 22.6%.
The operating margin was 8.6% and the restructuring charge for the workforce cutback reduced the operating margin by 523 basis points in the third quarter. After nine months revenue is up 5.1% including the restructuring charge, operating profit is up 37.3% and the operating margin is 7.7%.
The key revenue driver this year continues to be Platts. It was true again in the third quarter. Platts is a leading provider of global energy information as well as on other commodities to customers in more then 160 countries. With continued volatility in crude oil and other commodity prices these customers increasingly depend on our news and pricing information to help with decision making in uncertain times.
That’s what happens when your information becomes imbedded in customers’ workflow. This is a global phenomenon, growth at Platts is coming both in North America as well as overseas and as you know we headquarter it in three locations; Singapore, New York, and London.
Aviation Week benefited from the timing of a major international air show in the UK. That’s the [Farmboro] air show which is held every other year in the third quarter. Advertising pages for Business Week’s global edition was down 13.9% in the third quarter and even in this environment Business Week continues to attract new subscribers and improve its renewal rate.
Business Week also took an important step in September by launching the Business Exchange. This enables users to create topics around business issues that matter to them and connect with Business Week’s community. In a short period of time more then 500 topics have been created on the Business Exchange, which is a very nice start.
The introduction of social media in the business spaces will create an opportunity to leverage context and content for users and advertisers. We are enhancing the Business Exchange with two important partnerships, Linked In and Federation Media, which taps the blogs sphere.
The partnership with Linked In helps Business Week readers network with others that provides Linked In users with broader access to content; over 30 million professionals use Linked In. For the broadcasting group a solid increase in political advertising offset softness in local and national advertising in the third quarter.
In the Denver market we benefited from Colorado’s status as the swing state in the Presidential election. Advertising by candidate for the US Senate and House and significant spending on issues and propositions.
Spending has also been strong in Indiana because of the Governor’s race and the Presidential contest as well. So summing up for information and media, more progress this year with our business-to-business group, solid growth in political advertising for broadcasting and revenue growth of 4% of 6%, an improvement in the operating margin for this segment.
So therefore for the corporation overall, summing for the McGraw-Hill Companies, we now are forecasting earnings per share of $2.63 to $2.65 for 2008 and the projection excludes the restructuring charge but includes the associated benefits.
The forecast assumes earnings per share of $0.40 to $0.42 for the fourth quarter. We have started work on our budgets for 2009 but until that process is completed we’re not in a position to make a forecast for next year.
We already know the state new adoption market will not match this year’s total. Texas is not scheduled for a new adoption in 2009 and that always makes a difference in the market. The good news is that the state adoption market calendar improves sharply in 2010. We also know the college and university market is counter cyclical in times of economic difficulty in enrollment increase. In financial markets visibility is low and it will be important to see when various stimulus packages and other government led programs begin to have an impact.
In this environment we are very focused on managing costs and maintaining liquidity. So this would be the best time to turn it over to Robert and to hear about that part of it.
Thank you Harold, as we began to feel the full force of the decline of the credit markets last year, revenue for S&P credit market services dropped in the fourth quarter of 2007 by 14.1%, and the financial services segment was off by 7.2%.
But while we were looking at easier comparisons for financial services during the fourth quarter of this year the rate of decline has been steeper and that’s reflected in our guidance for this segment. We don’t expect a pick up in credit market services and we have seen a sequential decline in the revenue growth at Standard & Poor's investment services.
Growth will probably slow again in the fourth quarter for S&P investment services although it will still grow by double-digits this year. For McGraw-Hill education the fourth quarter is seasonally slow. In the elementary/high school market we may realize some sales from postponements earlier this year but that is hard to call in this environment.
In the US college and university market we will be introducing some new titles in the fourth quarter but the timing of any pick up is difficult to gauge. Sometimes [inaudible] materialize in December and in other years they don’t show up fully until January.
Under these circumstances we continue to take a very hard look at our costs and expenses. As Harold discussed we recorded a restructuring charge of $23.4 million in the third quarter primarily for severance costs related to a workforce reduction of approximately 270 positions to contain costs and mitigate the impact of current and future economic conditions.
Additionally we took a significant reduction in both long-term and short-term incentive compensation at all segments as well as at corporate. The year-over-year decline of $117 million was comprised of $71 million decline in stock-based compensation, the remainder being short-term incentive compensation. We lowered accruals for long-term awards due to reduced operating results.
This resulted in a negative $39 million for stock-based compensation in the third quarter. As mentioned previously the cash savings from reducing our short-term incentives in 2008 will not be realized until the awards are paid out in March of 2009.
The impact of reduced incentive compensation as noted in the earnings release is as follows. McGraw-Hill education $15.9 million; financial services $60 million; information and media $12.4 million; and corporate $29.1 million.
I’d like to take a few moments to discuss expenses at financial services, McGraw-Hill education and corporate. At financial services expenses decreased $43 million or 10.4%. Excluding the $4 million pre-tax restructuring charge in the third quarter expenses decreased $47 million or 11.5%.
This year-over-year expense comparison benefits from a $60 million reduction in incentive compensation. This is up from a $30 million year-over-year reduction in incentive compensation in the second quarter primarily due to the negative stock-based compensation I previously mentioned.
Expenses also benefit from savings from restructuring actions taken in the fourth quarter of 2007 and the second quarter of 2008 as mentioned earlier. These expense savings were partially offset by the impact of acquisitions and investments in our fast growing areas such as [Cresol], Capital IQ and index services.
Financial services sequential third quarter expenses decreased $66 million or 15.2% versus the second quarter as reported. The primary contributors to this expense decrease are a $46 million decrease in incentive compensation, a reduction in third quarter versus second quarter restructuring charges of $11 million, and savings from restructuring actions.
McGraw-Hill education reported expense growth of 2% or $15 million. Excluding the restructuring charge of $5.4 million expense growth was 1.3% or $9.6 million. The minimal expense growth at education is driven by a $14 million increase in pre-publication amortization, increased costs related to strong state new adoption opportunities, and investments in technology including $4 million in data center migration costs.
This is offset by a $15.9 million decline in incentive compensation as well as lower cost of goods sold due to the reduction in revenue. The migration to our new data center is nearly complete. In the third quarter the migration cost was $8 million. For the nine-month period it was $21 million.
Now that we’re nearing the end of the project we expect the overall cost will be around $30 million to $35 million for 2008 which is $5 million to $10 million lower then our original forecast.
We expect McGraw-Hill education to represent about half of the total cost as the segment continues to deliver more digital content and services. Corporate expenses were $9.7 million in the third quarter, a $28 million or 74% decrease versus the same period last year.
This overall decrease is driven by a $29 million reduction in incentive compensation accruals for the quarter and of course excluding the incentive comp accruals, expenses were about flat with last year.
We had previously forecasted a mid single-digit decrease in corporate expenses for 2008. Due to the reduction in incentive compensation we now expect corporate expenses to be down about $50 million and this would imply an approximate $10 million decline in corporate expenses in the fourth quarter.
Now let me recap the corporation’s strong financial position, net debt as of September 30 was $1 billion, this is down approximately $349 million from the end of the second quarter as a result of free cash flow generated in the third quarter.
The second half is when we generally generate the majority of our free cash flow primarily due to the seasonality of our education business. As of September 30 on a gross basis, total debt was $1.5 billion and is comprised of $1.2 billion of unsecured senior notes that we issued in 2007 and $307 million in commercial paper outstanding.
This is offset by $485 million in cash primarily in foreign holdings. The outstanding commercial paper is supported by a $1.15 billion credit facility which was renewed in the third quarter. Our commercial paper rating F1/P1 from the key credit rating agencies of Moody’s and Fitch.
Given the current liquidity issues in the CP market, being a Tier 1 issuer is very important not only for pricing but also for availability. We plan to reduce commercial paper outstanding through the balance of the year with our seasonal cash inflows.
As discussed previously our objective is to maintain a net debt level comparable to year-end 2007. As we typically do at this time of year we’re evaluating repatriating cash from overseas which is primarily invested in money market instruments.
Obviously repatriation does not impact net debt but causes swings between where cash is held and the level of commercial paper outstanding. Regarding net interest expense in the third quarter we had $22 million compared to $15 million in the same period last year.
We expect interest expense in the fourth quarter to be roughly comparable with the third quarter resulting in a full year interest expense of approximately $80 million.
Let’s now review free cash flow, as a reminder of our free cash flow calculation, we start with after-tax cash from operations which is after working capital and deduct pre-publication investments, CapEx and dividends. What’s left is free cash flow, funds that we can use to repurchase stock, make acquisitions, or pay down debt.
Despite a challenging 2008 we continued to generate free cash flow. Third quarter free cash flow was approximately $500 million which is roughly flat with last year. As we indicated on the second quarter earnings call free cash flow as of June 30 was approximately $300 million lower then the year before while third quarter free cash flow performance was comparable to the prior year given the reduction in third quarter revenue and its impact on cash collections in the fourth quarter, we now project free cash flow to be approximately $500 million for 2008 versus the $600 million forecast we provided during our second quarter earnings call in July.
To help offset the lower operating cash flow we’re carefully managing costs and capital investments while continuing to invest in fast growing areas such as [Cresol], Capital IQ and index services. Given the uncertain economic environment we will continue to monitor our investment priorities this year.
I’ll discuss capital expenditures in greater detail shortly, but will now recap our acquisition and share repurchase activities. For the first nine months we spent approximately $40 million on acquisitions. On October 7 of this quarter we announced that we had acquired a copy of the Reuter’s estimates and Reuter’s research on demand databases to enhance Capital IQ’s data offering.
In the third quarter we repurchased 3.5 million shares for a total cost of $142.4 million at an average price of $40.70 per share. That brings the year-to-date repurchases to 10.9 million shares for a cost of $447.2 million at an average price of $41.03 per share.
A total of 17.1 million shares remain in the 2007 program authorized by the Board of Directors. Given our new forecast for reduced free cash flow and our desire to maintain debt levels comparable to year-end 2007 we’re currently evaluating the extent of our share repurchases for the fourth quarter.
We remain committed to returning cash to shareholders through dividend payments and share repurchases but it is important to balance this while maintaining appropriate liquidity during this difficult credit environment.
Our diluted weighted average shares outstanding declined in the third quarter to 317.2 million shares. This reflects a 20.5 million share decrease compared to the third quarter of 2007 and a 3.9 million share decrease compared to the second quarter of 2008.
Our fully diluted shares at the end of the third quarter were approximately 315 million shares. I’ll now review unearned revenue which ended the quarter at approximately $1.1 billion, a 6.4% year-over-year increase.
Financial services unearned revenue grew 7.2% versus the prior year. The year-over-year revenue declined for credit market services primarily structured finance accounts for the slower growth in unearned revenue.
Financial services represents three-quarters of our unearned revenue balance and with the reduced revenue guidance for financial services we now expect minimal growth in the corporation’s unearned revenue for 2008.
Our effective tax rate was 37.5% in the third quarter and we expect it to be approximately at the same level for the full year. Let’s now look at capital expenditures, which include pre-publication investments and purchases of property and equipment.
In the third quarter our pre-publication investments were $65 million compared to $77 million in the same period last year. We continue to expect $270 million for 2008. Purchases of property and equipment were $18 million in the third quarter compared to $63 million in the same period last year and this was of course higher last year because of the building of our new data center.
In light of slower operating free cash flow as well as the uncertain economic environment, we’re delaying a number of capital projects. We now project CapEx will be $115 million for 2008 versus our previous forecast of $160 million.
I’d like to wrap up with a quick review of non-cash items, amortization of pre-publication costs was $125 million compared to $110 million last year. For 2008 we continue to expect it to be about $275 million. Depreciation was $30 million compared to $26 million in the same period last year. We still expect it to be approximately $125 million in 2008 primarily due to the completion of the data center as well as the purchase of new technology equipment.
Amortization of intangibles was $14 million compared to $12 million in the same period last year and for 2008 we expect it to be approximately $52 million. So let’s sum up, we’re taking a hard line on company expenses while prudently managing investments to support areas of high growth potential.
In short, we’re making every effort to protect the company’s strong financial position in a very difficult environment. Our priorities are clear, reduce expenses, ensure we have the resources to fund our growth and maintain liquidity.
We are now ready for your questions.
(Operator Instructions) Your first question comes from the line of Craig Huber – Barclay’s Capital
Craig Huber – Barclay’s Capital
Could you just talk a bit about your non-transaction line with an S&P ratings, about 2.5% almost, that line I understand includes syndicated bank loans? The transaction piece of that?
Craig Huber – Barclay’s Capital
So does that account for why that line was down sequentially, about $341 million in the second quarter versus $319 here in the third quarter?
That certainly was a factor but again I think that coupled in all of that is the obviously continued weakness in this current environment, just the last four or five weeks alone.
Craig Huber – Barclay’s Capital
As you think out to next year about that line would you expect that line to be up, putting aside the syndicated bank loan transactions in there?
Well it really depends on your expectations for revival of the credit market. We certainly would expect that at this point but we’re going to have to see some signals, some evidence of that.
Craig Huber – Barclay’s Capital
But I assume here in the third quarter your surveillance fee part of it which is a large portion of that line is up year-over-year right?
The structured finance side saw sequentially a decline on a quarter-to-quarter basis and that’s in part due to, and we saw that really coming from the first quarter and second quarter. Last year toward the end of the year there were a number of transactions that we had done our work on that had not been completed and they carried themselves over into the first and second quarters of this year. And as a result the issuers did not go forward and there were certain breakage fees that we recorded relating to those transactions. It was a non-transaction event because no transaction happened. We don’t see that same continuation. It clearly did not occur in the third quarter so that also contributes to the slower performance on a quarter-to-quarter basis.
Craig Huber – Barclay’s Capital
On the index business, just given what’s happened in the marketplace this year, are you actually seeing negative growth there right now or forecasting for the fourth quarter?
No, in fact we’re still seeing very good growth that way and this year the launch of the new ETFs in particular compared to last year has been at a stronger rate so there has been more interest in ETFs and involvement with various exchanges then last year. It’s a very encouraging development.
Your next question comes from the line of Michael Meltz – JP Morgan
Michael Meltz – JP Morgan
Can you give us a bit more of an update as to what you’re seeing at S&P right now. I did the math quickly but if I back into your guidance for the quarter for the full year it would imply you’re saying revenues for all of financial services will be flat to up in Q4 versus Q3 by, and at the higher end by almost $30 million and I would think it’s a tougher issuance environment today then it was say when you gave your call in July and I’m just wondering why wouldn’t you see more of a fall off at S&P overall in Q4?
First of all, investment services which has been strong all year, both in terms of indexes, dated information and in particular Capital IQ those continue. Now the question is given the guidance of $0.40 to $0.42 for the fourth quarter, are there implications on the top line growth of investment services from S&P and we’re taking a very conservative posture here because again there’s a lot just in the last four or five weeks, there’s just been so much uncertainty that you could see a single-digit but we don’t think so.
We still think and we see a fair bit of demand on that side and we think that will continue in the fourth quarter, but again we’re taking a very conservative posture in terms of guidance.
We’re also, we’re down in revenues through nine months, roughly 12%, and our guidance is to be up for the full year 11% to 12% which would imply the fourth quarter being very similar to what we experienced in the first three quarters. So we’re looking at revenue to be down in the fourth quarter.
Michael Meltz – JP Morgan
Right but you’re looking to be down 8% to 12% which would put it flat on an absolute basis, flat with Q3 versus up with Q3—
No, 11% to 12%, it was the guidance.
Michael Meltz – JP Morgan
But I think you can back into Q4 being...I guess related to that if you did I think you said, transaction revenues of a certain, $105 million in the third quarter, I’m confused that your revenue guidance would imply better, more revenue out of all of S&P in the fourth quarter but I would think that transaction number would be lower in the fourth quarter then it was in the third quarter, am I looking at this wrong?
What we’re forecasting and we’re projecting is a steeper decline in the fourth quarter then we had thought. We had originally thought that our comparisons would be a little bit better in the fourth quarter because last year was weaker, however we continue to look at a decline in credit market services revenue in the fourth quarter that’s clearly driven by the transaction side. We are looking for an increase at revenue from S&P investment services. For the full year we expect to be double-digit but it would be in the single-digit growth range in the fourth quarter.
Michael Meltz – JP Morgan
On corporate expense I understand what you’re saying on the accruals, you’re saying down $50 million year-over-year, so you’re saying $110 million or so of corporate expense for the full year, is that the run rate we should be thinking about now that you’ve reset the bar or will that step up next year as things smooth out?
First of all let me just say we have to have a very clear assessment of the environment that we’re going to be in. Your assumption is correct in the current environment. If we start to see signs of recovery and an easing of the credit crunch then obviously we’re going to be investing more heavily for that. But at this point, the cost controls and easing of investments, you’re looking more at that level.
Michael Meltz – JP Morgan
So I should start with $110 and then keep in mind you’re going to be tight on costs or is there an adjustment to the $110?
I think in order to look at this fairly, we’ll be in that budget stage, but the adjustments that we made in the third quarter, the $117 million is a combination of two elements. One is the short-term incentive compensation primarily in corporate and then financial services. These are payouts based on the current year’s performance. In addition to that there were adjustments to the long-term incentive stock-based compensation accruals that effect three years. It effects the 2006 grant, the 2007 grant and the 2008 grant. So there is a catch-up adjustment that goes back against 2006 accruals that occurred in 2006, 2007 earlier part of 2008.
Same with 2007 so there’s a negative stock-based compensation adjustment that’s effecting corporate expense. Obviously you have to discount that when you look at the normal activity expense growth. But clearly we’re looking hard at our expenses, we’re looking hard at the things that we do in order to make certain that we’re spending monies that are going to contribute to the overall success, the immediate top line growth of the company, and things that can be delayed and deferred are being delayed and deferred.
Michael Meltz – JP Morgan
The free cash flow guidance reduction, the $100 million, what portion of that is related the lag in the cash catch-up of the incentive comp?
There’s no impact on the incentive compensation because those are non-cash accruals. The change is driven by the softer performance then we had anticipated through nine months and the softer performance that we’re forecasting in the fourth quarter. Offsetting that is the cutbacks that we’re trying to do with regard to our capital expenditures.
Your next question comes from the line of Catriona Fallon – Citigroup
Catriona Fallon – Citigroup
One of the things we’re talking to a lot of our companies about is what they might do with their dividend. Is there any thought that you might actually cut the dividend in order to pay down debt?
We’ve got a very strong dividend record here. We’ve had increases in the dividend for the last 35 years and as you know when we calculate free cash flow that is after all expenditures including the payment of the dividend so I think you can take from that that we think the dividend is very, very important to us and we plan to continue to have a very strong policy there.
Catriona Fallon – Citigroup
It looks like the information and media business actually had a decent quarter and you’re able to improve the margin there, going forward in order to maybe streamline the business or improve the overall operating margins of the company, would you explore divesting portions of the information and media business or are there other acquisitions or divestitures that you would explore?
As I’ve said all along that every aspect in these kind of environments, every aspect of the portfolio is under scrutiny and we will continue that. You also have to consider the environment that we’re in but everything is being scrutinized.
Catriona Fallon – Citigroup
Just regarding the [read] business that had healthcare and aviation magazines and others, what’s your thought for that type of a transaction, was that just to advertising based, or is there another reason why that might be less attractive to you?
No, again we look at everything. We’re not interested in anything at this point that is advertising related. We were looking primarily at the construction and the energy assets but again in this environment everything has to be very scrutinized.
Your next question comes from the line of Edward Atorino - The Benchmark Co.
Edward Atorino - The Benchmark Co.
To what extent have you factored into your, you didn’t talk about 2009 education, but with the financial crisis and other issues the states are scrambling for money, to what extent would textbooks hold their own in 2009 or do you think they could be vulnerable as they were this year to spending pressures?
For sure the states have come under a lot more pressure. As I was saying through July we were seeing that clearly states were cutting back on their budgets but the education portion was not. Early August we saw a material change to that and states started postponing, they weren’t cutting material requests, they were postponing or they were chopping them up, we’ll take half this year and half next year.
So we’re sorting that out now, clearly on the education side from a state budget standpoint is weaker then we anticipated. As we get into 2009 the state adoption market now is going to be a little bit less then what we anticipated and less then 2008 and its being deferred into 2010 and 2011. So we’ll have to see what that situation is.
Its not going to be, there’s still going to be a strong need here that has to be met and there’s a lot of change in terms of the adoptions for digital products and so forth so its going to be a little bit weaker then 2008 as an environment but we’ll just have to see how that plays out.
Your final question comes from the line of Peter Appert – Goldman Sachs
Peter Appert – Goldman Sachs
In the context of what it seems like I see a protracted downturn in the credit markets, I’m wondering if you’re rethinking your expectations in terms of sustainable margins for the S&P business, what you think an appropriate level of margin in that business might be.
I am very pleased with the margin level that we’ve been able to maintain so far in 2008. With the fall off of revenues in the structured finance area and still good growth in corporate and governments and some public finance and international operations, we’ve been able to hold to a pretty good margin and I was pleased that we were able to change our guidance to improve the margin level for the year.
So we’ll see as we get into next year but I don’t see at this point any material erosion in that margin and we’ll see as we get through the budgeting process here but dependent upon where we are comparisons get a little bit easier and we might be able to even improve upon that.
Peter Appert – Goldman Sachs
Do you have the actual total dollar amount of what incentive compensation for the corporation in total will look like in 2008 versus 2007 and then likewise the stock-based comp?
Its $117 million adjustment on a year-to-year basis, the nine-month figure was $207 million was the adjustment. That’s a combination of adjustments for the long-term incentive awards, the three I mentioned earlier, as well as the short-term incentive primarily corporate and financial services where the bigger areas are that we’ve captured.
And that’s the adjustment at this point in time through the first nine months. We’ll see how the fourth quarter goes and whether there will be any further adjustments.
Peter Appert – Goldman Sachs
You’re down $207 year-to-year.
Through nine months, correct.
Peter Appert – Goldman Sachs
That would include the impact of the stock-based comp then.
Yes, that’s the stock-based comp as well as short-term for corporate and financial services, the two larger areas.
Peter Appert – Goldman Sachs
I think the guidance implies a fourth quarter loss for the education business which would be something you haven’t experienced for quite a number of years, what should we read into that in terms of further deterioration in business or perhaps need for further adjusting of the structure?
What we’re highlighting here and pointing to is one, a little bit softer revenue coming our way, clearly not the replacement type of revenue that we had experienced in the past albeit smaller because K-12 is obviously lighter in the fourth quarter but we’re expecting even a lighter replacement revenue stream. Higher education is up but not performing at the levels that we had thought. We’re seeing pressure on the custom testing side and the supplemental revenue is off just based on AAP statistics more dramatically then the [basel[ products.
Coupled with that we do have the higher pre-pub amortization that I talked about as well as higher costs with regard to data center migration so there are a number of factors and you’re right, our guidance at this point in time points to a little bit down in revenue and an operating loss for the fourth quarter which we have not experienced for several years.
And I think that’s a very conservative approach and the right approach to take in this kind of environment. Some of the softness that we’re seeing on the education side, especially at the higher education level is on the softer disciplines in some of the humanities, social sciences area in particular but we’re still seeing very good strength in the business economics, the science, engineering and mathematics and we could see a pick up before year end on that side of it but at this point, we’re just saying that to be very conservative, $0.40 to $0.42 for the fourth quarter and we’re still going to be able to come in with $263 to $265 which we’re pleased that in this environment we’re going to be able to do.
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