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McGraw Hill Financial (NYSE:MHFI)

Q3 2013 Earnings Call

October 22, 2013 8:30 am ET

Executives

Robert S. Merritt - Vice President of Investor Relations

Harold Whittlesey McGraw - Chairman, Chief Executive Officer, President and Chairman of Executive Committee

Douglas L. Peterson - President

John F. Callahan - Chief Financial Officer and Executive Vice President

Kenneth M. Vittor - Executive Vice President and General Counsel

Analysts

Alex Kramm - UBS Investment Bank, Research Division

Andre Benjamin - Goldman Sachs Group Inc., Research Division

Douglas M. Arthur - Evercore Partners Inc., Research Division

Peter P. Appert - Piper Jaffray Companies, Research Division

Craig Huber

Timothy McHugh - William Blair & Company L.L.C., Research Division

Patrick J. O'Shaughnessy - Raymond James & Associates, Inc., Research Division

David Reynolds - Jefferies LLC, Research Division

Operator

Good morning, and welcome to McGraw Hill Financial's conference call. I'd like to inform you that this call is being recorded for broadcast. [Operator Instructions] To access the webcast and slides, go to www.mhfi.com. That's M-H-F-I for McGraw Hill Financial, Inc.com and click on the link for the third quarter earnings webcast. [Operator Instructions] I would now like to introduce Mr. Chip Merritt, Vice President of Investor Relations for McGraw Hill Financial. Sir, you may begin.

Robert S. Merritt

Good morning. Thank you for joining us for McGraw Hill Financial's Third Quarter 2013 Earnings Call. Presenting on this morning's call are Harold McGraw III, Chairman, President and CEO; Doug Peterson, President and CEO Designate; and Jack Callahan, Chief Financial Officer. Also joining us is Ken Vittor, our General Counsel.

This morning, we issued a news release with our results. I trust you 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.mhfi.com. In today's earnings release and during the conference call, we are providing adjusted financial information. This information is provided to enable investors to make meaningful comparisons of the corporation's operating performance between periods and to view the corporation's business from the same perspective as management's. The earnings release contains exhibits that reconcile the difference between the non-GAAP measures and the comparable financial measures calculated in accordance with U.S. GAAP.

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 and 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 Forms 10-Ks, 10-Qs and other periodic reports filed with the U.S. Securities and Exchange Commission.

I would also like to call your attention to a new European regulation. Any investor who has or expects to obtain ownership of 5% of McGraw Hill Financial should give me a call to better understand the impact of this legislation on the investor and potentially the company. We're aware that we do have some media representatives with us on the call. However, this call is intended for investors. And we would ask that questions from the media be directed to Jason Feuchtwanger in our New York office at (212) 512-3151 subsequent to this call.

At this time, I would like to turn the call over to Harold McGraw III. Terry?

Harold Whittlesey McGraw

Okay. Thanks, Chip, and good morning, everyone. And let me quickly begin this morning by saying just how pleased we all are with the effort and the care that Chip Merritt demonstrates each and every day. And for those of you who have followed us for quite some time, you'll remember the great Don Rubin. Well, Chip is in that category now, and that's pretty high praise. So thanks for all that you're doing, Chip. And again, thanks for all of you for being with us this morning, and welcome to today's conference call.

I'd like to begin this call by summarizing the highlights that we will cover today. First and very importantly, after a very successful transition, Doug Peterson will become our President and CEO on November 1. We increased our investment also in CRISIL, India's largest rating agency. And that's up to 67.8%, a fine use of some of our x U.S. cash. Also the sale of Aviation Week was completed. We delivered several records during the third quarter, both S&P Capital IQ and S&P Dow Jones Indices delivered record quarterly revenue. And Commodities & Commercial Markets reported a record adjusted operating margin.

Despite difficult comparisons and lower issuance than the third quarter last year, Standard & Poor's Rating Services grew its revenue 8% and its adjusted operating profit at 5%. The company repurchased 5.7 million shares during the quarter, bringing the year-to-date total to 15 million shares. We reported 13% diluted adjusted EPS growth despite challenging year-over-year debt issuance comparisons. And lastly, as part of Jack Callahan's financial discussion, we will share our newly increased 2013 EPS guidance, guidance that has now been increased 2 quarters in a row.

We recently launched a brand awareness advertising campaign. And the purpose is to generate greater awareness among customers, the financial community, regulators and the media about the McGraw Hill Financial brand. The primary message is that we have combined the leading brands and ratings, benchmarks and analytics to become the world's foremost provider of financial intelligence. This is an example of one of the posters. COMBINED WE ARE is the theme that permeates this campaign.

Okay. Let's turn now to the financial performance during the third quarter. Revenue increased 7%, adjusted operating margin increased 130 basis points to 33.2% and diluted earnings per share grew 13%. Standard & Poor's Dow Jones Indices delivered the strongest revenue growth. But both Commodities & Commercial Markets and S&P Dow Jones Indices delivered the greatest adjusted operating profit growth of 24% and 23%, respectively. A reduction in shares outstanding from our continuing share repurchases has also contributed to the EPS increase. And these 2 pie charts should help put into perspective the revenue and operating earnings contribution of each of our business segments. Each of our segments is a major contributor to both revenue and operating profit.

We'd like to keep you current on various litigation matters, but there is not a great deal new to report at this time. 33 cases have been dismissed outright, and that's no change from last quarter. 2 additional dismissals by lower courts have been affirmed by higher courts, bringing the total to 13 dismissals. And 10 cases have been voluntarily withdrawn. That leaves us with just a few dozen nongovernmental cases that remain outstanding. Efforts by the plaintiff in the Reese stock drop litigation to reopen this dismissed case have been denied. And by the way, in the court's decision, it's stated and I'll quote this, "At bottom, the fact remains that plaintiffs have not convinced the court that it should alter its conclusion that Standard & Poor's statements about the integrity and independence of its ratings are not specific enough to amount to a guarantee that its ratings were made without regard to profits, market share or client feedback." In the Department of Justice case, we are awaiting the supplemental disclosure from the plaintiff relating to the claims. In the consolidated states case, we're awaiting on a ruling on the state's motion to remand the case back to the state. And only one new case, the New Jersey state case, has been filed since the second quarter earnings call.

With that, let me turn to the individual businesses, and I'll start with the S&P Dow Jones Indices. Beginning this quarter, all data is now comparable as we have lapped the anniversary of the joint venture formation. In the third quarter, revenue increased 14% to a quarterly record of $124 million. The principal driver of the revenue growth was a 29% increase in quarter-ending assets under management in exchange-traded funds linked to our indices, which reached more than $585 billion. The continued rise in equity prices of approximately 14% and strong fund inflows of approximately 13% drove third quarter consecutive -- third consecutive quarterly record for assets under management, again in exchange-traded funds linked to the S&P Dow Jones Indices. It's important to note that the revenue impact is not as pronounced as the growth in assets under management as the basis points charged are not always linear with asset growth.

With equity prices near record levels, investors increasingly utilized derivatives that are based upon our indices, such as the S&P 500 Index Options, or the SPX, and the CBOE Volatility Index, or the VIX, to hedge their positions. Volume at the Chicago Board Options Exchange for the SPX and VIX increased 18% and 26% respectively during the quarter. While the joint venture realized $80 million of adjusted operating profit, $58 million is retained by the company as 20% of the profit is forwarded to our partner, the CME. What is truly remarkable is that the entire incremental revenue of $15 million dropped to operating profit. That is just a testimony to what a fabulous, fabulous business this is. During the third quarter, we created 26 new indices and 10 new exchange-traded funds based on our indices that were launched. These new indices help us continue to diversify and grow this important business.

With that, let me move on to S&P Capital IQ. In the third quarter, this business delivered quarterly revenue with top line growth of 3%. Excluding the lost revenue from ongoing portfolio rationalization of several small products, organic growth was approximately 5%. This was the highest quarterly revenue for the segment. Adjusted operating profit returned to growth with an increase of 10%. Last quarter, we highlighted the 4 key categories that make up the segment. 3 of these, Desktop Solutions, Enterprise Solutions and Ratings IP delivered a mid-single-digit revenue growth, while the fourth, Proprietary Research, reported a mid-single-digit decline in revenue.

While we have made meaningful investments in S&P Capital IQ over the last year, we have also continued to fine-tune the portfolio. Most recently, we completed the sale of Financial Communications and are exploring options for Funds Management Research Europe, or FMR Europe, an independent qualitative research service that provides assessments of fund manager investment process and operational consistency. We expect that as the portfolio progresses, this will become a higher-margin, faster-growing business segment.

We'd like to highlight new product launches whenever we can, and Capital IQ had yet another. During the quarter, Enterprise Solutions leveraged QuantHouse technology to create Events Driven Alerts. Now Events Driven Alerts is a new offering that delivers S&P Capital IQ's most valuable indicators in a low-latency, machine-readable data form. These alerts contain credit rating actions, including upgrades, downgrades, CreditWatch announcements and credit outlook changes. While this is not likely to be a major revenue generator, we cite this today as an example of how S&P Capital IQ worked with Standard & Poor's Ratings Services to leverage new technology to create this offering. And we will see even more of this kind of collaboration and coordination across business units in the same time periods ahead. We're very proud of this. We call it the power of one, working together smart and focused.

With that, let me turn to the Commodities & Commercial Markets segment. Revenue grew 7% in the third quarter. Excluding the impact of the sale of Aviation Week, which closed on August 1, organic revenue increased 10%. Platts delivered double-digit revenue growth, while mid-single-digit growth at J.D. Power offset softness at McGraw Hill Construction. Adjusted operating profit increased 24%, resulting in record adjusted operating margin of 32.3%. Similar to our index business, the conversion of revenue to operating margin was remarkable here. $16 million of incremental revenue resulted in $15 million of incremental operating profit.

In Commodities, Platts recorded a 17% increase in revenue. Growth in petroleum product subscriptions continued to be the primary driver of this double-digit growth. In addition, licensing revenue from petroleum derivative trading increased more than 90% as volatile oil prices increased trading activity. Metals and agricultural product subscriptions delivered double-digit revenue growth, while petrochemicals and power and gas revenue reported single-digit revenue increases.

Building on our recent acquisition of Kingsman, Platts launched Platts Market Data-Sugar, a user-friendly means of receiving the latest historical sugar price assessments from Platts/Kingsman. It provides prices for all of the major sugar markets worldwide with over 30 Kingsman price assessments and over 30 third-party assessments published daily for most commonly traded grades and locations.

While sugar has been the latest commodity that we have been developing, in June of 2011, we moved more deeply into the iron ore market with the acquisition of Steel Business Briefing. Historically, iron ore prices were established during the annual negotiation among the world's largest iron ore miners and steel producers. By 2008, large gaps have emerged between spot markets and the annual contracts. This volatility created the need for benchmarks from an independent pricing agency. Much of the world's iron ore is now based upon Platts benchmark pricing, and we're very proud of that. The need for benchmark pricing has evolved from physical prices to derivative prices as market participants have a need to hedge their positions. Now this chart depicts monthly iron ore derivative activity. And I might add that more than 99% of the activity settles against The Steel Index, one of our primary iron ore benchmarks.

There is a great article that describes the changes to the iron ore market that have taken place. And the link to that article is at the bottom of this slide. I hope you have a chance to take a look at it. We think that the evolution of pricing that is taking place in iron ore is instructive for other commodities as well.

Commercial Markets revenue decreased 4% in the third quarter. Excluding the sale of Aviation Week, organic growth was 1%. We anticipate that McGraw Hill Construction's revenue decline may be nearing an end as new data and analytic products, along with an increase in the U.S. commercial construction starts, bode well for the business. Historically, we have not spent much time discussing McGraw Hill Construction business, so I thought today that I'd take a few moments to do exactly that.

Now according to economic research from Standard & Poor's Ratings Services, the U.S. commercial real estate sector continues to slowly recover from its worst slump obviously in decades. Construction starts in the commercial sector are on track to jump 15% this year. And while there is a long way to go to make up for the 58% plunge from 2007 to 2010, when the country was mired in the Great Recession, the recent increase is very encouraging. During the recession, McGraw Hill Construction streamlined its operations, eliminated low-margin legacy print products and publishing assets, gaining operational efficiencies without sacrificing quality. At the same time, the business invested in its Dodge analytics business to be solidly positioned for a market rebound. This investment produced new database-driven analytic products, like Dodge SpecShare, MarketShare and BuildShare that support the business premium market position. Today and most importantly, approximately 75% of the revenue of the business is from data and analytics, very similar to the rest of the company. Simultaneously, the business took the difficult steps to dramatically reduce costs. In fact, its contribution to earnings has improved as decreases in costs have outpaced the rebalancing of the portfolio.

Shifting now to J.D. Power. The auto business in China and the telecommunications business in Canada delivered the strongest revenue growth. Economic growth and growing consumer demand have led to the rapid expansion of the domestic Chinese automotive industry, and consequently, strong demand for J.D. Power's analysis and insight into consumer preferences and behaviors. This chart shows global light vehicle sales from 2006 to projected 2020. The most telling data on this chart is that approximately 1/2 of the growth is expected to come from China. And J.D. Power is well positioned in China to participate in this growth.

Okay. So that concludes a relatively quick review of the business units and their achievements in the quarter, and we're very proud of those. And we mentioned a little bit of the results in terms of the S&P Ratings Services. But let me turn that over now to get a little bit more detail on that from Doug Peterson to handle that. And as I previously mentioned, we are all very pleased and thrilled to be introducing Doug Peterson, not only as President of Standard & Poor's Ratings Services but as our next President and CEO as of November 1.

So with that, Doug, over to you.

Douglas L. Peterson

Thank you, Terry, and good morning, all. We noted on our last earnings call that comparisons for the Standard & Poor's Ratings Services segment would become much more difficult in the second half of 2013. And you can see that in the reported numbers.

Revenue for the segment, however, grew 8%. Adjusted operating profit increased 5%. The corresponding adjusted margin decreased 120 basis points to 42%. While third quarter expenses decreased sequentially, year-over-year, they increased approximately 10%, primarily due to technology-related investment, modest increases in marketing and compliance expenditures. However, headcount remained relatively unchanged year-over-year.

We were able to increase both revenue and profit despite issuance that actually decreased year-over-year. The increase in revenue was not driven by issuance but rather by increased bank loan ratings, entity credit ratings and rating evaluation services. Bank loan ratings were particularly strong, increasing 73%, driven by a tripling in Europe, primarily as a result of the refinancing of existing bridge loans, maturing debt and recapitalizations. In the near term, we expect the levels of issuance to be impacted by the continuing market reaction to the U.S. debt ceiling, Federal Reserve tapering and interest rate levels overall.

You'll see that non-transaction revenue grew 9%, driven by increased entity credit ratings and ratings evaluation services. Despite a decrease in issuance, transaction revenues increased 6% as a result of a 73% increase in bank loan ratings. As you see in the table, international gains exceeded domestic gains. This was driven by 16% growth in our European revenues, driven primarily by corporate activity despite a drop in corporate issuance overall. These charts also show third quarter year-over-year issuance decreases in both United States and Europe of 3% and 18% respectively.

In the U.S., corporate issuance was flat and public issuance was down 19% as municipal issuers shied away from the markets after Detroit's bankruptcy. Structured issuance was strong in the CMBS sector, up 47%, RMBS up 26% and CDOs, predominantly CLOs that were up 88%, albeit all of these were off smaller bases. And these offset the weaknesses in the larger ABS market, which dropped 14% overall.

In Europe, corporate issuance decreased 20%, but high-yield issuance increased 82%. This was due to record low spreads and diversification of funding from banks. Structured issuance decreased 9% due primarily to the ECB's long-term refinancing offering, known as the LTRO, and its impact on covered bonds.

Since this will be Terry's last earnings conference call, we thought it only appropriate to highlight a few of the major accomplishments that have taken place under his leadership. Terry became CEO April 29, 1998. In his first letter to shareholders, he wrote, "Our commitment to our shareholders is to increase shareholder value by serving our markets aggressively and ethically and, like our customers, striving to reach our full potential." Since 1998, the company has delivered a total return of approximately 300% versus only 97% for the S&P 500. The company returned more than $13 billion to shareholders through dividends and share repurchases. And the company continued yearly increases to a dividend that began in 1937 and has been increased every single year since 1973.

But more importantly, under Terry's leadership, he has transformed the company. In 1998, the company was predominantly a collection of publishing assets. Financial Services represented only 31% of the $3.7 billion annual revenue and the operating margin was 18.5%. During the last 15 years, the company has divested the publishing assets to others who can make the most with those businesses. And it has reshaped the Financial Services segment into the leading portfolio of brands we have today, a portfolio with an adjusted operating margin that has more than doubled since 1998 and a portfolio that provides essential intelligence. That's essential intelligence through leading ratings, benchmarks and analytics to its customers.

While Terry is stepping down as President and CEO, he will remain as Chairman of the Board, providing his guidance and insights to me and the rest of the management team. Now I'd like to turn the call back to Terry. And thank you, all.

Harold Whittlesey McGraw

Okay. Thank you, Doug, and thank you for the kind words. The bottom line is very simple that McGraw Hill Financial is a very, very special place with very special people, who are dedicated to making a very, very positive impact in the markets that we serve. And clearly, as Chairman of the Board, I look forward to continuing to work with Doug and the management team and the rest of the board to continue to build this great company.

So with that, let me turn the call now over to Jack Callahan, our Chief Financial Officer, for additional details on the third quarter full year and on our financials. Jack?

John F. Callahan

Thank you, Terry. This morning, I want to briefly close out this call with the discussion of several items on our performance and our outlook for the balance of 2013. First, I want to recap key financial results in the quarter. Second, I will review recent changes to the portfolio and the associated onetime items, largely gains that were incurred during the quarter. Third, I will provide updates on the balance sheet, year-to-date free cash flow and share repurchase activity. And finally, I will comment on the increase to our 2013 earnings per share guidance.

As expected, third quarter comparisons proved more challenging than the first half, but we were able to deliver another solid quarter of growth. Revenue grew 7% to $1.19 billion with organic revenue growing 8%, excluding the sale of Aviation Week, which occurred during the quarter, and the divestiture and selected product closures at S&P Capital IQ. Adjusted segment operating profit grew 11%, driven primarily by the strong results at S&P Dow Jones Indices and Commodities & Commercial Markets. In addition, I would note that S&P Capital IQ returned to profit growth in the quarter. Adjusted unallocated expense increased 10%, primarily due to an increase in excess office space. Overall, the margin expansion was significant as the consolidated adjusted operating profit margin increased 130 basis points to 33.2% despite a modest decline in year-on-year margin performance in S&P Ratings, our largest and most profitable business unit.

The tax rate came in at our guidance level of 35%. This was an increase of 160 basis points from the third quarter of 2012. The third quarter a year ago was low due to the impact of S&P Dow Jones Indices joint venture that was created that quarter. Adjusted net income from continuing operations increased 11%. And the impact of the share repurchase program can be seen in relatively faster growth in adjusted diluted earnings per share at 13% as average diluted shares outstanding declined approximately 2% to 278.8 million shares. The ending basic share count was 270.6 million, down 2.5%. Overall, another strong quarter demonstrating the strength and breadth of our portfolio.

There were a number of changes to our portfolio during the quarter. As Terry mentioned earlier, the company did invest $214 million to increase its ownership of CRISIL from approximately 53% to 68%. CRISIL has earned approximately $185 million in revenues during the last 12 months. It has a leading position in India, a broad product line serving global customers and is an essential partner working closely with the S&P Ratings business. Our previous CRISIL investments have delivered tremendous returns, and we are pleased to be able to increase our ownership even further. S&P Dow Jones Indices and the Bombay Stock Exchange completed the formation of Asia Index Private Limited, a 50-50 joint venture. It is hoped that the new company will raise the profile of SENSEX and other S&P Bombay Stock Exchange indices as S&P Dow Jones Indices looks to further extend its South Asia growth.

During the quarter, the company also divested Aviation Week and Financial Communications. Financial Communications is a small, noncore asset that was within the S&P CapIQ segment. CRISIL also exited its equity investment in India Index Services and Products Ltd. As a result, there were a number of onetime items that need to be adjusted to better evaluate the ongoing performance of the business.

In our adjusted earnings, we are excluding a $16 million gain on the sale of India Index Services, an $11 million gain on the sale of Aviation Week, a $3 million loss on the sale of Financial Communications and we are also excluding $10 million of Growth and Value Plan costs, which have largely wound down. There was also some limited restructuring actions. In total, we excluded a net gain of $11 million.

We continue to maintain an exceptionally strong balance sheet. As of the end of the quarter, we had $1.6 billion of cash and approximately $800 million of long-term debt. Going forward, this strong balance sheet positions us to continue to make investments like CRISIL that are targeted at building the business and, as appropriate, sustaining our share repurchase program.

Our free cash flow during the first 9 months of 2013 was $388 million. As we discussed previously, there were 2 large items that have negatively impacted year-to-date results. First, because of Hurricane Sandy, the IRS allowed fourth quarter estimated tax payments that are normally paid in December to be paid in February. This payment was approximately $130 million and was paid in the first quarter. The second item was a $77 million payment associated with a legal settlement that was also included in our first quarter 2013 results. Including the impact of these items, our free cash flow guidance remains $650 million to $700 million for the full year.

Now let me update you on our share repurchase activity. During the third quarter, approximately 5.7 million shares were repurchased. So far, in 2013, we have spent $850 million and have repurchased 15 million shares at an average price of $56.70. Approximately 1.9 million shares remain under our existing share repurchase authorization, and we anticipate in completing this authorization before the end of the year. Of note, this 50 million share authorization was approved by the Board of Directors in mid-2011.

So summing up, we have delivered excellent year-to-date results with 12% revenue growth and 24% adjusted earnings per share growth. And we continue to fine-tune the product portfolio as evidenced by activity during the quarter. Now looking forward, we know that year-on-year comparisons in the fourth quarter will be challenging, particularly for Standard & Poor's Ratings Services. And as we have seen in the last few weeks, markets remain somewhat volatile. Nevertheless, we are on pace for a strong full year results and are raising our 2013 adjusted diluted earnings per share guidance from a range of $3.15 to $3.25 per share to $3.25 to $3.30 per share, up $0.05 on the high end of the range.

So now with 3 quarters of the year in, we are on pace for a terrific first year for McGraw Hill Financial. And today, we have delivered a great last quarter for Terry McGraw as President and CEO. With that, let me now turn the call back over to Terry.

Harold Whittlesey McGraw

Okay. Thanks, Jack. And again, we are well on our way to delivering excellent 2013 results. And as Jack said, we have raised our EPS guidance for the second time in as many quarters and are harnessing the earnings power of our leading brands by providing essential intelligence to our customers. And we're obviously very proud of this record and a lot more to come.

So thank you, all, for being with us on the call. And now let me turn it back to Chip Merritt, who will provide instructions for the question-and-answer session. Chip?

Robert S. Merritt

Thanks, Terry. Just a couple of instructions to our phone participants. [Operator Instructions] We will now take our first question. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Alex Kramm with UBS.

Alex Kramm - UBS Investment Bank, Research Division

Just starting, I guess, on the Ratings business real quick. I think, Doug, you did a decent job of running through some of the items that impacted the margin, which surprised a little bit with the decline. But can you just maybe go back and just parse out what exactly that was that you would call necessary investments that might have been onetime or what really -- if all of this is ongoing? Basically, the question I'm asking is how does this impact the margin outlook or the operating leverage going forward?

Douglas L. Peterson

Yes, let me start, then I'm going to hand it over to Jack. So we -- see, first of all, as you noticed, compared to sequential, we were able to decrease our expenses sequentially quarter-on-quarter, although you see an increase year-on-year. The year-on-year increase is primarily driven, as I mentioned, by a combination of technology expenses. We are increasing our modernization of our workflow processes, our publishing, as well as compliance and control systems to always modernize and update and have continuous improvement in our businesses. In addition, as I mentioned, we've had some other increase in compliance expenses, which is partially headcount and partially related to those systems. We see on the top line as well a -- what you saw was a decrease significantly in corporate issuance across the globe. But we were able to make up for that and continue to see growth compared to last year at the top line based off of very strong bank loan ratings, ratings evaluation services and other areas that are allowing us to diversify our business processes and continue to maintain relevance in the credit markets. For the fourth quarter, I'm going to ask Jack to provide a little bit more update on what we're seeing there.

John F. Callahan

And I would just add that the third quarter was our lowest revenue quarter of the year. And so I -- some of these expenses have been feathered in during the course of the year. Moving forward into the fourth quarter, it's going to be a tough overlap for the Ratings business in the fourth quarter. We just had a spectacular finish to 2012. But that all being said, on the expense side, we do not anticipate expense growth of this magnitude at all as we go into the fourth quarter as the overlaps also change there. So we're -- we just acknowledge the tough overlap in the quarter on the top line and to remain diligent in managing expense growth as we go into the balance of the year to prepare for next.

Harold Whittlesey McGraw

Okay. Does that do it, Alex?

Alex Kramm - UBS Investment Bank, Research Division

I think that was very helpful. Maybe just, Doug, if I may ask you another question. And I appreciate that you still have a couple of weeks until you really take over as CEO. But obviously, the last time we heard from you was on the last earnings call 3 months ago. And I assume that since then, in preparation to get ready for the new job, you've met with all the business leaders more and more. So as you've done that, any early indications of things that surprised you over the last few months, maybe any sort of items that you see where you can accelerate integration, work on the margin profile for the business? Anything on that end yet?

Douglas L. Peterson

Well, you almost answered the question in the question itself. But let me tell you, first of all, I'm really thrilled by this opportunity and thank Terry and the board for the opportunity to take this on. The biggest surprise I've had is that I continue to be really overwhelmed and amazed by the quality of our brands, the quality of our people, the commitment to markets and our customers. And it's premature for me to give you any specific answers. But I do want to reiterate something that I've said before, which is in Terry's letter to the shareholders in 1998, he reiterated a commitment to the shareholders to increase shareholder value, to serve the markets aggressively and ethically. And I look forward to continuing with that legacy and that approach and, in particular, focusing on our customers and our people.

Alex Kramm - UBS Investment Bank, Research Division

All right. I guess, I'll stay tuned for bigger updates next quarter then. Very briefly, just lastly on Platts, and maybe you've talked about it in the past. But obviously, the growth is just outstanding right now. But one of the things, in particular, on the energy side, we hear more and more large banks exiting, energy trading businesses' funds shutting down. It doesn't seem to be impacting you today. But do you think the addressable market in that area could make an impact? And if so, any sort of box you can put around that?

Harold Whittlesey McGraw

Well, Alex, this is Terry. I wouldn't put a box around anything with Platts on that one. One of the things that we've able to do is really expand upon the whole commodity base. And one of the things that we reported here was some of the continuing initiatives that are going on both in terms of sugar, iron ore and the like. And we will be continuing to adding commodities and broadening out that base in terms of price discovery and price assessment. Again with spot markets cropping up all over the world, again the ability to have prices that can solve the gap between long-term annual contracts and spot market activity is exactly what we're about, and that's what we're benefiting from.

Operator

Our next question comes from Andre Benjamin with Goldman Sachs.

Andre Benjamin - Goldman Sachs Group Inc., Research Division

I just wanted to follow up a little bit more on the ratings agency. I know that early in the year, you actually gave some guidance for what you expected the actual segment to grow that would be embedded in the updated EPS guidance. I was wondering if you had any update to that. I think it was previously high single-digits. Any color on kind of how you think we should be thinking about of this fourth quarter dip versus maybe going into 2014 would be helpful.

Harold Whittlesey McGraw

Well, okay. Andre, first of all, welcome to the team, and I know this is new for you. And we're delighted that you're with us. Let me turn it over to Jack here, and we can go through the guidance for you.

John F. Callahan

Andre, I think that your point is a fair one. We initially did give full year guidance of high single-digit for both revenue and profit growth. On a full year basis, kind of given the very strong results that we've had so far this year, I think we would see revenue growth for the year to be in the low-teens and operating profit growth to be in the mid-teens for right now. I'd like to shy away from quarter-specific guidance, but I think that thinking shows that -- and obviously, we're having a very good year and ahead of what we initially had given guidance on back in the first quarter.

Harold Whittlesey McGraw

Okay, Andre?

Andre Benjamin - Goldman Sachs Group Inc., Research Division

Yes, that's helpful. And then I guess, for my follow-up, on capital allocation priorities going forward, you've clearly highlighted a willingness to return a fair amount of capital to shareholders. Should we expect kind of more of the same in terms of run rate and just assume that you're probably not going to take much of a deviation from that until some of the litigation and other matters unfold? Or I guess, this would be more for Doug, if there's anything that we could see, call the change in that before we get some regulatory clarity.

Harold Whittlesey McGraw

Yes, Andre. Again, this is Terry. I mean, if history is anything prologue, again in terms of all of the 4 commitments for capital allocation, we've been very strong in terms of increasing the dividend every year for quite some time and also in having a very active share repurchase program. We are also going to be, as we have, in terms of talking about investments and acquisitions and the like, both on the transaction and on the organic side, have focused on that as well. But without making any predictions about what tomorrow brings, share repurchase has been a very important part of our capital allocation program. And I expect that to continue.

Operator

Our next question comes from Doug Arthur with Evercore.

Douglas M. Arthur - Evercore Partners Inc., Research Division

Yes. First, Doug, great summary of the Terry McGraw years. Congrats to everyone, great accomplishment. Just on the numbers, and this is really more, I guess, for Jack. You've noted a couple of times in the call the leverage you got outside of the ratings industry in the quarter. I mean, for instance, Capital IQ costs were almost flat year-over-year, and they've been up quite a bit in the first half. So you are investing in new products. So I'm just kind of curious as to what was behind really the terrific cost performance in all the non-Ratings segments in the quarter and how you're kind of weighing that against new product investment. And then secondly, it's been pretty quiet on the EU investigation of the oil market, trading market in Europe. Any updates there and how it pertains to Platts would be appreciated.

John F. Callahan

It's Jack. Why don't I take the margin point? Doug, I think your point that we did get great margin leverage across the balance of the portfolio outside of Ratings, I'll give you just a little color on each. First of all, in terms of S&P Capital IQ, our level of investment in new products really kicked up in the third quarter a year ago. And so that step-up in investments has been lapped to some degree. And so it's a little bit more of a steady-state going forward. We did see going into this year that we hope that we'd return to profit growth by the end of the year. We were pleased to see it in the third quarter. On index, the flow-through was tremendous, as Terry noted in his comments. And I think we're still benefiting there from some of the merger benefits of putting Dow Jones and S&P together, which I think was just wonderful for the margins in that business. And within Commodities & Commercial, it's prudent cost management for J.D. Power and Construction. But we're also getting the very strong growth we're seeing at Platts that comes in at a modestly higher margin that, from an overall mix, really contributes to the tremendous performance that particular business put up in the quarter.

Harold Whittlesey McGraw

Okay. And again, in terms of all of our businesses, clearly, given the relevance that they play, regulatory setups are going to be very important. One of the things that we have done and Doug has supported and beefed up in a big way is the entire risk compliance and regulatory side. Platts is going to get a lot of attention in a lot of different ways, not just Europe. But let me ask Ken Vittor, as General Counsel, to comment specifically on Europe for Platts.

Kenneth M. Vittor

There really has been no significant new developments in the EU investigation. We continue to cooperate with the EU in helping them to understand how that market works and how Platts works within the markets. So there are no significant developments on that front.

Operator

Our next question comes from Peter Appert with Piper Jaffray.

Peter P. Appert - Piper Jaffray Companies, Research Division

And first, Terry, thanks for a great run. You've set the bar high here obviously for Doug. So I assume he's targeting the same outperformance, 3x the...

Harold Whittlesey McGraw

Thank you for that, Peter, but Doug's up to it.

Peter P. Appert - Piper Jaffray Companies, Research Division

Absolutely. We'll expect no less. So in terms of the S&P business, I was hoping, Doug, maybe you could give us just a bit more color in terms of what you're seeing in the fourth quarter. I understand October started slow. But can you just talk a little bit in terms of what you're seeing on backlog of issuance? And in particular, I'm interested in what you're seeing in the Structured Finance market in terms of trends there, which seems to be showing some signs of life and how you're feeling about market share trends, in particular?

Douglas L. Peterson

What we are seeing right now on the overall markets are continued volatility and choppiness. We have seen an increase in issuance recently. And what I mentioned in the fourth quarter, there had been a decrease in some of the other traditional ABS markets. We've recently seen the U.S. banks, in particular, given their access to capital and their need to diversify and interest in diversifying funding sources, returning to the credit card and auto loan securitization markets. CMBS has been particularly strong, although our market share in the CMBS area, we've been focusing on using our criteria, which is very transparent and has a focus on the quality of the assets. So despite some of the surge of the CMBS market, our market share has not been that high, it's in the 30% range, but higher than it has been a year ago. So overall, we're seeing corporate issuance a little bit slower and, as I said, choppy after the government slowdown. Many of the issuers and banks that we've been speaking with are looking carefully at the interest rate environment, which means that on the one hand, you've got people cautious about entering markets, and on the other hand, in particularly high-yield corporate issuance, picking up to continue to take advantage of the very interesting and attractive markets. In Europe, we continue to see the deleveraging of the bank environment overall, which means that the capital markets are strong. Corporate issuance, despite dropping the third quarter, continues to see high-yield issuance and smaller global corporates in Europe are tapping the capital markets. So without giving any specific guidance for the fourth quarter, we do know that we have a tough overlap from last year and we are watching the pipelines very closely. And as we said, the beginning of the month was quite choppy because of the U.S. government shutdown.

Peter P. Appert - Piper Jaffray Companies, Research Division

That's helpful. And thinking ahead, the comp obviously is going to be fairly tough going into '14, given how strong this year has been. I'm wondering if you're thinking preliminarily at least that the signs of life in Structured Finance, some of the good things you're seeing out of Europe, maybe the pricing action you're taking, is that going to be sufficient, do you think, to continue to sustain revenue growth for S&P in the first part of next year?

Douglas L. Peterson

I don't have a full-blown projection for the first half of next year. But I would tell you that we are carefully targeting our investments and our expenses to match what we expect to see in the markets. We have certain expenses we can flex one way or the other, depending on what we see. But as you heard earlier in the call and you can see in our numbers, we have also undertaken a plan to find other sources of revenue, one of those being the bank loan ratings product, which we had identified last year as an area that we wanted to target specifically. We knew that having bank loan ratings would allow banks to have more liquidity for their loans. It also makes those loans easier to put into securitizations and CLOs. And so we're finding ways, whether it's Europe with the deleveraging taking place in the bank loan markets in Europe, as well as our growth in Asia, which doesn't hit the bottom line as much. But we see that as a very critical long-term area for us to continue to grow. So we will be responsive to what we see in the markets with our products and services. We continually try to find other areas that we can grow and leverage our expertise and our knowledge. At the same time, we're also ensuring that we are flexible on expenses. As I mentioned earlier, despite some of the investments in technology and compliance-related expenses, as you know, the CRA3 came into effect, which meant that we had some people that were working very hard to meet all of those compliance areas there. We've been able to provide service to all of our clients to the markets without appreciable increase in headcount. So as I said, we will be watching the markets carefully and we will be very, very cognizant of our expense base and flex, where possible.

Operator

Our next question comes from Craig Huber with Huber Research Partners.

Craig Huber

I guess, a few questions. First, can you talk about your margin outlook long term here for the Ratings business? And I ask this partly in the context, do you think you could over time close the margin gap relative to the ratings [ph] in your Ratings business?

Douglas L. Peterson

Well, I'm going to give you a first part of the answer, and then hand it over also to Jack, who studied this very carefully. First of all, we've been targeting our margins in the mid-40% range as our operating margin. This is the target that we've been consistently looking at. We believe that there's a combination of, on the revenue side, diversification of revenues as we've mentioned with things like bank loan ratings, regional and geographical expansion and ensuring that we are covering all the relevant markets, where capital markets activities are increasing. So we're focused heavily on the top line growth, and in addition to that, on the bottom line. But on the other hand, we're going to continue to operate at a very high level of quality, of assurance with our compliance requirements around the globe. And we want to make sure that we have the best quality of delivery of our services, of our publishing and our data and other types of standards. So we're targeting a level of margins in the mid-40% range. And that's really quite important for us. Let me hand it over to Jack.

John F. Callahan

Yes. I don't have a lot to add, though. I mean, I think, building on your point earlier about the tight management of expense, particularly around headcount, that we have to be very diligent the way we add cost to this business, kind of given the volatility that we have in the top line. And just as note, the revenue for this business, for the Ratings business in the third quarter is the lowest we've seen now in 4 quarters, and so it does -- when you have a little bit of that volatility in the top line, we do tend to have a little bit of compression in margins. And I think that's manageable. And we will pace any investments we make in the technology and/or compliance-related activities as tight as we can, given the near-term outlook that we have on the market.

Harold Whittlesey McGraw

I think that's well said, Jack. Craig, anything else?

Craig Huber

Yes, I do have a follow-up there and a couple other questions, please. But just [indiscernible] Can you just hit on, though, why do you think your margins are lower in your S&P Ratings business than Moody's? And then also, can somebody just give us a further update on the DOJ case, please?

Douglas L. Peterson

Jack and I have looked carefully at Moody's margins. And we think there are couple of reasons. One of them has to do with the inclusion of CRISIL in our Ratings segment. CRISIL has a slightly different business mix. It is a combination of an Indian rating agency. They also provide outsourcing services, or if you want to call it, in-sourcing, where they do an excellent quality of support work and analytical and data input work for the Ratings business. And then they have a third business line, which is global analytical research that they support investment banks and insurance companies around the globe with their analytical processes. CRISIL operates at a lower margin. And that's one of the factors, which, if you look at, is about 120 to 150 basis points differential in the margin between Moody's and S&P. Another key differential is the level of market share and penetration in the Structured Finance business. And as you know, in 2011 and 2012, S&P had withdrawn for a period of time from the CMBS market and was operating at a much lower penetration of the CMBS market. So there was a significant difference in the revenue levels in the CMBS area, which was another 250 to 300 basis points differential in the Moody's margin between theirs and ours. And additionally, there was another level of difference that we believe that we operate in a slightly different business model with some of our regional offices and the infrastructure that we think is very important to support our businesses, to be responsive to the regulators and local constituencies. We don't know what the difference is of the margin there, but it's critical for us to have a strong global franchise and we invest in that because it gives us presence in the market and allows us to support our activities. So that's really something that we see as 3 of the key different components in our margin differential. And I'll hand it over to Ken to give us an update on the DOJ.

Harold Whittlesey McGraw

Yes. And Craig, Terry. Just on those 3 points that Doug mentioned, that first one is very, very important. As you know, this is a very global business, and we're all over the world. But the Indian market is going to be a spectacular market for us. And we started early on with the development of our relationship with CRISIL. And we couldn't be more pleased the way how this has turned out. And now that we're up to 68%, and we'll continue to focus on this, so we're very excited about what that business is going to mean to us on that one. Ken, do you want to make a quick comment on DOJ?

Kenneth M. Vittor

Sure. We are in an initial discovery period in the DOJ case during which the government is required to identify with specificity those securities that they will be litigating on in the case and which S&P will be required to defend. So we will know -- and the deadline for that specification by the government is November 18. We will know on that date precisely what securities are at issue in the case, precisely what ratings are being challenged by the DOJ so that we can then go ahead and aggressively defend each of those ratings. At the same time, S&P is engaged in a very broad discovery effort on the government to discover those documents and those witnesses that bear on a variety of our defenses. So for example, we are asking the government to provide us with all documents supporting all of the government official statements about the housing market during the relevant period because those statements were exactly the same as S&P's statements about the housing market. So we are interested in learning from the government's files what were the documents and supporting information that led to Bernanke and Paulson and Geithner and others speaking about the economy in the same way that S&P spoke about the economy. So those document requests are out there. The next status conference will be held on the schedule on December 16 by Judge Carter in California. And at that point, the next phase of the case will be scheduled.

Operator

Our next question comes from Tim McHugh from William Blair.

Timothy McHugh - William Blair & Company L.L.C., Research Division

I just wanted to ask about Capital IQ. I think last quarter, you had talked about some optimism that growth might start to pick up late this year and into next year based on some of the new products, and hopefully, a better environment, I guess. I just wanted to get an updated sentiment on that and the response to some of the new products.

Harold Whittlesey McGraw

Yes. Well, Tim, first of all, again it's a work in progress. And as we broke out the 4 categories that make up S&P Capital IQ last time, we have shown strength in all 3 of those areas. The fourth area in terms of proprietary solutions, we have been making some acquisition and development efforts there. And this had to do with the QuantHouse technology. And so we would expect going forward that, again, this is going to be a higher-margin, higher-growth business. And we wish to continue to do that. And by the way, Tim, for you as well, welcome on board. It's nice to have your representation with us.

John F. Callahan

And Tim, let me just add. It's Jack. Look, it's a tough competitive marketplace for those products. We recognize that. But I think the overall growth rate is being impacted because we have closed down a couple of smaller businesses. We exited Financial Communications. So that will be a drag of 1 point or so of the growth kind of going forward under it. But underneath that, the core CapIQ business, some of the Ratings IP businesses are, as we mentioned earlier, have been growing more in sort of mid -- a little bit stronger. And we remain a little bit more optimistic as we get deeper in leveraging the innovation that's just now coming into the marketplace.

Timothy McHugh - William Blair & Company L.L.C., Research Division

Does the end market or the health of the demand feel any better? There's some view that the improving stock market and so forth should drive a healthier customer base for that. But I guess, we don't see it yet in the numbers. Are there any signs of it as you hear commentary?

John F. Callahan

Maybe a little bit. Maybe some segments doing better than others. So investment banking, maybe a bit more challenged than investment management, maybe a little bit stronger. So it's not -- maybe plateau-ing the play will be maybe the best way to say it for right now.

Timothy McHugh - William Blair & Company L.L.C., Research Division

Okay. And then just one -- the other question, McGraw Hill Construction. You talked about you're starting to see some data points that give you a little bit more optimism. But I guess, are you seeing signs of that in the business activity itself? Or is it more external, just kind of the overall trends in commercial construction volumes that you're pointing to there?

Harold Whittlesey McGraw

No. It's both, Tim. One, as we see more recovery in the real estate sector, we'll benefit from that. But also as we discussed, there's been some changes to the portfolio as well. And we look for this business to be very much like many of our businesses, largely focused on data analytics and benchmarks. So no, no, no, we see improvement both in terms of the market and we see improvements also in terms of the construction of the portfolio.

John F. Callahan

Yes. Just by its building book of business, we do anticipate from a revenue point of view this year to be the sort of the low mark. And we anticipate beginning to return to revenue growth as we enter into next year.

Operator

Our next question comes from Patrick O'Shaughnessy from Raymond James.

Patrick J. O'Shaughnessy - Raymond James & Associates, Inc., Research Division

Just a couple of quick questions. First, on the share count. So you guys bought back 5.7 million shares during the quarter, but your share count was actually up a little bit sequentially. What was going on there? Was it a timing issue? Or was there a lot of share issuance? Can you kind of give a little bit of color there?

John F. Callahan

I think it's a question of 2 things. One, there was -- there continues to be a fair amount of option exercise. It's not quite as heavy as last year, but there has been some of that. Also, too, just from the calculation of the fully diluted share count with the increase in the stock price, there's a little bit of an impact. We'll have to -- those are [indiscernible]. And also there was a vesting of an earlier performance share grant that I think also had an impact on a sequential basis.

Patrick J. O'Shaughnessy - Raymond James & Associates, Inc., Research Division

All right, that's helpful. And then my second question. So there were a couple of high-profile articles during the quarter kind of accusing you guys of ratings shopping. Can you just talk a little bit about your protocols and procedures to make sure that ratings shopping doesn't take place and maybe just provide a response to those articles?

Robert S. Merritt

This is Chip. Just one clarification, both basic and diluted were down sequentially from the second quarter.

Douglas L. Peterson

So let me mention that what's really critical here is that our analysis and our ratings are based off of very hard-working independent team of analysts and credit experts that we call our criteria or basically it's our methodology that we define and work on for different products. And since the financial crisis, we have undertaken a thorough review of every single set of criteria that we have across the entire organization to incorporate the lessons learned from the financial crisis. We've updated our models. We've reviewed our models. These are done by a team of experts, as I said, that are independent from the ratings process itself. The first set of criteria that were changed in the organization related to those that had the largest and highest impact from the financial crisis, and that meant RMBS and CMBS. That was followed by other types of structured products, and then banks and insurance companies. And recently, we have undertaken a review as well of public finance and are now just launching a review of corporates, which is at the back end of all of this. So our criteria team puts out into the market for review and review and comments our criteria. We then take it back. We apply it to the markets. And what we then have is a set of products and services that we go to the market on with our ratings. Now in particular, there were a couple of critical articles on CMBS and RMBS. Our CMBS and RMBS, both of our criteria, they focus on the quality of the assets and the transaction and the long-term cash flows that are generated by those assets. And as you've seen deals that were at a higher-quality end of the spectrum, we have been more likely to be included on those deals. When the pricing or there's more aggressive underwriting or optimistic expectations for financial performance, we have not been rating on those deals. We are working very closely with the markets and have different proposals that we're looking at related to ratings shopping. These look at potentially modifications to the 17g-5. I know I'm getting a little bit too technical there, but ways to modify transparency and more information being provided to the markets. But basically, let me go back to where I began. We have a very high quality set of people that focus on the quality of our criteria. It's developed independently, and then it's applied by our analysts also independently. And we see what we get in the quality of the assets and we call it as we see it.

Robert S. Merritt

Patrick, this is Chip. I shouldn't have chimed in. I was wrong. Basic was down, diluted was up. Apologize for that.

Operator

Our next question comes from Bill Berg [ph] from FBR [ph].

Unknown Analyst

First, Terry, congratulations, really nice to see you go out on top. I was wondering if you could just talk about how much of the $1.6 billion of cash is in the U.S. And Doug, just at a high level, how do you think about acquisitions and how the role they'll play in your strategy?

Harold Whittlesey McGraw

Okay. First of all, thanks, Bill [ph]. And you've been with us for a long time and we really appreciate your coverage as well. But thanks on that. Let me go over to cash with Jack, and then we'll go to Doug with acquisitions.

John F. Callahan

Of the $1.6 billion in cash, a little less than $1 billion is offshore right now, just roughly.

Douglas L. Peterson

And on acquisitions, as we've mentioned earlier in this call, we want to have a very well articulated in [ph] a plan for capital, which is defined and worked closely with the board. That would include a combination of investments in organic growth, in investments in acquisitions, dividends and share repurchases. So it's premature for me to give you any guidance on that yet. And sometime next year, Jack and I will be working with Terry and the board on giving you more guidance on what direction we see on those. But I think all 4 of those are critical ways for us to think about our capital. And as I said earlier, we want to continue with programs that do provide adequate returns for our shareholders.

Harold Whittlesey McGraw

Yes. And Bill [ph], as you know, in all 4 quadrants of dividends, share repurchase, organic and transaction, we have been active in varying degrees, dependent upon portfolio considerations and the like on that one. But to date, we've had a very strong dividend and share repurchase program. We look forward to continuing that. But obviously, we also are looking at the areas for other kinds of growth in terms of organic and transaction. But it's obviously always a balance.

Operator

Our final question comes from David Reynolds from Jefferies.

David Reynolds - Jefferies LLC, Research Division

I wonder if I could just explore Capital IQ a little bit more with you, please. Proprietary Research obviously is showing a revenue decline in the quarter. Perhaps you could just give us a little more color on how material that is within the Capital IQ division and perhaps in a more normalized environment, where you would see the revenue profile and the margin dynamic of that business.

John F. Callahan

David, just generally -- and there's even a few different businesses within our research portfolio, but it's roughly 10% of the overall mix. There are some components of it that are showing some nice growth. There are some others more that have been a little bit more challenged. So it is the smallest segment, but it has been a big a bit of a drag. And we recognize that. And we are looking at a variety of ways in trying to think about how to shore that up as we move forward as we get ready for next year.

Harold Whittlesey McGraw

Yes. And the whole game plan on this, David, has been that we're going to continue to work the portfolio in all 4 quadrants that we put out there in terms of sectors. And we're looking at this being a much faster-growing business and a higher-margin. [indiscernible] investments through the QuantHouse technology on the proprietary solutions. And we expect that to be behind us. And next year ought to be continued improvement on that.

Operator

That concludes this morning's call. A PDF version of the presenters' slides is available now for downloading from www.mhfi.com. A replay of this call, including the Q&A session, will be available in about 2 hours. The replay will be maintained on McGraw Hill Financial's website for 12 months from today and for 1 month from today by telephone. On behalf of McGraw Hill Financial, we thank you for participating and wish you good day.

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