Donald Rubin - Senior Vice President Investor Relations
Harold McGraw III - Chairman, President and CEO
Robert Bahash - Executive Vice President and Chief Financial Officer
Peter Appert – Piper Jaffray
Craig Huber – Private Investor
Michael Meltz – JP Morgan
The McGraw-Hill Companies, Inc. (MHP) Q3 2009 Earnings Call October 26, 2009 8:30 AM ET
(Operator Instructions) Welcome to McGraw-Hill Companies Third Quarter 2009 Earnings Call. I would now like to introduce Donald Rubin, Senior Vice President of Investor Relations for the McGraw-Hill Companies.
Good morning to our worldwide audience that has joined us this morning for the McGraw-Hill Companies Third Quarter Earnings Call. I’m Donald Rubin, Senior Vice President of Investor Relations at the McGraw-Hill Companies. With me this morning are Harold McGraw III, Chairman, President and CEO, and Robert Bahash, Executive Vice President and Chief Financial Officer.
This morning we issued a news release with our third quarter results. We trust you’ve 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 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 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 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 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. It is now my pleasure to introduce the Chairman, President and CEO of the McGraw-Hill Companies, Terry McGraw.
Welcome to our review of the third quarter earnings and the outlook for the remainder of the year. As Don mentioned, with me today is Bob Bahash our Executive Vice President and Chief Financial Officer. We’ll start today by reviewing the operating results and then Bob will provide an in depth look at some of our key financials. After our presentations obviously we’ll be pleased to answer any questions or take any comments that you may have about the McGraw-Hill Company. With that let’s get started.
Earlier today we reported third quarter results. Earnings per diluted share were $1.07, revenue in the third quarter decreased by 8.4%. We also raised earnings guidance for the year, we now expect to achieve the top end of our $2.20 to $2.25 earnings per share guidance. At the end of the second quarter we had anticipated coming in at the lower end of that range. The new earnings per share guidance excludes second quarter restructuring charge of $0.03, a $0.03 loss on the divestiture of Vista Research in May and a projected $0.02 gain on the sale of BusinessWeek which will close in the fourth quarter.
As I’ve said before, in this environment management is reviewing, obviously, everything within the portfolio and that obviously included evaluating strategic options for BusinessWeek. BusinessWeek in its 80 years with McGraw-Hill Companies has made significant contributions to this company. We must focus on resources on areas with the greatest opportunities for growth and that means building size and scale globally in essential markets and expanding our digital capabilities. In reaching an agreement with Bloomberg we believe that BusinessWeek will continue to operate within an organization that shares the same high standards for editorial independence, integrity and excellence that are the hallmarks of this publication.
In looking ahead, we’re encouraged by recent reports that suggest an improving economic picture. Although the recovery is still expected to be sluggish our economists forecast GDP growth of 1.8% next year after a decline of 2.7% in 2009 and that shows GDP growth in the third and the fourth quarter. Stimulus spending is helping the economy but it appears that the funds are being spent more slowly then expected. That certainly seems to be the case this year in education but we are also seeing some positive indications that Federal Reserve and Treasury programs are contributing to improvement in the credit markets.
Let’s start our review of operations and let’s begin with an outlook for the Financial Services segment. Our expectations for a pick up in the second half of this year at Financial Services started to take shape in the third quarter; improving market conditions, tighter spreads, and a surge in global debt issuance are evident in our results. For the first time in two years year over year quarterly revenue increased at Standard & Poor’s credit market services. The modest increase, 0.7%, reflects a 6.5% gain in transaction revenue despite continuing softness in the structured finance market.
Revenue at S&P Investment Services, which account for about one third of the segments top line declined by 7.6%. For the Financial Services segment in the third quarter revenue declined by 2.2%, operating profit decreased by 10.1% and the operating margin was 40.2%.
The results, again underscore the position S&P Credit Market Services established in global markets. With total new issuance in the third quarter growing faster in Europe which was up 39.2% than in the United States which was up 31.4%, international revenue increased 3.3% in the third quarter or $6.7 million despite a $7.7 million hit by foreign exchange. Foreign source revenue accounted for 49.1% of S&P Credit Market Services revenue in the third quarter.
Growth in the United States and European corporate industrial debt issuance was a key factor in these results. In the United States new issued dollar bond of industrials increased by 98.9% in the third quarter, in Europe the growth was 120.1% for this same period. S&P Credit Market Services also benefited from a 491.3% increase in high yield issuance and obviously off a low base in the United States in the third quarter. Speculative grade issuance was up 226.2% in Europe.
In debt markets the spread or the excess interest rate over treasury bonds is a key gating factor for issuance. As this table shows spreads for investment and speculative grade bonds have narrowed significantly since the beginning of the year. The composite spread for investment grade at the beginning of this year was 531 basis points, by last week it was 226 basis points. The composite spread for speculative grade bonds was 1,628 basis points last January and by last week it was 693 basis points. Spreads for investment and high yield issues are still above their five year moving average and may remain elevated for some time as investors and the credit market tread cautiously through the current economic environment.
Signs of progress are unmistakable. Improving credit market conditions enabled many companies to raise cash to fund operations or to refinance current or future maturing debt. The third quarter global volume for high yield bonds was the highest and more than a decade. Speculative grade companies with lower credit ratings were able to raise billions of dollars as risk premiums fell dramatically from the record levels in late 2008.
An aversion to equity and structured finance risk has increased investor appetite for investment grade industrial bonds. Combined with industrial company’s effort to avoid refinancing risk over the next 18 months and the lack of new money from the bank market, new issuance has taken off. Investors have also become more comfortable buying lower rated investment grade bonds, 54% of corporate issuance in this category has been low BBB, that’s up from 28% earlier in the year.
Financial institutions are continuing to de-leverage balance sheets and shrink liabilities. As expected, those balance sheet constraints have reduced growth in the corporate lending by the banks but banks are becoming more comfortable in obtaining funds from each other. They key gauge of how banks assess the riskiness of lending to one another is the spread between Libor and the Feds overnight rate. Recently the spread between the three month Libor and the Feds overnight rate fell to 0.34% which is near a pre-2007 level.
Federal actions have clearly helped the financial sector. As the slide shows, the Federal programs are wide ranging. In the midst of the decline this year in the structured finance market the asset backed securities market benefited from the TALF (Term Asset Backed Securities Loan Facility). The program stimulated issuance in a wide array of ABS asset classes including credit cards, auto loans, auto leases, and student loans. As volume picked up and spreads began to normalize, traditional real money investors have returned to the market and the use of TALF leverage has decline sharply.
The Fed continues to operate two short term funding facilities to help stabilize the commercial paper market and the money markets which invest heavily in asset backed commercial paper. The Fed has extended these programs to February of 2010. The US Treasury is preparing to implement the PPIP (Public Private Investment Partnership) which is designed to increase demand for existing legacy residential mortgage backed securities as well as commercial mortgage backed securities.
In the third quarter the European Central Bank began to purchase Euro denominated covered bonds to stimulate the residential mortgage backed securities market there. In short, there are positive signs for S&P Credit Market Services as we head into the fourth quarter. Clearly comparisons will be the easiest of the year. In the fourth quarter 2008 revenue fell 24.5%, the steepest decline of the year.
In the corporate market, a combination of tight spreads, a healthy refinancing calendar, low rates, and investor demand for yield should be positive for new issuance. In the municipal market the third quarter is historically slow but state and local governments should be active in the fourth quarter as the economic slow down increases the need for deficit borrowing.
Federal stimulus plans including the Build American Bonds which initially got off to a very slow start, should be a positive in this market for the fourth quarter. In the asset backed securities market we have seen the benefits of the TALF program. Spreads remain tight and the deal flow looks positive. In the US mortgage backed securities market activity will remain light, particularly for the commercial mortgage backed securities. In the US, residential mortgage backed securities market re-securitization of existing securities enhanced with additional credit support, the Re-Remics are the main source of rating activity here.
While the structured finance market continues to be challenged the momentum in corporate issuance is expected to help produce a double digit increase in transaction revenue at S&P Credit Market Services in the fourth quarter.
Given the slow start to the year we expect transaction revenue for the full year to show a low single digit decline. Non-transaction revenue at S&P Credit Market Services slipped by 1.6% or $4.9 million in the third quarter. A reduction in breakage fees and the impact of foreign exchange were the primary reasons for the decline. This remains a durable revenue stream and should finish the year with only a slight decline. Again, the primary reasons for the decline will be the reduction in breakage fees and foreign exchange.
Revenue declined at S&P Investment Services by 7.6% in the third quarter and that reflects the divestitures of Vista Research and CRISIL’s in India, CRISIL’s Gas Strategy Group. The expiration of the independent research settlement with the banks at the end of July and some softness in index products and services. If you exclude those divestitures the decline would be 4.4%. A mitigating factor is the continued growth of Capital IQ products and services despite bank consolidations, downsizes, and closures on Wall Street. Capital IQ has increased its customer base this year by 7.5% to more than 2,800 customers.
A reduction in trading volume of over the counter and exchanged traded derivatives based on S&P indices is a major reason for the softness in index products and services. We are encouraged by the rebound in assets under management in exchange traded funds based on S&P indices. As this chart illustrates, assets under management have increased sequentially since the first quarter and are now more then $17 billion higher then the year end 2008 closing figure.
We continue to be active in this market. Five new exchange traded funds using S&P indices were launched in the third quarter. There are now 214 exchange traded funds using S&P indices, that’s up from 189 at the end of the third quarter in 2008 and many, many more are in the pipeline.
Following the expiration of contracts for independent equity research at the end of July S&P signed contracts with Citibank and Morgan Stanley for continuation of stock coverage. New post-settlement business will be coming from Merrill Lynch which recently signed a contract to integrate our stock reports into research portals for their advisors and their clients.
No review of the Financial Services is obviously complete these days without comments on the regulatory and on the legal outlook. S&P Credit Market Services is complying with new regulations, new rules, and new laws. In the United States new rules from the Securities and Exchange Commission became effective in April and in August.
In September the SEC approved additional rules requiring more disclosure of rating histories and information underlying structured finance transactions and approved amendments to eliminate references to NRSRO ratings in certain rules and in certain forms. More new rules and proposals were issued in October. S&P will continue to work with the SEC on all of these issues.
In Europe the European Parliament and Council last April approved a regulation rating agency formal approval of the legislation is expected shortly, the effective date to be in compliance is expected by mid-2010. In the next year we also expect additional regulation of rating agency to become effective in Japan and Australia. All these changes could affect the performance of S&P Credit Market Services but we don’t believe they will have a material adverse effect on its financial condition or its operations.
In the fall or early 2010 we expect the US Congress to pass legislation on the rating agencies as part of an omnibus financial reform bill. The drafting process is underway and the situation is still fluid. Again, we’re looking for either this fall or very early into 2010.
We continue to review our concerns with decision makers in Washington and abroad and these include making sure that we’re looking at this in a beginning to end solution so that regulations cover all aspects of capital markets to ensure effective and efficient funding. Also, analytical independence that’s fundamental. Foster competition in the ratings industry by establishing a fair and level playing field and this is most important, internationally consistency because ratings are issued and used globally and contribute to the global flow of capital. Globally consistent regulation has got to be a benchmark.
We think our concerns are being heard but we will continue working with policy makers, legislators and others to help restore investor confidence in ratings. In short, this is still a work in progress.
In previous discussions on legal proceedings we have grouped lawsuits into three general categories. Number one is lawsuits alleging that S&P is an underwriter or seller of securities, which they’re not. Secondly, lawsuits alleging corporate statements on earnings and ratings that were misleading, the so-called stock drop suit. Three, lawsuits based on state law claims. All these lawsuits are at relatively early stages of litigation.
In the category one area, several motions to dismiss are or will so be fully briefed before court. An oral argument was held in mid-August on our motion to dismiss the case Public Employees Retirement System of Mississippi v. Merrill Lynch et al.
In category two, motions to dismiss have been fully briefed in each of four cases. Two of these cases have had fully briefed motions to dismiss pending since May and we’re just waiting for court time to be able to get judgments there.
In category three, we are waiting for decisions on two cases. The Oddo Asset Management v. Barclay’s et al and Grassi v. Moody’s Investor Services et al. In two cases are motions to dismiss have fully been briefed and argued before the court and obviously we’re waiting for judgment there.
The Abu Dhabi case is also in this category and we continue to see somewhat mangled reports in the media on the latest decision by Judge Shinlin. As you may recall, the Judge, on September 2nd dismissed 10 of the 11 claims and permitted only the claim of fraud to proceed into the next phase of this litigation. As I’ve pointed out in previous sessions the court is legally required to accept as true all the facts alleged by the plaintiffs in the fraud charge, that’s a critical but little noted point. Judge Shinlin had discussed some of the 10 other claims without prejudice that allowed the plaintiffs to re-plead them.
They did and on October 15th the judge dismissed those reasserted claims with prejudice which means the plaintiffs lost their opportunity to proceed with them. We think we’re making good progress here. Overall we continue to believe our legal risk is low.
There is so much noise in the system that I want to take a moment to make a fundamental point about some very important developments at Standard & Poor’s Credit Market Services. Next year, S&P celebrates its 150th anniversary. In its long history S&P has achieved worldwide recognition for the value and quality of its credit ratings. To help the market analyze trillions of dollars of debt and millions of securities, S&P created a common basis for analyzing credit risk. It developed a common vocabulary for describing credit risk and it provided a simple one dimensional scale for measuring credit risk.
It is a remarkable achievement that enabled S&P to play an important and productive role in the capital formation process in global financial markets. But, we can’t rest on that achievement in today’s environment. To meet new market needs, to maintain a leadership position and to grow the business. S&P must find new ways to increase the value of its credit ratings for investors. That is one of the greatest lessons of this credit crisis and it is one that S&P has learned well.
As investors seek more tools and analytics to assess risk more effectively S&P is responding. In the last 18 months S&P has taken important steps to improve ratings stability, add value to ratings through more analysis and features, increase comparability of ratings, increase the transparency of its processes, and add more checks and balances to the rating process and continue to educate the market about ratings and the rating scale.
In applying the lessons of the past to improve ratings for the future, S&P starts with criteria, the framework that S&P uses to rate debt. By providing additional detail regarding rating definitions and then reassessing criteria in structured finance we have improved the transparencies of ratings definitions, and criteria.
S&P has been making important qualitative and quantitative revisions to its rating criteria for collateralized debt obligations or CDOs. Also for US residential mortgage backed securities and US commercial mortgage backed securities. Strong analytics underlying our rating definitions and our rating criteria are key to enhancing the comparability of ratings across sectors. Since ratings provide a common vocabulary to describe credit risk, we pursue comparability.
When ratings are more comparable an investor can better assess credit risk across different types of bonds. Our goal is to make our benchmarks more consistent and more comparable across all asset classes, geography, and time. In our view, a rating symbol over time should aim to represent approximately the same general degree of credit worthiness whether it was for a municipal security or a corporate bond.
Credit stability is another important factor in adding value to our ratings. We want to account for the fact that some issuers may be prone to gradual decay in credit quality before the default, while others may be more vulnerable to sudden deterioration. Last year S&P went beyond its primary consideration of default risk to introduce explicit stability measures in its ratings criteria. With the additional stability factors we evaluate two securities with similar default risk but will provide a lower rating if we believe one is more prone to sharp deterioration in periods of economic stress.
S&P also considers other factors in its ratings such as payment priority of an obligation, following default, and potential payment after default.
To increase transparency S&P now regularly provides more information about the assumption and its models, the use of what if scenarios, and stress tests. S&P has published specific economic scenarios for each rating category that illustrate the levels of stress an instrument might withstand without defaulting.
S&P has expanded and enhanced its compliance efforts which are now headed by a chief compliance officer and a team of independent compliance professionals who oversee compliance with regulatory requirement as well as S&P policies including policies related to managing potential conflicts of interest.
A risk assessment oversight committee has been established. It assesses risk that could impact the ratings process and operate independently of the rating business. We also have separated the quality and criteria of functions from the ratings group. S&P’s quality function consists of a group of experienced professionals headed by the chief quality officer. They oversee the quality of S&P processes and the consistent application of S&P criteria.
The independent criteria group headed by S&P chief criteria officer performs a number of key functions including leading S&P efforts to develop timely, relevant, credible, transparent, and analytical criteria and overseeing the periodic reviews of existing criteria in light of potentially shifting credit risk.
Finally, we continue to educate the market participants about ratings, what ratings represent, and how to use them. That undertaking includes a comprehensive report in June on understanding S&P ratings definitions and other publications including a guide to credit rating essentials which explains what credit ratings are and how they are useful to capital markets.
That brings me full circle. After nearly 150 years S&P is still a learning institution determined to find new ways to service capital markets more effectively. Strengthening analytics, increasing transparency, and reinforcing the integrity of the ratings process are important steps that will enable S&P to enhance the value to investors of its global benchmarks for credit risk.
Therefore, let me sum up for financial services for 2009. A slight decline in revenue, an operating margin decline of 175 to 200 basis points versus earlier guidance of a decline of 225 to 275 basis points, and that of course excludes 2008 and 2009 restructuring charge and the loss on Vista Research. The new guidance implies an operating margin of 39.5%.
Now let’s review McGraw-Hill Education. All year education has been a tale of two markets and the trend continued into the seasonally important third quarter. Our third quarter results reflect both the counter cyclical growth in the US College and university market that has been fueled by a surge in enrollment and a declining elementary/high school market that’s grappling with budget pressures and so far has realized only a modest benefit from Federal stimulus funding.
In the third quarter for the McGraw-Hill Education revenue declined 11.6%, operating profit decreased 15.9%, the operating margin was 29.8%. Revenue for the McGraw-Hill School Education Group was off 19.6% and revenue for McGraw-Hill Higher Education, International and Professional declined by only 1.5%.
Reduced potential and postponed spending are key factors in the El/Hi market this year. In challenging circumstances we still expect to win more then 30% of the total available dollars this year in the state new adoption market, a capture rate that will probably match our performance last year. In 2008 the total available dollars in the state new adoption market were an estimated $980 million. In 2009 the opportunity now appears to be only $500 to $510 million which is down from our original forecast for the year of $550 to $600 million.
As the bar chart illustrates, the El/Hi market has declined all year. Only in the month of August did industry sales come close to matching last year’s results. Sales for the industry declined only 0.7% in August versus the same month last year but year to date after eight months the market was down by 21.4% and that’s according to the Association of American Publishers.
We now expect the El/Hi market to decline by 20% to 25% this year down from the 15% to 20% decline originally projected. District level postponements in reaction to state and local budget pressures were clearly evident in such adoption states as California, Florida, Kentucky, Oregon, and Georgia. Postponements are somewhat harder to track then the open territory but it is clear that they also had a negative impact on third quarter purchasing in those states. Sales in the non-adoption states declined by 12.7% through August year to date and again that’s according to AAP statistics.
Postponements severely reduced purchasing in California which originally offered this year’s biggest industry sales potential. School districts there normally have two years in which to buy new state approved programs in core subjects and 2009 was the first year of the K-8 reading adoption and the second year of the K-8 math adoption.
As the first two quarters progressed it became apparent that purchasing levels would fall short of historical levels but the number of deferrals increased sharply in July following the passage of an austerity budget by the state legislature which also gave districts the flexibility to use their allocations from the $334 million state re-structional materials fund for other purposes. The legislature also suspended the requirement that districts buy new K-8 core curriculum programs within two years after their approval by the state.
The result was a statewide first year reading implementation rate of about 10% as compared to the 40% rate we had estimated in January and the 60% to 70% rate that is more typical of California in better economic times. The deterioration in California is the primary reason for the reduction in our estimate for the total available dollars in this year’s state new adoption market. But, heavy postponements also suggest future demand. Let’s look at the situation more closely.
In California the last reading adoption took place in 2002 when our Open Court program was only one of two state approved K-5 programs. It proved to be very effective in improving student performance across a wide variety of districts and many local customers are looking forward as funding allows to implementing the new edition which is called Imagine It. California approved a broader K-5 list for the 2009 adoption and we are also competing there with a state specific edition of Treasures. That was the program that was so successful in Florida last year.
Each of our programs offers a full range of classroom resources including Spanish and ESL ancillaries and sophisticated digital assessment tools. With the new school year underway, greater clarity on the retention of teaching positions and some cushioning from the distribution of Federal stimulus funds, a number of California districts are now considering using their state textbook funding for its intended purpose.
Furthermore, districts eligible for incremental Title 1 stimulus funds can use them for new reading purchases. Here’s a real paradox. Just as uncertainty drove 2009 postponements fear of mid-year deficits that may lead to additional cuts in educational funding could drive purchasing in the first half of 2010. That possibility is the reason why our field personnel are seeing new adoption activity late in the season, particularly in school districts with no child left behind performance issues.
In Florida, we don’t see much opportunity for late ordering in the 6-12 literature market, although we may see some Middle School activity for reading intervention materials. Many educators feel that content of literature texts doesn’t change that much and they can get along with older books supplemented if necessary with paperbacks and library books. The second year outlook for K-12 music is better. This non-core subject can be implemented during the school year and can be phased in a few grades at a time, making it a flexible purchase for districts.
In Kentucky the outlook for 2010 is promising for K-12 math because first year postponements were pushed by the State Department of Education due to funding concerns in the delayed release of new standards. McGraw-Hill School Education still did brisk business in Kentucky in 2009 and should do well again next year.
Oregon is another state with many first year postponements in math. McGraw-Hill School Education captured a solid share of available business in Oregon in 2009, anticipates doing well in 2010 and 2011.
In short, pent up demand is certainly very real in some places but the extent to which it can drive revenue may depend on improving economic conditions. Of course the decision to continue using older programs could also result in increased replacement sales as existing copies become tattered and as enrollments continue to grow. With Texas back on the adoption calendar in 2010 and Florida preparing to buy K-12 math we still expect state new adoption market to top $950 million next year but probably won’t reach the $1 billion mark.
We expect to have a sold lineup of products and services to compete for the state new adoption dollars in 2010. In Texas all grades of our 6-12 literature program were recommended for the states conforming list and reviews of our Imagine It and Treasures K-5 reading programs continue to do well. Florida has not made its state approved list official yet but our math programs are being well received in districts that are already reviewing programs for next year’s adoption.
With states still struggling with budget deficits, 48, the $100 billion for education which comes from the American Recovery and Reinvestment Acts of 2009 will be obviously a very important factor in 2010. Funds have been moving slowly into the pipeline, following the money down to the district level is not easy. Most of the stimulus dollars that reached the market by the third quarter appeared to have come from the IDEA special education distributions. Also Title 1 funds reached the market a little bit more slowly but could stimulate some fourth quarter purchasing with more activity next spring for implementation in the fall of 2010.
The other main program is the $39.5 billion state fiscal stabilization fund which is intended to help states fill deficits created in their education budgets. Some states have already received their grant and all distributions are expected to be made by the end of the year. Much of this funding has been earmarked for staff retention and professional development but some districts have indicated that they would use part of their allocations to buy instruction materials. The greatest impact on the El/Hi market will probably occur in 2010.
There are also several programs still being finalized by the US Department of Education that could offer new opportunities for providers of El/Hi instruction materials or assessments beginning in 2010 but with even greater impact in the out years. These include the Race To The Top fund which will offer $4.3 billion in competitive grants to encourage state level initiatives and the investing in innovation funds which will offer $650 million in competitive grants to local districts and non-profit educational groups.
Finally, and perhaps more significantly for 2010 Congress is working on the fiscal year 2010 budget for the US Department of Education. As proposed by the Administration in May, the budget would provide an increase of $1.3 billion or 2.8% over the current fiscal year, a figure that does not include the American Recovery Reinvestment Act stimulus appropriations. The new budget includes important new programs that represent renewed Federal support for reading, which has been sharply curtained in recent years by Congress, because of perceived problems with the Reading First program.
Federal stimulus dollars have also contributed to the growth in enrollments this fall in US colleges and universities. The effect was more indirect because it has taken the form of higher Pell grant scholarships and a higher tax credit that allows students or their families to deduct up to $2,500 a year for tuition and other college related costs including course materials. There is separate legislation known as the post-9/11 GI bill that helps veterans pay for tuition, housing, and course materials while they are enrolled in college. By the end of September more then 24,000 veterans have been approved for stipends under this new bill.
For many students the support afforded by these programs undoubtedly made a difference between enrolling and not enrolling or between attending full time or part-time. In difficult economic times the higher education market has tended to be counter cyclical as people return to school to gain new skills or remain in school because of limited employment opportunities. The confluence of Federal stimulus funds and the counter cyclical trend have resulted in enrollment numbers that are easily outstripping earlier government estimates, particularly at community colleges and career schools.
Although no official fully aggregated statistics are available it does appear that there could be close to a 10% increase in overall post-secondary enrollments this fall. Surging enrollments clearly help strengthen the market for higher education products which is up 11% through August and that’s according to AAP reports. McGraw-Hill Higher Education experienced growth in the third quarter in all four major imprints.
With our digital products growing at a double digit rate it also evident that the imaginative use technology is expanding our opportunities in higher education. As this diagram illustrates, digital products like McGraw-Hill Connect create new ways to connect with students beyond the traditional textbook.
For years publishers have focused their sales efforts almost exclusively on instructors because they select the text for the course, they still do. Their decisions are still critical to success in higher educational publishing. The new digital products have broadened the college market by offering optional resources for purchase by students. By focusing on the student’s workflow we can provide critical course related content that can help them master the material they need to earn good grades. It’s on online market and we’ve been gaining traction quickly.
In international markets strong demand for higher education products was offset by softness in school and professional sales and unfavorable foreign exchange rates. In domestic professional markets digital subscription products in science, medicine, and technology continue to be a bright spot in a challenging retail environment as booksellers reduce inventory and limit new orders.
With that sum up for McGraw-Hill Education, because of the decline in the elementary/high school market we are reducing our revenue guidance for McGraw-Hill Education we now expect a decline of 10% to 11%. Our earlier forecast had called for an 8.5% to 9.5% decline in this year. With tight cost controls we now expect a margin decline of just 300 to 350 basis points and that’s excluding the 2008-2009 restructuring charge. The previous estimate had called for a 300 to 400 basis point decline.
Now let’s shift to Information and Media. In the third quarter for this segment revenue declined by 10.1%, operating profit increased 29.3% reflecting a pre-tax restructuring charge in the third quarter last year that reduced operating profit by $13.9 million. The operating margin was 12.4%. In a non-election year, revenue at our Broadcasting Group declined by 23.6% in the third quarter. Decreases in advertising, declines in the automotive industry and softness in the construction market were all factors in the 8.7% revenue decline in our business to business group.
Ad pages in BusinessWeek global edition declined 29.3% in the third quarter. The standout performer continues to be Platts and global energy market. Oil prices are approximately half of what they were a year ago. Such volatility in crude oil prices and other commodities continue to create demand for our data and our information services. The strength in data and information products for business markets will be key to our future development.
Let me sum up for the outlook for Information & Media in 2009. Revenue will decline 9% to 10% versus our previous guidance of 8% to 9%. Operating margin will decline 200 to 250 basis points versus our previous guidance of 300 to 400 basis points, again that’s excluding 2008 and 2009 restructuring charges.
That completes the review of the operations for the third quarter and how we’re looking at the completion of the year. Let’s sum up the outlook for the corporation in 2009. We now expect revenue to decline approximately 7% this year because of continued weakness in school education and advertising. We previously had forecast a decline of 5.5% to 6.5%.
With stringent cost controls we now expect to achieve the top end of our $2.20 to $2.25 diluted earnings per share guidance for 2009. Previously we had guided to the low end of that range. The new guidance excludes a second quarter restructuring charge of $0.03 loss on the divestiture of Vista Research and again a projected $0.02 gain on the sale of BusinessWeek in the fourth quarter.
That concludes my remarks. I think that we needed to address a number of subjects and I hope it’s helpful to you. Let’s now hear from Bob Bahash on some of the key financials and then let’s go anywhere you would like to go.
This morning I’d like to review the key factors affecting our third quarter results and our full year guidance and what it implies for the fourth quarter. I’ll focus on the decrease in consolidated costs and expenses which were down 5.4% in the third quarter or 3.8% excluding last year’s restructuring charge. This decrease occurred despite the impact of incentive compensation which increased by $68.3 million in the third quarter. I’ll also focus on the influence of foreign exchange on our results, the pending BusinessWeek divestiture, and the improved outlook for free cash flow in 2009.
Let’s start with a look at our costs and expenses and the impact in each segment’s performance. For McGraw-Hill Education expenses declined 9% in the third quarter excluding the 2008 restructuring charge and were down 8.2% at constant currencies. Higher incentive compensation was more then offset by stringent expense controls, savings from previous restructuring actions, lower sales and marketing costs, and lower cost of goods sold due to the reduction in revenue. For the full year we now expect a high single digit decline in expenses versus our previous guidance of a mid-single digit decline in expenses, excluding the restructuring charges of 2008 and 2009.
For Financial Services, expenses increased 5.1% excluding the restructuring charge of 2008 and were up 7% at constant currencies. Excluding the impact of increased incentive compensation which was most significant in this segment, expenses would have declined slightly due to continued tight cost controls and restructuring savings as well as benefits from the divestitures of Vista Research and CRISIL’s Gas Strategies Group.
For the year, as Terry indicated, we now expect margins for the segment to decline 175 to 200 basis points which implies roughly flat expenses year over year versus our previous guidance of a slight increase, excluding restructuring charges in both years and the loss on the divestiture of Vista in the second quarter of 2009.
Year to date, margins are down 240 basis points but the fourth quarter 2008 had the lowest margins of the year because the fourth quarter revenue was depressed by low debt issuance. That had a pronounced impact on margins given the high fixed cost of this business. With an expected double digit increase in transaction revenue fourth quarter margin should improve although the increase will be mitigated by increased incentive compensation.
For Information & Media, expenses decreased 8.6% excluding the restructuring charges. Restructuring savings and lower cost of goods sold due to the reduction in revenue were key factors, partially offset by increased incentive compensation. Our new margin guidance implies a high single digit decline in expenses versus our previous guidance of a mid-single digit decline, excluding restructuring charges in both years and the gain on the divestiture of BusinessWeek in the fourth quarter.
As we’ve indicated on previous calls Information & Media results have been affected by the non-cash accounting impact of converting studies on to Compass, JD Power’s online reporting and analytical tool. Revenue previously recognized at the time of our syndicated studies release will now be recognized rightably over the 12 month life of the subscription. This is similar to the sweets transition that we mentioned to you back in 2006. For the full year we continue to expect a $12 million decrease in revenue and $7 million decrease in profit due to the impact of Compass. For the third quarter the Compass conversion resulted in a revenue decrease of $5.4 million and $2.6 million decrease in profits. The fourth quarter impact is expected to be minimal.
Corporate expenses in the third quarter were $27.9 million and $18.2 million increase for the same period last year, largely due to higher stock based and short term incentive compensation. We now expect full year corporate expense to increase by $20 to $25 million and excluding the 2008 restructuring charge and that’s down from our previous estimate of a $25 to $30 million increase. This implies fourth quarter expense of $36 to $41 million and growth is largely due to increased incentive compensation.
Clearly changes in incentive compensation were an important factor in our results. Significant reductions in both long term and short term incentive compensation accruals taken in the third quarter of last year made expense comparisons extremely challenging. In total, incentive compensation increased by $68.3 million during the third quarter of this year including a $34.7 million increase in stock based compensation. The impact of this $68.3 million increase in incentive by segment is as follows:
McGraw-Hill Education $13 million
Financial Services $32.1 million
Information & Media $5.7 million
Corporate $17.5 million
On our second quarter earnings call I indicated that incentive compensation would increase by about $90 million in 2009. We now believe that the full year increase will be closer to $75 million due primarily to reductions in stock based compensation accruals as well as reductions in short term accruals at McGraw-Hill Education.
Year to date, incentive compensation increased approximately $40 million comprised of $68 million increase in the third quarter, partially offset by the $29 million decrease in the first half of the year. We expect increased incentive compensation of approximately $35 million in the fourth quarter because the fourth quarter of 2008 also benefited from reduced incentive accruals though to a lesser extent then the third quarter of last year.
Foreign exchange also continues to influence our operating results. The dramatic strengthening of the US dollar in the second half of 2008 reduced year over year growth in revenue by $74.6 million and expenses by $82 million in the first half of the year. This impact will lessened in the third quarter as changes in currency reduced revenue growth by $21.6 million and expense growth by $15.3 million, resulting in an operating profit reduction of $6.3 million. If current foreign exchange rates hold the situation will change in the fourth quarter. Revenue comparisons in the fourth quarter will benefit from foreign exchange but expense comparisons will be negatively impacted.
Now I’d like to update you on the pending divestiture of BusinessWeek. On October 13 we signed an agreement to sell BusinessWeek to Bloomberg. We will receive $5 million in cash and Bloomberg will assume certain liabilities including our unfulfilled subscription liabilities. The transaction is expected to close in the fourth quarter of this year. We will recognize a $9.3 million pre-tax or $5.9 million post-tax gain or approximately $0.02 per diluted share. Given the timing of the transaction we expect minimal financial impact in 2009 from operations.
In 2010 the divestiture will reduce year over year revenue growth by approximately $100 million. We expect to realize savings next year of approximately $20 to $25 million pre-tax or $0.04 to $0.05 per diluted share. This is net of the portion of allocated expenses such as shared services and rent that will no longer be absorbed. Savings could vary depending upon the length of the transition services with Bloomberg as well as the ability to consolidate or sub-lease space.
The divestiture will reduce our dependence on advertising revenue. Following the divestiture of BusinessWeek advertising will represent about 2% of pro-forma total revenue versus approximately 4% previously.
Let’s now review the improved outlook for free cash flow. To calculate free cash flow we start with after tax cash from operations and deduct investments and dividends. What’s left is free cash flow, funds we can use to repurchase stock, make acquisitions or pay down debt. As expected, we made a pension contribution during the third quarter in the amount of $20.5 million. Despite the pension contribution and lower operating results compared to the prior year our year to date free cash flow is ahead of last year by $323 million.
As discussed on our calls earlier this year this increase is driven mainly by the significant reduction in incentive compensation payments, prudent investments, continuing focus on working capital improvements, and cost containment initiatives. We continue to expect the fourth quarter to be negatively impacted by lower anticipated receipts; however, given our strong cash flow performance to date we’re raising our guidance. We now expect free cash flow for the year to be in excess of $500 million, up from our previous guidance of $430 to $450 million.
Clearly the corporation’s financial position remains strong. Net debt decreased by $240.5 million down $491 million versus the second quarter and $556 million versus year end, reflecting the strong free cash flow generation in the third quarter which is generally our strongest cash flow quarter. On a gross basis total debt at the end of the quarter was $1.2 billion and is comprised of long term unsecured senior notes. This is offset by $957 million in cash. There was no commercial paper outstanding at the end of the third quarter.
Interest expense was $18 million in the third quarter, a $4 million decline from the previous year. The decline was largely driven by a reduction in interest accruals related to uncertain income tax positions. For the full year we still expect interest expense to be roughly comparable to the 2008.
The company’s effective tax rate was 36.4% in the third quarter versus 37.1%. We still expect a full year 2009 tax rate to be 36.4%.
Our diluted weighted average shares outstanding were 313.6 million in the third quarter a 3.6 million share decline versus the same period last year roughly flat compared to the second quarter of 2009. The year over year decrease is primarily due to 2008 share repurchases and the decline in our stock price. Fully diluted shares at the end of the quarter were approximately 314 million.
In today’s challenging environment we’re continuing to manage investments prudently without negatively impacting the enterprise. Pre-publication investments were about $45 million in the third quarter which is a decrease of $21 million compared to the third quarter of 2008. For 2009 we still expect pre-publication investment of approximately $200 million. Purchases of property and equipment were $16 million in the third quarter compared to almost $18 million in the same period last year. We expect an up-tick in CapEx in the fourth quarter primarily related to technology spending as well as international expansion and continue to expect approximately $75 to $80 million for the full year.
Now let’s take a look at some non-cash items. Amortization of pre-pub costs in the third quarter was $127 million versus $125 million last year. For the full year we continue to expect pre-pub amortization of $275 to $280 million versus $270 in 2008. Depreciation was $26 million in the third quarter, $4 million lower then last year. We now expect full year depreciation to be approximately $120 million versus our previous forecast of approximately $130 million. Amortization of intangibles was $11 million for the third quarter of 2009 versus about $14 million for the same period last year. For the full year we continue to expect approximately $50 million.
I’ll conclude with a comment on the growth of unearned revenue which ended the third quarter of 2009 at $1.1 billion. That’s roughly flat with the prior year and the second quarter. In constant currency it grew 1.9% versus the prior year. At the end of the third quarter Financial Services represented approximately 73% of the corporation’s total unearned revenue. Financial Services unearned revenue was roughly flat versus prior year. For the full year we still expect unearned revenue to grow slightly, excluding the impact of the divestiture of BusinessWeek. Including the divestiture of BusinessWeek we expect unearned revenue to experience a slight decline for 2009.
In summary, on the last call we promised that we would maintain stringent expense controls and we’ve delivered on that promise. Our cash flow generation and our strong financial position leave us well positioned for growth as we move forward.
Thank you and now back to Terry.
Obviously relative to one of the worst business environments we’ve all endured a year ago and coming forward we’re obviously pleased that the economy is starting to recover and some our markets have started to recover. We’re pleased, obviously, to be improving our guidance for 2009 and obviously the improvement in free cash flow as well.
With that let me turn it back to Don and we’ll go in any direction you’d like.
Just a couple of instructions for phone participants. (Instructions) We’re now ready to take the first question.
(Operator Instructions) Your first question comes from Peter Appert – Piper Jaffray
Peter Appert – Piper Jaffray
The success you’ve enjoyed in terms of controlling costs is very impressive. I’m wondering about the sustainability of these cost reductions you’ve implemented. Is there going to be some catch up in 2010 in terms of deferred expenses?
We have been pretty active, as you know, in trying to control our costs. If you look by segment, especially if you take a look at the Education segment part of the influence this year was lower sales and marketing costs, free with order costs, etc. simply because the adoption cycle is so much lower. As you look at a doubling of the adoption state opportunities next year you’ll see an increase in those costs, also cost of goods sold.
We will be benefiting and we are benefiting this year from previous years restructuring actions and we will also benefit in 2010 from the restructuring action that we took in this year in the second quarter. We will see some up-ticks naturally as business starting improving for us but we’re going to continue to focus awfully hard on our costs and expense.
Peter Appert – Piper Jaffray
Does your cost suggest that margins in the Education business are basically flat next year even in the context of some recovery in revenue?
It’s a little bit early to be predicting the margins but as you know that first in a major adoption you have some higher costs because of sales, marketing, free with order costs, etc. so they do tend to influence your overall margins.
Peter Appert – Piper Jaffray
Can you share with us any granularity on the drivers of revenue performance in the Investment Services business? Specifically what I’m wondering is that the deteriorating revenues you’ve seen this year to the extent that a lot of this is subscription based revenues, does this imply that revenues remain under pressure going into 2010?
In the Investment Services area we’ve experienced some pressure from the index services side simply because of what has happened in the overall marketplace. When you look at price volume from the standpoint of the impact of the overall Dow and such that is clearly influenced these size of assets under management and our fees. On the other side we have seen an increase from a volume standpoint of individuals moving more into index services. That has counter balanced to a certain degree the loss of revenues simply because of the rate impact.
We continue to sustain marginal growth in the environment in some of our data information products, most notably Capital IQ which continues to grow albeit at a much slower pace but in this environment showing growth is pretty darn good. We are influenced also by the loss of revenue from some of the Investment Services contract that came due this year.
I would only add a couple things on the Education side; we’re buoyed by the fact on the El/Hi side higher ed and international is doing fine. On the elementary/high school side we’ve got two really strong funded programs, Florida with K-12 math and Texas with K-12 literature. We also are still waiting to see the full picture in terms of some of the $100 billion associated with the stimulus funds on that.
Even with some of the cutback rate wise on the Investment Services side we added 60 new indices at S&P index services this year. Even with a curtailment of the settlement on the Equity Research side we were very pleased that we were able to get continuing contracts with Citigroup and Morgan Stanley and the new contract with Merrill Lynch. I think going into 2010 we’ve got a pretty good picture starting to form.
Peter Appert – Piper Jaffray
Do you think we’ll get some news or developments in terms of further restructuring in the Info Media segment before year end?
From a transaction standpoint acquisitions or divestitures I wouldn’t comment prematurely. Clearly as I said and as I’ve discussed with you is that everything in the portfolio obviously is being looked at. We want to get to higher levels of growth and earnings so we’re going to be looking at everything.
Your next question comes from Craig Huber – Private Investor
Craig Huber – Private Investor
I think you mentioned $950 million of cash on the balance sheet. I was wondering how much of that is tied up in your overseas operations and what’s your current thought on share repurchases given you bought back a few million dollars of stock back in 2006-2007 given what you stock is here what are your current thoughts on that?
With regard to the $950 million of cash about half of that is in the US the other half is spread between Europe which is the predominant location for most of that balance of cash as well as Asia, Latin America, and some of our subsidiaries that we have less than 100% interest in.
As regard share repurchase, as you know we’ve been very, very strong on a share repurchase program. Obviously given the current environment we suspended that at this point and we look forward to getting back to it. We need to continue to see the stability and the recovery. Given our cash flow projections now and as you said, some of the cash on the balance sheet we will be giving that hard consideration.
Craig Huber – Private Investor
If you could jump over to Education for second, you talked about the adoption market $950 million your thoughts for next year versus $500 to $510 million this year. What is your current thought to the open territories next year? I know its early but percent change potentially for next year, the open territories that are half the market.
In terms of open territories they have not shown growth for a number of years now. Therefore we’ll have to see what the stimulus funds, what effect they will have on that one. It could be very good but it’s guessing at this point. Clearly you have 48 states that are now in deficit and the Federal funds, the stimulus funds are going to have a big impact. I would have to think that there is going to be some growth on that side. We’ll have to see where the stimulus money comes as we get into 2010.
Craig Huber – Private Investor
In S&P ratings as you look at your fourth quarter for business there what have you seen for the trends for the various debt categories that’s looking better in the fourth quarter versus what you saw in the third quarter, what categories?
You’re seeing some very strong growth as we were talking about in terms of the new issuance both in Europe and here in the United States, especially on the corporate and government side. You’re also seeing some on the municipal size. The interesting part is that as spread narrow we’re starting to see some real pickup on the speculative side and the high yield issuance both here and in Europe. I think what you’re going to start to see is the return to some of that kind of investment.
Structured finance is going to soft for a while but we’re seeing as we’re saying how the asset backed side we’re starting to see some rejuvenation there. Residential mortgage backed with the exception of some of the Re-Remics and the commercial mortgage backed market will be soft into 2010. Obviously the credit markets are unthawing and we’re starting to see a much brighter picture.
Craig Huber – Private Investor
Are you feeling better about the syndicated bank loan market?
Better. I want to see continued activity in that market. At this point the pickup that we’re seeing is welcome. We’ve got to see it continue.
Your next question comes from Michael Meltz – JP Morgan
Michael Meltz – JP Morgan
Peter’s question about Investment Services trajectory I think you answered this where you’re saying assets under management tied to S&P indices have ramped and then you talked about getting some new contracts. Is it fair to say you expect Investment Services revenues to grow next year?
Michael Meltz – JP Morgan
On BusinessWeek the financial detail you gave there at the end your estimate of $20 to $25 million of pickup does that have potential to go up if you’re able to sub-lease out facilities? That number just seems low to me.
It would if we’re able to sub-lease our facilities. We’re just looking at a pretty difficult environment in terms of space requirements here so we’re looking at the space that BusinessWeek occupies currently that we would be holding that through the balance of next year. Although there will be a period of time during the transition services that the BusinessWeek people will remain in our building but that’s only for a few months. If we do get an opportunity to sub-lease that space earlier that would be a pickup.
Michael Meltz – JP Morgan
I know you commented on Education margins. On S&P margins going forward to the extent you continue to see a pickup in transaction oriented revenues and Investment Services actually starts growing are there any factors we should think about that could mitigate margin upside going forward?
We’re actually fairly pleased given all of the things that have gone on this year in that front. I can tell you that now as we take a look at some of the additional administrative costs from regulation and some of those we were thinking that it’d had about a two percentage point margin erosion factor. We think it’s now more like 1%. As the regulatory environment starts to abate and we get some clarity here I think that’s all for the good and we can operate in that kind of environment in a more efficient way. We think that the additional costs that we once had projected are not going to be as onerous.
Michael Meltz – JP Morgan
Can you clarify that; is that just back in the envelope you had thought it would be like $40 million number now you’re seeing $20 million?
Yes. Somewhere in that range.
Michael Meltz – JP Morgan
That’s from what? More people for record keeping and compliance type efforts?
That’s why I went through all the different components that we had put in place now and we have a lot more clarity in terms of what those costs are.
That concludes this morning’s call. The presenter slides are available soon for downloading from www.McGraw-Hill.com and a replay of this call will be available in about two hours. On behalf of the McGraw-Hill Companies we thank you for participating and wish you good day.
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