The McGraw-Hill Companies Q2 2006 Earnings Conference Call Transcript (MHP)

Jul.25.06 | About: S&P Global (SPGI)

The McGraw-Hill Companies, Inc. (MHP) Q2 2006 Earnings Conference Call July 25, 2006 8:30 AM ET

Executives

(Harold) Terry McGraw - Chairman, President & CEO

Bob Bahash – EVP, CFO

Donald Rubin – SVP of IR

Analysts

Peter Appert - Goldman Sachs

Fred Searby – JP Morgan

Michael Meltz - Bear Stearns

Lisa Monaco - Morgan Stanley

Karl Choi - Merrill Lynch

Drew Crum - Stifel Nicolaus

Michael Kupinski - Bear Stearns

David Raso - Citigroup

Brian Shipman - UBS

Operator

Good morning and welcome to The McGraw-Hill Companies second quarter 2006 earnings call. (Operator Instructions) I will now turn the conference over to Donald Rubin, Senior Vice President of Investor Relations for The McGraw-Hill Companies. Sir, you may begin.

Donald Rubin

Thank you and good morning and thank everyone for joining us for The McGraw-Hill Companies second quarter 2006 earnings conference call. I am Donald Rubin, Senior Vice President for 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 second quarter 2006 results. We trust you have all had a chance to review the release. If you need copies of the release and financial schedules, they can be downloaded at www.McGraw-Hill.com/investorrelations.

Before we begin, I need to provide certain cautionary remarks about forward-looking statements. Except for historical information, the matters discussed in the 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 risk 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 U.S. Securities and Exchange Commission.

We are aware that we do have some media representatives with us on the call; however, this call is for investors, and we would ask that questions from the media be directed to Steve Weiss in our New York office at 212-512-2247 subsequent to this call.

Today's update will last approximately an hour. After our presentation, we will open the meeting to questions and answers. It is now my pleasure to introduce the Chairman, President and CEO of The McGraw-Hill Companies, Terry McGraw.

Terry McGraw

Thank you very much, Don. Good morning, everyone and thank you for joining us for a review of McGraw-Hill Companies second quarter. I am Terry McGraw, and joining me on today's conference call is Bob Bahash, our Executive Vice President and Chief Financial Officer.

I will begin by discussing some of the performance of our businesses and give you a little sense of the outlook for the remainder of 2006, and then Bob will review some of our financial performance and expectations for the year. Obviously after those presentations, we will go in any direction anybody would like.

As most of you know, earlier this morning we announced second quarter results. Diluted earnings per share increased 17.6% to $0.60, and that include $0.03 for incremental stock-based compensation. Net income was $221 million, a 13.3% increase; and revenue was $1.5 billion, a 4.9% increase for the second quarter.

The year is off to a good start. Based on the strength of this performance, we are taking this opportunity now to raise our earnings per share guidance for the full year by $0.08 per share. Our previous guidance for 2006 called for earnings per share in the $2.36 to $2.41 range, and that, of course, excluded the incremental impact of all stock-based compensation.

Our new EPS guidance for 2006 is $2.44 to $2.49, and again that also excludes the incremental impact of all stock-based compensation. To be clear, that excludes $0.13 per incremental stock-based compensation this year and $0.04 for the one-time charge for the elimination of the restoration stock option program, which was already announced in the first quarter.

With more robust opportunities taking shape next year, we expect to return to double-digit earnings growth in 2007.

Now concern over rising interest rates is abating. Based on recent comments from Fed Reserve Chairman Ben Bernanke, there is growing sentiment that the Fed -- after 17 straight rate hikes -- may be done with them for some time. We will know that with more certainty obviously after the Federal Reserve meets on August 8th, but it now looks like we may be at the start of a long pause.

The Fed has been working to cool the economy, and there is evidence that the strategy is working, although there is still some concern over the rate of inflation. David Wyss, the Chief Economist at Standard & Poor's, expects the U.S. gross domestic product to grow at an annual rate of about 2.5% over the next 18 months after an estimated 4.3% increase in the first half of 2006 and a 3.5% growth rate in 2005. Given the outlook for economic growth and inflation, David Wyss concludes that after a long pause in interest rate hikes, the Fed is very likely to start cutting interest rates by the middle of next year.

In the meantime, capital expenditures continue to grow at about 10%, construction is benefiting from a reduction in office vacancies and states are in great financial shape; probably the best shape that they have been in since the year 2000. That is certainly a plus for education and educational spending, especially given the robust adoption schedules for 2007, 2008 and 2009.

With that as background, let's take a closer look at the second quarter results and the outlook for the second-half. Let's start with McGraw-Hill Education. In the second quarter, revenue was off 2.7%, operating, profit declined 5.3%, and that includes $2.5 million for incremental stock-based compensation. The operating margins slipped 31 basis points to just over 11%, and that reflects excellent cost controls.

Revenue for the McGraw-Hill School Education Group, which is our elementary and high school business, was off 5.8% for the second quarter and is down 4.5% for the first half.

Revenue for McGraw-Hill Higher Education Professional and International Group was up 3.3% for the second quarter and is ahead by 4.1% for the first half. We have said all along that this will be a challenging year in the elementary/high school market. Industry sales after five months are down 1.2%, and that is according to the Association of American Publishers. We still expect the market this year will be flat at best and could be down as much as 4% because an approximately 30% decline in the state new adoption opportunities limits potential sales.

Our estimate for the state new adoption market this year is still in the $650 million to $700 million range, but the dollar volume may be at the lower end of that range because of the delayed purchasing in California and in Florida. By law California schools can buy over several years, and we now expect that about 35% of the state's social studies business will slip into 2007 and beyond. That is 10 percentage points higher than the original estimate for next year.

In Florida, school districts have only two years to implement new state-adopted programs, and here too we have seen some large districts delay purchasing until 2007.

In assessing our second quarter results, it is clear that the 17% gain in sales last year in the second quarter is not making comparisons any easier. Given the weaker new adoption calendar for this year, we are focusing more attention on the open territories and our new elementary basal reading program called Treasures. Treasures is off to a really strong start. We are very pleased with that. It has already won the two largest open territory districts to date, which is Wichita and Pittsburgh. Our program has also been successful in Kentucky. This is an adoption state whose rules permit schools to purchase our product off-list. Since Treasures was not completed in time to meet the state adoption deadline last year, we obtained permission to sell our new national edition off-list, and as a result of that, we expect to capture second-place in the Kentucky adoption.

We are also benefiting from the growing interest in reading and math intervention as No Child Left Behind accountability measures begin to take effect. Under these rules, schools face sanctions if they fell to achieve improvement in test scores prescribed for them. Several years ago when the term intervention became common, interest was chiefly in remediation reading at grades 4 through 6. That was based on the understanding that students moving into the middle schools would not be able to handle increasingly heavier content loads in science and social studies and other subjects without reading proficiency.

Recently educators have realized that intervention must begin earlier because many children, particularly in urban districts, start school without the English vocabulary or really the number sets needed to deal with standardized primary grade instruction.

Several of our newer programs like Early Interventions in Reading, Kaleidoscope and Number Worlds includes the early grades and are selling well in both the open territory and in adoption states where most schools can access federal and other special funding for intervention materials.

Because many students still enter the middle and high schools without achieving proficiency, this secondary intervention market is also growing rapidly. We are encouraged by the favorable reception of Jamestown Reading Navigator. This is our new online program for the middle schools. Jamestown Reading Navigator is a subscription product and we expect revenue to build. Early adopters include Palm Beach County in Florida and Lawrence, Massachusetts and have committed to three-year subscriptions for these programs.

In this year's key adoption, science in Florida and social studies in California, we're achieving strong results at the secondary level. In Florida we expect to lead the list in the secondary market, which offers the higher dollar volume. We had expected to ship more middle school product in the second quarter, but the early flow in Florida emphasized K-5 programs. As a result, we will be funding many of the additional middle school orders in the third quarter.

In California we also expect to capture the leading position in the secondary market, although some sales anticipated in the second quarter will move into the third quarter because of a delay in the state's approval of middle school books. Our performance in elementary science in Florida and elementary social studies in California fell short of expectations.

Looking ahead, we continue to face tough comparisons in a soft market. Last year we had an outstanding year in the Texas adoption, but Texas did not start processing orders last year until mid-August. As you all remember, late ordering from Texas contributed to our 18.9% increase in sales in the third quarter and a 23.6% gain in the fourth. We don't have that going for us in 2006, nor is it clear that success in the open territories will make up for the shortfall in new state adoption market dollars this year.

We also face some margin pressure in testing as the market continues to shift away from norm referenced tests. These are the high stakes test to state-specific custom assessments where speed and custom is so important. New requirements created by the No Child Left Behind Act are driving these changes.

In the second quarter, increased custom contract work on the state assessment programs did not offset the decline in off-the-shelf testing products. Growth in the study guide and state reporting markets helped mitigate the ongoing shift away from the norm reference test. In this connection, The Grow Network's effort in Florida is notable because of the compilation, validation, production and delivery of 1.8 million student reports represented a major logistical achievement.

Now those 1.8 million documents comprised of 46 different reports in three languages across nine grades and four subjects. The reports offered features and user support unprecedented in the assessment field. For example, new family reports offered dynamic translations in Spanish and Haitian Creole, as well as task samples that incorporated nearly 2 million student response images, which allowed each family to view their students own work. A special website was also launched in Florida with personal login accounts that permitted parents to view individual student data.

That effort underscores why we are continuing to invest in technology and paperless publishing systems to improve development, delivery and scoring capabilities. Technology initiatives are the key to improving our margins and testing.

In Higher Education Professional and International, a good year starting to take shape for us in this U.S. college and university market. We had a strong close at the end of June, which is a good signal as we enter the critical period in July and August, what in the education market we call the 60-day month.

Our three major imprints all produced gains in the second quarter. The imprints are science, engineering and math; then humanities, social sciences and languages; and finally, business and economics. We expect the U.S. college and university market to grow about 5% this year, and we expect to outperform it.

Summing up then for McGraw-Hill Education, we will continue to be diligent in managing our cost structure, very important. Our costs and expenses in this segment actually declined in the second quarter, so the effort clearly benefited our performance this year. Some of the benefit came from timing because of delays in filling some of the positions. We will now be adding to staff to ensure that important projects are completed, so we don't expect the same level of savings in the second half.

Excluding the impact of incremental stock-based compensation on the segment, we expect modest revenue growth, we expect a decline in operating profit as much as 10%, a decline in operating margin which in part is attributable to investments that we are making now for the very robust El-High market in 2007 and beyond. That is McGraw-Hill Education.

Let's shift now to Financial Services, which just completed another record second quarter. Revenue was up 13.4%. Excluding $34.8 million from Corporate Value Consulting, which was sold at the end of September of 2005; and $8.1 million from CRISIL Limited where we acquired majority interest on June 1, 2005; revenue was up 18.9% on a non-GAAP basis. Operating profits grew by 21.5%. Now that includes a $6.3 million of incremental expense for stock-based compensation. Corporate Value Consulting contributed to approximately $7.5 million to operating results in the second quarter of 2005. The operating margin expanded to 46.3%, and that is up from 43.2% last year.

There are many contributors both in the U.S. market and abroad to our outstanding record, the hallmark of a diversified portfolio. We produce growth in global structured finance. We had growth in corporates, growth in ratings, products and services that are not dependent on the new issue volume. Growth in data and information products, growth in products and services related to our indexes.

International ratings accounted for 37.4% of rating revenue in the second quarter, and that is up from 36.7% for the same period a year ago. Ratings and services that are not tied to the new issue market -- now these are things like bank loans and counterparty risks ratings, rating evaluations for example -- produced 24.2% of ratings revenue in the second quarter. That is up from 21.5% a year ago.

In the U.S. residential mortgage-backed securities market, we saw the first signs in the second quarter that new issue volume was softening a little bit. Now these are the comparisons, year-over-year comparisons softening a little. New issue dollar volume for the U.S. residential mortgage-backed securities slipped by 1.2% in the second quarter. But these figures, like the estimates for the gross domestic product, are regularly updated. Frequently the estimates grow, so I don't take today's figures as the last word on market activity here.

Rating smaller deals is a plus for Standard & Poor's, so we benefited in the second quarter from an 8.6% increase in the number of U.S. residential mortgage-backed security issues. We also benefited from a 20% increase in residential mortgage-backed securities dollar volume issuance in Europe in the second quarter.

We also enjoyed solid growth in the U.S. commercial mortgage-backed securities market, but the major factors in structured finance in the second quarter were U.S. collateralized debt obligations, CDOs. New issue dollar volume for U.S. collateralized debt obligations grew by 162%. Collateralized debt obligations are an excellent example of the financial market's ability to innovate by pooling bonds and loans and derivatives that are then split into tranches with varying risk profiles for various investor audiences.

What emerges are collateralized debt obligations that are based on cash flow, which are backed by the actual bonds, loans or asset-backed securities; synthetics backed by derivatives or some combination of both called hybrids.

Strong growth in collateralized debt obligations throughout 2006 has been driven by a number of positive factors, including robust debt origination in areas like leveraged loans, residential mortgage-backed securities, commercial mortgage-backed securities which are used to create pools of available loans to be put into these large baskets, these collateralized debt obligation structures.

Strong investor demand, as CDOs provide opportunities for higher yields in a low interest rate environment and diversification across credit. And, attractive arbitrage opportunities for issuers and investors to transfer specific risks or to take advantage of spreads between asset income and liability funding costs.

The asset-backed securities market softened because of a sharp decline in auto loan issuance, but we did see strong pickup in activity in the credit card receivable end and student loan sectors.

We saw a surge in the U.S. corporate market as companies turned to the public market to finance activity and refinance debt that was coming due. The action was not confined to the investment grade market where dollar volumes issuance soared by 51.3%. The high yield market was also very active with dollar volume issuance climbing by 77%.

The softness in the public finance market continued in the second quarter as refunding volume again declined. We also had another good quarter in the data and information market. As the fixed-income market continues to grow, we're seeing strong demand for ratings data from our web-based services like Ratings Direct or Ratings Express.

We are pleased by the progress at Capital IQ, which now has more than 1,500 clients. The latest release in April included additional fixed-income data, auditable international data and enhanced functionality.

Revenue generated by Standard & Poor's Index has increased as assets under management for exchange traded funds rose to $143.4 billion, a 21.3% increase over the same period last year.

We have also benefited from the increased trading of derivatives based on S&P indexes. June has been a busy month with more exchange traded funds coming to the market.

ProFunds launched four S&P Index exchange traded funds. These funds are the first exchange traded funds to use derivatives to implement short and leveraged strategies. This model opens the door to more exchange traded funds offering returns like those of structured products.

State Street Global in June introduced five more spider industry exchange traded funds. State Street successfully launched three industry funds last February, so this family is starting to attract a lot more assets.

The S&P BRIC Index was released in June, and as we know, that provides exposure to leading companies from Brazil, Russia, India and China -- hence BRIC. It has a unique waiting system that takes into account capitalization and liquidity. Lehman and UBS have already been licensed to create products based on the index.

Those are just some of the highlights of a very strong second quarter and first half. For the second half -- and this is excluding Corporate Value Consulting and the impact of stock-based compensation -- we expect double-digit top and bottom line growth to continue, although probably not at the same pace we achieved in the first half. That may also have some effect on operating margins, which have expanded to 44.3% in the first half of 2006. Our optimism is based on continued strength in international ratings, as well as products and services that are not tied to new issuance.

There are tougher comparisons ahead in the U.S. residential mortgage-backed securities markets, which enjoyed a spectacular second half, as we all know, in 2005. Residential mortgage-backed securities growth continued into the second quarter this year, and the U.S. residential mortgage-backed securities dollar volume issuance is up 13.5% for the first half of 2006.

We still have a very good pipeline of business heading into the third quarter, but probably not enough to expect year-over-year growth in the face of the challenging comparisons. We now expect U.S. residential mortgage-backed security issuance to climb by about 5% in 2006. But in Europe we expect the residential mortgage-backed security and the commercial mortgage-backed securities markets to show year-over-year growth in the second half.

Prospects for the U.S. commercial mortgage-backed securities, asset-backed securities and public finance look a little soft to us right now but the pipeline for U.S. collateralized debt obligation issuance, CDOs, remains very strong; very strong indeed.

We also expect some strength in corporates in the second half. There is a healthy pipeline of bonds maturing for refinancing. Debt finance merger and acquisition activity is still promising. There is continued solid spending on capital equipment. Balance sheet restructuring will also be a positive factor. The demand for data and information remains strong on a global basis, and we expect more growth from the trading of derivatives based on S&P Indexes.

Let me close this segment and make some comments on the regulatory outlook for the trading agencies. Now that the House of Representatives has passed House Resolution 2990, we have consistently supported demands for greater transparency and more competition. Transparency is critical for the operation of sound and efficient capital markets. The transparency and efficient of our rating process has served the Capital Markets well. We are not alone in observing that investors look at S&P's opinions on credit worthiness because of the credibility of its rating over significant periods of time.

It is clear that the market has functioned successfully for many, many years. That is why any move here to change a system that has worked so effectively for decades should be very carefully evaluated. The wisdom of market-based self-regulatory approach is widely recognized in Europe after years of careful study.

When market participants were asked by the SEC in connection with the preparation of its 2003 release, if the current Nationally Recognized Statistical Rating Organizations, NRSRO system, should be retained, they overwhelmingly said it should.

We hope that Congress would allow the SEC to complete its work by streamlining and making transparent its process for NRSROs and opening the market to more competition. We support the SEC's proposed rule that is expressly designed to accomplish these important objectives.

We also hope the SEC will soon finish its ongoing discussions with the rating agencies to implement a voluntary oversight framework that is similar to the self-regulatory market-based system adopted by CESR and IOSCO in Europe. These are the security regulators and security commissioners.

In passing HR 2990, the House unfortunately voted for quantity over quality. The bill says a credit rating agency in business for only three consecutive years can become an NRSRO, a Nationally Recognized Statistical Rating Organization. That sets the quality bar pretty low. We think investors deserve a higher standard, so we will continue to work with Congress, the administration and the SEC to ensure quality, to improve transparency, to increase competition which is good, and to ensure global regulatory consistency of the capital markets.

Standard & Poor's has been rating bonds since 1916, so the market knows our capability and our reputation very well. The integrity, reliability and credibility of S&P has enabled us to compete successfully in an increasingly global and complex market, and that is true today and we are confident it will be so in the future. That will not change even if the proposed legislation passes in its current form. Either way I see no material adverse effect to our business.

So summing up for Financial Services, excluding the impact of CVC, which was divested at the end of last September and the incremental stock-based compensation on this segment, we expect double-digit top and bottom line growth, continued strength in global ratings, a solid performance in corporates, growth in structured finance and an operating margin that at least matches our 2005 performance.

Let me shift at this point over to the McGraw-Hill Information and Media segment. In the second quarter, revenue increased 3.6%. Operating profit reflecting the incremental impact of $3.7 million for stock-based compensation declined $652,000 or 4.8%. The operating margin was 5.4%, down from 5.9% last year.

Revenue for the Broadcasting Group was up 14.3%. Local advertising was solidly driven by increases in auto, services and retailing categories. We also benefited from political advertising, mainly in California. There was an election to replace Duke Cunningham in the House of Representatives, and while the election for Governor of California will not be held until November, we are already running political advertising for that race from the Governor, as well as his opponents.

Revenue for the Business to Business Group was up 2.1%. At J.D. Power & Associates, new products and additional services for both automotive and non-automotive clients drove an increase in revenue. Investments for the new syndicated and consultative studies offset the revenue increase, but we expect these investments to create new growth opportunities in the second-half of this year and next year as well.

In the volatile energy market, Platts News and pricing services continue to attract new customers. The McGraw-Hill Construction Network and advertising-based products showed gains in the second quarter. Global advertising pages at BusinessWeek were off 11.7% in the second quarter, and that is according to Publishers Information Bureau, PIB. Elimination of BusinessWeek's European and Asian editions impacted revenue but benefited the bottom line. In the second quarter last year, the international editions had revenues of $4.6 million.

Growth in online advertising continues both domestically and internationally at BusinessWeek.com, which produced 14.1% of BusinessWeek's total ad revenue in the second quarter. BusinessWeek.com introduced a new home page design and will be rolling out the new look throughout the site in the coming months. I hope you get a chance to view that. After four issues in July, BusinessWeek's ad pages are up 29.3%. Year-to-date through the issue of July 24, BusinessWeek's ad pages are off now only 2.2%.

Summing up for the Information and Media segment and excluding the impact of incremental stock-based compensation, we anticipate mid to high single-digit growth in revenue, a slight increase in operating profit after absorbing the impact of a $15 million revenue reduction in suites where we are smoothing out the revenue recognition process by going online.

That completes our view of operations, so let me sum up for The McGraw-Hill Companies. Based on the strength of the first-half performance, we are pleased that we're raising our guidance for the year by $0.08. Our previous guidance, as I said earlier for earnings per share, was $2.36 to $2.41 and of course, that was excluding the incremental impact of all stock-based compensation.

We now expect earnings per share in 2006 of $2.44 to $2.49, and again that excludes incremental impact of all stock-based compensation. That is $0.13 for incremental stock-based compensation and $0.04 for the one-time charge of the elimination of the restoration stock option program, which was done in the first quarter. With more robust opportunities taking shape next year, we expect a return to double-digit earnings growth in 2007.

That is a review of the operations. Let me turn it over now to Bob Bahash, and he will review some of the financials measurements with you, and then we will go in any direction you would like.

Bob Bahash

Thank you, Terry. I will begin this morning with a discussion of our shareholder return initiatives. We continue building on our record of producing total shareholder value through increased dividends and share repurchases. We acquired 18.4 million shares in the first quarter, completing the original authorization approved by the board in January. Now this authorization consisted of two parts: the purchase of 3.4 million shares remaining from the board approved 2003 program and 15 million shares from the new 45 million share program approved by the board in January of 2006.

In April the board increased this year's authorization by another 10 million shares. During the second quarter, we acquired 7.7 million shares from the board's additional authorization at a cost of $392.2 million. So for the first half of 2006, we have acquired 26.1 million shares at a cost of $1.4 billion. The $1.4 billion return to shareholders through the first half share repurchases was more than double the amount for all of 2005, and both years together represents a return of more than $2 billion.

We expect to repurchase the remaining 2.3 million shares that are authorized during the second half. When we complete the full program, 20 million shares will remain from the 45 million share repurchase program approved by the board in January 2006. This program represents in total 12.1% of the Corporation's outstanding 372.7 million shares as of the end of 2005. Share repurchases will benefit the year by approximately $0.03 and is reflected in the earnings guidance that Terry discussed earlier.

The diluted weighted average shares outstanding for the second quarter of 2006 was 365.5 million shares, a 14.5 million share decrease compared to the second quarter of 2005 and an 11.8 million share decrease compared to the first quarter of this year.

As a result of the increased share repurchases, we have ramped up our borrowings in the commercial paper market. With our traditionally strong cash flows in the second half of the year, we expect to return to a net surplus cash position by year end.

As of June 30, our debt outstanding is $681.6 million. This is offset by our cash holdings of $211.1 million, primarily in foreign holdings, resulting in a net debt position of $470.5 million. Net interest expense was $8.6 million in the second quarter, a $5.1 million increase compared to last year. The increase is due to increased commercial paper borrowings for the expanded share repurchase program, as well as rising interest rates. We expect that net interest expense will continue to increase in the third quarter and then decline in the fourth quarter as we return to an expected net surplus cash position by year end.

For 2006 we project interest expense in the range of $22 million to $24 million. The Company began expensing stock options at the beginning of this year and expects to incur an incremental $0.13 per share in 2006 as a result of the accounting change per FAS 123-R. This new incentive stock-based compensation program is skewed more toward restricted stock and less toward stock options. In the second quarter, the Company incurred incremental stock-based compensation expense of $14.9 million or $0.03 per share.

In terms of the impact on the segments, McGraw-Hill Education's second quarter stock-based comp expense increased $2.5 million; Financial Services increased $6.3 million; Information and Media increased $3.7 million; and corporate second quarter stock-based compensation expense increased $2.4 million, which covers both corporate and shared services personnel.

Let's now look at corporate expenses. Corporate expense increased $4.7 million in the second quarter and was driven by increased stock-based compensation I just referred to, as well as a revaluation charge for certain equity investments. Corporate expense is now expected to increase in the high single digits in 2006, excluding the incremental stock-based compensation.

In 2006 we still expect dilution of $0.03 to $0.04 from the acquisitions that were made in 2004 and 2005. They will be approximately cash neutral. In 2007 we expect these acquisitions to be cash positive. Of course as you know, the Company did not make any acquisitions or material dispositions in the first half of 2006.

The effective tax rate in the second quarter was 37.2%, and we continue to project this rate for the balance of the year.

Let's now look at capital expenditures, which include prepublication investments and purchases of property and equipment. In the second quarter, our pre-publication investments were $63.5 million compared to $60.7 million for the same period last year. Our full-year expense for pre-pub investments remains at approximately $315 million. This level of investment has driven mainly for products we are currently developing to realize significant opportunities in the El-High markets in 2007, 2008 and 2009.

Purchases of property and equipment were $20.5 million in the second quarter compared to $26.3 million for that same period last year. Construction will start later this year on a new information technology data center and a new facility for McGraw-Hill Education in Iowa, as well as technology initiatives at Financial Services. As a result, we continue to project $200 million for capital expenditures for 2006.

Now for non-cash items. Amortization of prepublication costs were $53 million in the second quarter compared to $55 million in the same period last year, and we continue to project $250 million for 2006. Depreciation was $28 million in the second quarter compared to $26 million last year. We continue to expect it to be about $130 million in 2006, reflecting the higher level of capital expenditures in 2006 and full-year depreciation from capital expenditures made in 2005.

Amortization of intangibles was $12.1 million in the second quarter compared to $12 million in the same period last year, virtually flat. For 2006 we expect $50 million, the increase driven by 2005 acquisitions. Thanks and now back to Terry.

Terry McGraw

That concludes our review of operations and we are obviously very [inaudible – audio gap] in the second quarter and the ability to change to the upside on the guidance. Let me turn it over to Don, and let's go to your questions and go in any direction you want.

Donald Rubin

Thank you. Just a couple of instructions for our phone participants. (Operator Instructions) We will now begin to take questions.

Question-and-Answer Session

Operator

Our first question comes from Peter Appert - Goldman Sachs.

Peter Appert - Goldman Sachs

Thank you, good morning. Terry, these operating results from S&P obviously are very impressive. Two questions about the margins for S&P. First, just on a short-term basis, should we take your comments to indicate that you would expect margins to be flat to down in the second of the year? And just help us understand better why that might be.

Two, I guess more importantly on a longer term basis, are you rethinking what you think the margin potential of this business might be, specifically whether there might be some further meaningful upside to margins relative to what you have been able to generate historically? Thanks,

Terry McGraw

Thanks, Peter. Well, okay, when we talk about margins overall, we don't forecast all of that because we've got to take into account out year investments and the continued global expansion and so forth. But clearly we were very pleased with both some of the cost controls and some of the added revenue, especially coming out of the structured finance market; but also corporate coming out of Europe and also our index operations, and data and information did well as well. So we were very pleased with that.

These are all timing issues in all of that, and so even though we were up with a margin a little over 46% in the second quarter to a little over 44% for the first half, what we have said at the beginning of the year is that we would do at least what we did in 2005, which was 42.2%.

You know, I don't want to get into forecasting and all of that, but given the strength of the first half, would it be reasonable to expect that there be some upside on that? Yes, I think so. But we will have to see as to what the Fed is going to do and what the impact of that is going to do.

So it is quite strong, and as you know, our posture has been to continue to work on margin improvement. You can fully expect that that is what we're going to do.

Peter Appert - Goldman Sachs

I guess the real issue that keeps coming back from investors, Terry, is that there seems to be a fairly big disparity between the profitability of S&P versus Moody's. That gap has closed substantially. So the real question I suppose is, do you think that gap closes further?

Terry McGraw

Well, yes. Again, if you're comparing rating operations, that is one thing. If you're comparing all of S&P and all of the operations that we have, we have to be careful how we compare some of that. But yes, we have closed some of that perceived gap.

There are issues in terms of revenue recognition, and as you know, we have worked very hard to smooth out that recognition so that there is a consistency there in all of that.

I think the best thing I can tell you, Peter, is that obviously we have to make appropriate investments, but the market is strong. It will continue to stay strong for sometime. There might be shifts in leadership between categories as we have seen, for example, in the structured finance market, where as residential has fallen off a little bit, commercial has done a lot better. The CDOs in that whole area is red hot. It is doing extremely well. We have seen corporates do better, not only because of some refinancing but also because of strong M&A activity.

So we are going to see shifts in leadership in these various categories, but there is no question that the capital market growth is strong and increasingly outside the United States is getting stronger. That is where we are benefiting.

Peter Appert - Goldman Sachs

Thank you, Terry.

Operator

Our next question comes from Fred Searby - J.P. Morgan.

Fred Searby - J.P. Morgan

A couple of questions, Terry. One is, CDOs obviously were extremely strong. I am wondering if that momentum can continue into the third quarter, what you see? If you could help us understand how much of that was merger-related? You alluded to that.

Secondly, can you give us some sense on the non-ratings businesses within S&P? Capital IQ, obviously the equity research business and indices, how much margin expansion you're seeing there as well? Or is this really being driven more by ongoing strength at the ratings business? Thank you.

Terry McGraw

Thanks, Fred. Let me take the non-ratings first. On the non-ratings side, you have got some very, very strong operations, especially in the primary research and the index operations that are contributing nicely there. On the Capital IQ side, the revenue growth there has been spectacular. As I mentioned, we are up to 1,500 clients, and that sales and marketing effort continues to strengthen as the acceptance of Capital IQ in the marketplace also get stronger. You are going to see a lot of push.

This is very, very important, Fred because what we said from the very beginning was what we are creating here is a data and technology platform. That is an open architecture system that has proprietary data, but it has a lot of third-party data. It has a terrific toolset capability for flexibility and navigation, and we're just going to continue to add more and more content to its capability to serve a broader range of customers.

So this is one to watch, but we are focused on the revenue growth here. The margin improvement or the profit contribution is secondary relative to the investment that we are making there.

On CDOs, it is really right across the board. The whole structured finance market or the securitized market is the desired choice of most investors, most financial institutions, because it gives them more options in terms of being able to specifically tailor their investment portfolios to components that they need.

So, with the collateralized debt obligation market, you are able to have a lot of flexibility in the multitude of tranches that you can take advantage of, and these are very large, very complex instruments. Therefore, I would expect those to continue. Eventually you'll be getting into collateralized fund obligations, collateralized equity obligations, and this is just again a continuation of the strength of the securitized market.

It is not U.S. alone; it is very strong in the United States, very strong in Europe. It is gaining tremendous acceptance in Asia, most notably in Japan. So it's a very strong market, and it is going to continue to do extremely well.

Fred Searby - J.P. Morgan

Thank you.

Operator

Our next question comes from Michael Meltz - Bear Stearns.

Michael Meltz - Bear Stearns

I just have two questions. Terry, I just want to make sure I understand the guidance. Maybe I'm alone here, but I had thought you were including that $0.04 relo charge earlier in the year, and now it sounds like you're excluding. I just want to understand what’s in that. The quarter was a good one, the $0.08 there, I am just wondering – it feels to me like you are limping by $0.04, I just want to understand that more. Maybe that is just conservatism or the higher interest costs.

Secondly, Bob you had mentioned this revaluation of equity investments. Can you just talk a little more about that? Thank you.

Terry McGraw

Michael, again with the stock-based compensation, I am trying to be very, very clear on exactly what is in that capability. What we have said is we have taken our guidance up $0.08, $2.44 to $2.49, and we said it excludes all stock-based compensation. And that includes the $0.13 for 2006 and it includes the $0.04 for the end of the restoration stock option program, which we took in the first quarter. So it is the $0.17, it is the $0.13 and the $0.04. It is $0.17 which represents all the stock-based compensation expense.

Bob Bahash

Michael, with regard to the corporate expense area, the increase on the year-to-year basis was approximately $5 million. Half of that was due to the stock-based compensation. The other half related to the revaluation that I referred to. There were certain distributions that we received from a number of our equity investments that we make really along the lines of looking into some of the latest technology, latest thinking that affects a number of our businesses. There was one particular investment that we adjusted downward. So on a net basis, we had a net charge of about $2.5 million.

Michael Meltz - Bear Stearns

Just following up and just to be clear then, when I look at your guidance for the second half and then I look at consensus, you are saying that there will be some margin drag and then there will be the higher costs, and that is where you are guiding now for the year? Is that fair?

Terry McGraw

Yes, I would say that certainly it will be a little slower from that standpoint. But the guidance, we did $0.08 better in the second quarter than we had anticipated. There is some real strength, possibly also on the cost side and also on some timing issues.

So what we have done is increase the $2.36, $2.41 guidance by $0.08 to reflect that change, and we see no change from the beginning of the year in how we see the rest of the year completing.

Michael Meltz - Bear Stearns

Thank you for your time.

Bob Bahash

Michael, just to follow up on that point, as you know the second half of the year is much more heavily influenced by the McGraw-Hill Education segment, which when you look at the different margins of the different businesses, clearly that is lower than Financial Services. So naturally there is on an overall basis, the second half of the year would have a lower margin contribution simply because of the wait coming from Education.

But, as Terry just pointed out, we're not changing the second half of the year forecast that we had made earlier. So we are staying consistent with that, which as I mentioned is more heavily weighted toward the Education segment, which is simply having a later adoption year.

Michael Meltz - Bear Stearns

Thank you.

Operator

Our next question comes from Lisa Monaco - Morgan Stanley.

Lisa Monaco - Morgan Stanley

Terry, could you just elaborate on how we should think about expense growth for Education, particularly El-High? You commented a little bit about the second half; if you could, elaborate on that for the second half.

Into '07, as you're ramping up your spending ahead of the big adoption years in '07 through '09, will we see some easing in expense growth in '07?

Terry McGraw

Sure. Well, again in looking at the pre-pub costs Lisa, we came into the year with a very healthy net level, which we have been able to control at this point for 2006 at the $315 million level. We are working on 2007/2008 programs now and even a little bit of 2009. So what I would expect as we get into next year is things should be flattening out a little bit.

Now you also have other kinds of cost implications here. Especially as we continue to push aggressively into the online environment, you are going to have some cost issues that are going to dissipate. You also have the effect of the whole order to cash system, which was the global transformation project. You also have the global resource management initiative as we continue to look at all of our costs and look at different ways to manage that cost base and taking advantage of some outsourcing opportunities on that one.

So on the program development side you should see a flattening out; and secondly on the infrastructure costs, a continued emphasis to be even more efficient.

Lisa Monaco - Morgan Stanley

Can you just give us any more color on what you are expecting for testing and supplementals in terms of growth this year and perhaps next?

Terry McGraw

As you know, we have made and are making tremendous investments here to reflect a shift in the whole nature of the business. Now with mandatory testing in reading and math, and science next year, this whole emphasis on high stakes tests, the summative tests, the norm reference tests, is still strong. But where we are going to see the faster growth is in the formative side or the low stakes side where teachers, administrators all over are going to be doing a lot of testing on their own to continue to gauge where their students are at; so that by the time they get to the higher stakes tests, they are going to have a pretty good indication of what they need to work on and so forth.

So the issues are now speed and customization. So if you're developing a test for a particular district in Indiana or California or what have you, they want those test results in the low stakes testing environment right away. Therefore, from a technology standpoint, we need to really have the capability and the flexibility to be able to respond not only quickly but also to the customized requirements that they may have that we want to respond to.

You are going to see continued investment this year, and as we get into next year, we should start to see that improvement.

Lisa Monaco - Morgan Stanley

Should we expect testing to be up this year in terms of top line?

Terry McGraw

I don't want to get into forecasting any specific unit that way. Let me just say, though, we like the position that we are in, we like the changes that have taken place and the response that we have had to those, and I fully expect to be in a very good position as we finish the year for 2007.

Lisa Monaco - Morgan Stanley

Thank you.

Operator

Our next question comes from Karl Choi - Merrill Lynch.

Karl Choi - Merrill Lynch

Good morning, Terry. A couple of questions. The first one is, can you comment a little bit for this year based on what you are seeing right now, do you expect to perform in line with the El-High industry performance for this year? You're calling for flat to down 4%; or do think you could actually under perform a little bit given the tough comparisons that you have?

The second question is, in terms of the cost control in the second quarter, how much of that did you benefit from the global resource management programs that you have put in place, or was the cost control more of a function of timing of expenses as you pointed out? Thanks.

Terry McGraw

On the latter part -- and Bob, if you want to comment on this as well -- I would just say to you it is a little early on the global resource management to be looking at specific savings. This is a lifetime diet. This is a transformational change in terms of how we look at infrastructure and how we are going to manage infrastructure costs.

Therefore, as the business also becomes more global and we need capabilities in other markets, you are going to see a continued push both for more efficiency but also a higher quality. So that is going to be a program that we are going to be talking about going out.

On the elementary high school forecast, it is just a little squishy at this point. We're coming into a very obviously robust market. I'm very pleased with our participation in the middle school and at the secondary school, and you're going to see, in my opinion, very good numbers as we have seen in the first half of this year on that.

On the elementary side, it has been a little softer and we will have to see. We also want to watch, Karl, the shifting of dollars in California and Florida, for example, into 2007. That augurs well for 2007, but we want to see how much is going to be shifted in terms of their purchasing capability there. So the industry we have been saying flat to maybe down 4. It is a little early to tell where we are in that, but we are pleased with certainly the results at the secondary middle school area. Bob, do you want to add anything on the cost control area?

Bob Bahash

As Terry mentioned, the Global Resource Management initiative is one that is going to be with us for some time. We're getting underway in a number of projects. Some are already up and running. We have mentioned the development efforts with regard to our titles for 2007, 2008 and 2009 which are simply reducing the investments we are making. We will see that coming through in the later years as we have lower amortization of pre-pub costs.

But having said that, there are a number of other initiatives dealing with application development, infrastructure costs across all three segments and the corporate areas. But this is not just simply an effort to focus on offshoring and outsourcing. This is really looking at process improvement across the board, and each one of the segments in the corporate areas are working on these initiatives.

So I don't want the message to be conveyed that we are simply reducing costs by offshoring and outsourcing. This is, as Terry said, it is a steady diet with regard to looking at the end win process of how we conduct our business and try to be more efficient.

So some of the savings that we have, some of them are real and will stay with us. Some are timing clearly, but it a combination of process improvement a little bit now because we are just getting underway in some of the offshoring and outsourcing, and we do have a number of timing initiatives as well.

So it is a collection of different approaches to try to watch our costs, to manage our costs and to be responsive to the marketplace.

Karl Choi - Merrill Lynch

To follow up, could you quantify the amount of orders that were delayed into the third quarter in the El-High area?

Terry McGraw

Well, we said that in California we were expecting that probably 75% of social studies would have been purchased in this year, and that means 25% going into '07. Right now it is looking more like 65% in California; again, we are guessing a little bit. But it looks like district by district there is some holdback in both California and Florida that will benefit '07.

Karl Choi - Merrill Lynch

Thank you.

Operator

Our next question comes from Drew Crum - Stifel Nicolaus.

Drew Crum - Stifel Nicolaus

Terry, just to follow up on that point. The delays you're seeing in purchases in California and Florida, is it specific to those states, or are you seeing that across the entire market?

Terry McGraw

Well, I mean those are the biggest states. There is flexibility built into purchasing guidelines by states. It is pretty much in the same line. But when you're talking about a state the size of California and Florida, again this is a typical pattern. It is usually about 75/25.

We are seeing that there is a little bit more caution district by district, and so they are just being a little bit more cautious in the spending, but we fully expect them to complete it. It is just that it's taking a little longer. So it is a state-by-state issue, but it is about the same model, if you will, or purchasing behavior.

Drew Crum - Stifel Nicolaus

In terms of uses of cash, you have been relatively aggressive on share buyback, conversely relatively quiet in terms of acquisitions. Is that just a situation where you're adjusting what you have acquired over the last two years, or is there kind of a general lack of acquisition candidates out there?

Terry McGraw

Well, I have a little bit of different view on that one. Certainly making sure that we are investing properly in the integration of the acquisitions that we have completed is extremely important, and we will continue to do that. This is also a little bit of a different period from an economic standpoint. There is tremendous liquidity in the market, and that excess liquidity is chasing very high returns.

What we are seeing is people taking enormous risks to get those returns, especially when we are taking a look at a lot of transactions both on the private equity side and venture capital side. I don't think it is as prudent an environment right now to pay up such incredible premiums for things that we would like to be able to do in this kind of environment.

I think what we're going to see is globally a lot of that excess liquidity will be reduced through more moderate monetary policy, and I think what we will see is an environment over the next 12 to 18 months that could be very conducive to doing things at more reasonable valuations.

But it makes no sense to be paying enormous premiums for things that will take a lifetime to get returns on. So we don't want to do that. We want to see more reasonable valuations to do that.

Drew Crum - Stifel Nicolaus

Okay. Thanks for the color.

Operator

Our next question comes from Michael Kupinski - A.G. Edwards.

Michael Kupinski - A.G. Edwards

Thank you for taking the question. I was just wondering if you can give us an update on share repurchases so far in Q3, and if you can provide the number of shares outstanding at the end of Q2, not the weighted average but total shares outstanding? Then I have a couple of quick questions.

Terry McGraw

Okay. Good. Bob, do you want to go over that again?

Bob Bahash

First off with regard to our policy, we do not go into the marketplace once we are in the quiet period. So the beginning of a quarter, that being July 1 through the period of earnings announcement, we are out of the market. So we could not enter the market until tomorrow. So hence, no buying.

Michael Kupinski - A.G. Edwards

Okay. And the actual shares outstanding at the end of Q2?

Bob Bahash

If you hold on a second, we will get that for you.

Michael Kupinski - A.G. Edwards

If I could just ask another question then. On the broadcast group revenue, I know this is a small division, but it was up over 14%, which is extraordinary given that the industry average is probably up in the 3% to 5% range. How much political was in that number?

Bob Bahash

Actually not that much at this point. We really expect that in the third quarter. Obviously it will lead up to it, I think. It was a little higher than we had anticipated only because of the fact that California has gotten very active. We will really see the lion's share of that in the third quarter.

I was pleased with the performance at the television stations. The area that we benefited from big time was the local sales effort, the part that we get to control. So not only was it in auto and service, but it was very strong retail for us, which was nice to see and nice to see from an economic standpoint.

Michael Kupinski - A.G. Edwards

Yes, it is surprising. I know this is a hypothetical question and you may not want to answer it, but I will try anyway. In terms of the House bill -- and I know it's moving away from the voluntary oversight that you're seeking -- I was just wondering about plans in the Senate. Are you hearing anything? Could you update us on what might be coming out of the Senate?

Also, I think you indicated that the House bill may be unconstitutional. I was wondering if you would challenge the bill in the courts if that would pass?

Terry McGraw

Yes, you know again, you reserve all of these rights to do things as a practical matter. I'm less interested in doing those kind of things. We want to be very constructive with all government agencies that we work with in terms of a global platform.

For example, whatever country we are in, we deal with those related government agencies. Now what we are looking for is a more uniform regulatory environment that satisfies everyone. It was Europe through the commissions: both IOSCO, the commissioners and a regulator, CESR that came up with a code of conduct and came up with the voluntary framework oversight framework that we think does exactly what was intended: it increased competition, increased transparency, increased accountability, and so we adopted a similar code of conduct on our own to parallel that. That voluntary framework, oversight framework, is before the SEC today.

Now the House made a move on a couple people’s parts to quickly rush to legislate, pass 2990. I think the Senate is a little bit of mixed minds. They want to study it a little bit more to see what the implications are. Are there implications of unintended consequences or any of those kinds of things in that? So I cannot forecast what the Senate will do.

Either way from our standpoint, there will be no material adverse effect on us whether they do or not. But if a market-based self-regulatory process works and if the participants are very much in favor of increased competition because competition is good, it makes you better; and also higher transparency and accountability, we’ve got it. We have a system that works on that part.

If the wisdom of Congress wants to put it in writing, so be it. We don't think it is necessary.

Michael Kupinski - A.G. Edwards

I totally agree. Thanks.

Bob Bahash

Just to follow up on that question you asked earlier, at June 30 there was approximately 355 million shares outstanding.

Michael Kupinski - A.G. Edwards

Great, thank you.

Operator

Our next question comes from David Raso - Citigroup.

David Raso - Citigroup

I just had a quick question on interest expense. On your first quarter call, you had stated your expectations were $14 million to $15 million for the year and I had written down for this call that you had upped that to $22 million to $24 million

Was the debt load higher than you expected about three months ago or interest rates higher than you expected, or is there something else going on?

Bob Bahash

It is really a combination of the increasing debt load. We are buying an additional 10 million shares, which we had not factored in at that point in time, but also interest rates moving up. So it is really a combination of events.

David Raso - Citigroup

Thank you very much.

Operator

Our final question comes from Brian Shipman - UBS.

Brian Shipman - UBS

Thanks, good morning. I am wondering if you can just simply size the open territory sales potential in 2006 and what kind of growth rate would you peg on open territory sales in 2007? Thank you.

Terry McGraw

Well, it is a little early, Brian, for that. The open territory is obviously going to be the bigger piece this year, only just because new state adoption dollars are going to be lower on that one. If I had to guess, open territory growth rates of 6%, maybe more on that.

We will be in the thick of it over the next three months and as we go, we will be able to give you better indications of that. Right now it is looking very good, but we have got to materialize that.

Brian Shipman - UBS

So you are thinking 6% this year, is what you're saying?

Terry McGraw

Yes, and maybe more. We will have a better guide as we get into the next three months.

Brian Shipman - UBS

Can you put a number on the size of the open territory market this year, a rough number? $2.1 billion, $2.2 billion?

Terry McGraw

Good enough. Again, I would not want to put a hard number on that one because I would be just guessing; but you're not unreasonable.

Brian Shipman - UBS

Thank you very much.

Operator

That concludes this morning's call. On behalf of The McGraw-Hill Companies, we thank you for participating and wish you a good day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!