The McGraw-Hill Companies, Inc. (MHP) Q4 2009 Earnings Call January 26, 2010 8:30 AM ET
Donald Rubin - Senior Vice President Investor Relations
Harold McGraw III - Chairman, President and CEO
Robert Bahash - Executive Vice President and Chief Financial Officer
Craig Huber – Access 342
Peter Appert – Piper Jaffray
Michael Meltz – JP Morgan
Edward Atorino – Benchmark
Brian Shipman – Jefferies
(Operator Instructions) Welcome to McGraw-Hill Companies Fourth Quarter and Full Year 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. Thank you for joining us for the McGraw-Hill Companies Fourth Quarter and Full Year 2009 Earnings Call. I’m Donald Rubin, Senior Vice President of Investor Relations at the McGraw-Hill Companies. With me today are Harold McGraw III, Chairman, President and CEO, and Robert Bahash, Executive Vice President and Chief Financial Officer.
This morning we issued a news release with our 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 the presentation we will open the meeting to questions and answers. It’s now my pleasure to introduce the Chairman, President and CEO of the McGraw-Hill Companies, Terry McGraw.
Welcome to our review of the fourth quarter earnings and the outlook for 2010. As Don said, with me today is Bob Bahash, Executive VP and Chief Financial Officer. We will start today by reviewing the fourth quarter operating results and then we’ll move on to the prospects for 2010. Bob will then provide an in depth look at our financials. After the presentation, as Don said, we’ll be pleased to address any comments or questions about the McGraw-Hill Companies that you may have.
Earlier today we reported a 43.2% increase in diluted earnings per share for the fourth quarter. Diluted earnings per share of $0.53 in the fourth quarter included a pre-tax gain of $10.5 million or $0.02 on the divestiture of BusinessWeek in December. That compares with a $0.37 last year which included a restructuring charge of $0.05 per diluted share. Revenue increased by 3.3% in the fourth quarter.
The fourth quarter results mark the first quarterly increases in diluted earnings per share and revenue for the McGraw-Hill Companies since the third quarter 2007. These results set the stage for more growth in 2010. Our assessment of improving prospects is reflected in the guidance of $2.55 to $2.65 per diluted share for 2010.
We’re encouraged by the improvement in the economy which has finally begun to recovery, albeit it at a modest pace. Financial markets are definitely improving. Bond spreads have narrowed, interest rates remain low, our Chief Economist at Standard & Poor’s, David Weiss believes no tightening by the Federal Reserve is likely before this summer and perhaps not until after the November elections. We expect a better year in our Education markets.
Last week the Board of Directors underscored its confidence in our financial strength and growth prospects by increasing the dividend by 4.4% and announcing the corporation’s intention to resume share repurchases this year. We will buy back over time the 17.1 million shares remaining in the program that was authorized by the Board in 2007.
We have now increased the dividend annually for 37 consecutive years. Since 1974 the dividend has grown at an average compound annual rate of 9.9%. Since 1996 we have returned approximately $9.4 billion to shareholders and that’s through dividends as well as stock buyback.
With that as an overview let’s take a closer look at our operations and the prospects for 2010 and we’ll start with the McGraw-Hill Education.
A solid finish in the key education markets helped produce an upswing in the fourth quarter performance at McGraw-Hill Education. In the fourth quarter for McGraw-Hill Education revenue increased by 2.6%, operating profit was $33.5 million and that compares to a loss of $12.7 million in 2008 which included a restructuring charge of $11.4 million. The operating margin was 6.4% including restructuring charges of $11.6 million. The operating margin for 2009 was 11.6% excluding the restructuring charges the operating margin was 12%.
In 2009 Education has been a tale of two markets, a steady decline in the elementary-high school sales and growth in the US College and university market. As this bar chart shows, revenues started improving in the el-hi market in September and kept growing in October and November. While we don’t have AAP figures for December we expect to see another increase in sales.
Despite the recent gains, industry revenue will be down about 15% in 2009, far better than the previous expectations of a decline of 20% or more. In this challenging environment we still captured 30% of total available dollars in the State New Adoption Market which will close out the year in the $500 to $510 million range. That’s about a 50% decline, by the way, from the 2008 State New Adoption Market. We also won a 30% market share in 2008.
In the fourth quarter, state allocations that reached local districts later then usual in some regions, together with arrival of some Federal stimulus funds, helped produce the pick up in ordering. We caught the wave with our basal products and our intervention programs which benefited from the incremental Title 1 and IDEA funding for disadvantaged and special education students respectively, provided in the stimulus package.
These gains were offset by a substantial decline in testing. The results was a 7.6% decrease in fourth quarter revenue for the McGraw-Hill School Education Group, the major reason for this decline was testing and was the managed phase out of the statewide summative contracts in Arizona, California, and Florida, as part of a more selective approach to the custom testing market. In rebalancing the testing business we’re increasing our focus on the expanding formative market and the non-custom or off the shelf market, while decreasing our emphasis on lower margin custom contracts.
We continue to win summative contracts with a selective bidding strategy. In the fourth quarter we were awarded contracts in North Dakota, Alabama, Indiana, and New York State. Acuity, which is our formative testing program, continues to show solid growth, retaining existing subscription customers and adding new ones. New York City, the largest school district in the nation is now in the third year of its Acuity contract and Philadelphia has signed on for the start of the new school year. These are multi-year, multi-million dollar contracts.
Many district level opportunities for the new business are in the pipeline for 2010. Some states have also included the introduction or the expanded use of Acuity in their applications for the Federal race to the top funding.
Growth in the el-hi market in 2010 hinges on substantial increase in state new adoption opportunities. We estimate that the state new adoption market this year will be in the $925 to $975 million range. Given state budget pressures we expect industry sales in the open territory to decline in 2010. We also expect a decline in residual sales in the adoption state which usually fall off at a strong state new adoption year. Given the strength of the state new adoption schedule we think the el-hi market could grow now in the 6% to 7% range off of 2009 low base.
Texas and Florida, of course, are the key adoption states in 2010 and we are well positioned in both. The Florida legislative session starts in March. Senate and House leaders have given early indications of full support for funding K-12 instructional materials. Math is scheduled to buy K-12 Math this year. The state recently adopted new math standards which essentially is obsolete books now in the classroom. Adoption activity in Florida is already very brisk at the district level, something we did not see at this time last year when the state still planned to buy literature.
Texas returns to the market this year with funding already in place for a K-12 reading and literature adoption. The state legislature has appropriated $465 million for the adoption. We continue to see evidence of pent up demand in the market but budget pressures also remain until the economic recovery is further along. We may also see some purchasing postponed from 2009 in adoption states like California.
Funding levels in California remain uncertain but some districts may buy K-8 reading programs as part of the second year of that adoption. There also is some potential for math sales at the Middle School, that’s grades 6-8 and High School, grades 9-12. The governor’s budget proposal for the 2010-2011 fiscal year calls for $332.5 million for instructional materials which is flat with 2009. We are following this situation closely and will keep you updated on the developments there.
A solid 2009 performance in higher education culminated with a surge in second semester ordering late in the year. We don’t have the final 2009 figures but it now appears that the industry is going to outstrip our 8% to 10% growth estimate. Revenue in the fourth quarter at our higher education professional and international group grew by 7.5%. We expect the US college market to grow in the 5% to 7% range in 2010.
A surge in enrollments helped drive industry growth in 2009 and its going to do so again in 2010, although probably not at the same pace. Based on a number of surveys and reports, we estimate the most rapid rate of growth was concentrated in two year colleges and career colleges. We saw the benefits in career education; it was the fastest growing imprint in our higher education lineup in 2009. All our major imprints grew in 2009 and are expected to do so again in 2010.
Fourth quarter and full year digital sales increased at double digit rates. That includes eBooks, online courses, and online study tools for students, including McGraw-Hill Connect, the industry’s most advanced interactive platform. There’s clearly acceleration in the pace of integrating content, technology and distribution and we will take full advantage of the rapidly involving digital opportunity.
There is growing momentum in the eBook market as evidenced by the almost daily announcement of new devices and new formats. We will continue to look for optimal ways to deliver data and source files for each of these devices. In the near future you will undoubtedly see a McGraw-Hill eBook for the college market running on an Apple Tablet.
All our titles on CourseSmart, the industry eBook consortium, are already available to students on an iPhone operating system, that’s because CourseSmart developed an iPhone application last summer with the support from Apple. The goal was to have core educational content available on the iPhone operating system which also makes it possible for eBooks to run on new Apple devices using that system such as the Tablet.
Consider the Apple Tablet computer, which will be introduced shortly, there is a lot of secrecy about the introduction but many expect that the Apple device will use the iPhone operating system. If that’s the case, and we believe it is, we are confident that our CourseSmart eBooks should run well right out of the box on any Apple Tablet. Stay tuned.
I should also point out that CourseSmart does not share revenue with Apple. For a student to access our eBooks they must subscribe to CourseSmart or its college bookstore partners the eTextbooks feature the iPhone application and it lets students access our titles on a device that runs on the iPhone operating system, that application is free to subscribers. About 95% of the McGraw-Hill higher education current titles are available as eBooks with interactive features including search and note taking functionalities.
Digital publishing also a bright spot in our professional market with subscriptions to our services growing at a consistent double digit pace and we continue to innovate in this space. In the first quarter of 2010 we will launch Access Physiotherapy, the 6th vertical or specialty sight in the Access Medicine Family of online medication information subscription sites. The new specialty offers an excellent opportunity to broaden the market for the respected Access brand beyond medical education and clinical practice to the Allied Health field.
Our professional business group will also launch more digital products in the first quarter. Kiss, Bow, or Shake Hands is a new subscription based reference for international business etiquette; clearly that’s a digital product with widespread global appeal. Change is coming rapidly in our markets; growth in the digital world will be transformational. For the prepared, it will unlock huge new opportunities.
We are not waiting for a tipping point that means we will continue to ramp up our investments in learning platforms and content management capabilities to stay ahead of the curve in creating the next generation of innovative products and programs. The increase in marketing and sales expenses associated with the robust state new adoption schedule also put some pressure on operating margins in 2010.
Let’s sum up then for the McGraw-Hill Education. Growth in key education markets, 6% to 7% increase in the elementary-high School market, 5% to 7% growth in the US College and university market, revenue growth for the segment at 7% to 8%, and operating margins unchanged from 2009.
With that, let’s go on over to Financial Services. In Financial Services, improving conditions in the financial market, marked by the narrowing spreads, low interest rates and a growing investor appetite for yield were important factors in the strong finish this year. In the fourth quarter for Financial Services, revenue increased by 10.6%, operating profit grew by 14.6%, and the operating margin was 36.3%. Excluding the loss of the divestiture of Vista Research and the net restructuring charge, the segments operating margin for the year was 39.4%.
This 2009 operating margin also reflects the cost of compliance to meet the increased regulation of Standard and Poor’s Credit Market Services. The improvement in 2009 in investment grade industrials and high yield issuance culminated in a 19.4% increase in fourth quarter revenue against the easiest comparisons of the year at Standard and Poor’s Credit Market Services.
In the United States, we saw 181 industrials issued with a par value of $93 billion compared to 94 deals with a par value of $78.1 billion in the fourth quarter of 2008. That’s a 92.6% increase in the number of issues and a 19% increase in the par value of the issuance. There were 101 high yield industrial and financial institution issues for $44.1 billion in the fourth quarter compared to three for $1.3 billion for the same period in 2008, obviously tremendous improvement.
In Europe, the dollar value of industrial issuance was $93.6 billion up 36.9% in the fourth quarter. That represented 154 deals, an increase of 46.7%. There were 27 high yield deals in the fourth quarter 2009 in Europe and none in the same period 2008, obviously a clear pick up. All this activity helped produce a 62.5% increase in the fourth quarter transaction revenue at S&P Credit Market Services. For 2009 transaction revenue was up 0.2% after being down 20.2% for the first six months.
Non-transaction revenue which represented 69.2% of S&P Credit Market Services total revenue in 2009 grew by 6% in the fourth quarter, to finish the year at just over $1.2 billion. It was the first quarterly increase in non-transaction revenue in 2009. This continues to be a durable revenue stream. It includes annual and surveillance fees and subscription revenue. If you back out the impact of brokerage fees, non-transaction revenue grew by 2% in 2009 instead of the reported decline of 0.6%.
We expect growth in 2010 in transaction and non-transaction revenue for S&P Credit Market Services and we expect growth in domestic and international markets in 2010. International markets finished strongly in 2009. S&P Credit Market Services international revenue in the fourth quarter was up 17.7% in all regions; Europe, Canada, Asia/Pacific, Latin America grew in the fourth quarter and provided 49.4% of total revenue. Improving financial market conditions are clearly making a difference in the worldwide outlook for S&P Credit Market Services.
Consider the changes in spreads; spreads to US Treasuries, always a key factor in the level of issuance, are continuing to narrow for investment and speculative grade issues. As this table shows, since the record highs at the start of 2009, investment and speculative grade spreads have tightened and are near the range of their five year daily moving averages. Spreads continued to tighten in January, another indication of why the month is off to a good start. That’s a reflection of optimistic sentiment in the credit markets and an expectation of some stabilization in credit quality.
The spread between the three month Libor and the Federal Reserves overnight rate, this is a key gauge of how banks assess the riskiness of lending to one another and it is down to 0.25%. We’ve also seen spread contraction across the major consumer asset backed securities during 2009 and as this table shows the spread narrow dramatically in auto, credit cards, and student loans. S&P expects further contraction in credit spreads this year.
There are other important favorable trends in the credit markets. There is a strong demand for non-financial institution paper by investors who want to diversity their portfolio. Investors have already demonstrated that they are increasingly comfortable in buying low rated bonds. In the fourth quarter 2009, 60% of speculative grade issuance was rated at B+ or below.
In corporates, the high yield bond market has become more attractive then the leverage loan market and companies with riskier credits are lining up to tap it. Some issuers choose speculative grade bonds because covenants are less restrictive and in some cases maturities are longer. Because it is widely expected that corporate borrowing costs will increase as the economy improves, some non-financial firms are borrowing now to repay expensive debt, including commercial paper as well as bank loans. Some companies are beefing up their balance sheets with an eye on merger and acquisition activity or buying new equipment.
The de-leveraging of financial institutions is another factor in credit market as these institutions shrink the liabilities on their balance sheet and tightening lending standards, credit availability is declining systemically. Limited availability of bank loan funding will result in a greater reliance on the primary bond market. S&P believes that 2010 may offer a window of opportunity for refinancing debt. Refinancing of current and future maturities was robust in 2009 and should be again in 2010. About one third of the estimated $300 billion coming due in 2010 was refinanced in 2009.
There is a dramatic rise in corporate debt coming due from 2011 through 2014. It’s estimated to be $2 trillion. Some of that debt may be refinanced in 2010, adding to the remaining $200 billion that is coming due this year.
In public finance, 2009 was a solid year and 2010 looks even better. Municipalities sold the second heaviest volume of debt in 2009, $468.3 billion. The all time record, by the way, was $468.4 billion and that was set in 2007. The biggest factor boosting issuance here was the Building America Bonds program which authorized municipalities to sell taxable debt and receive a federal subsidy equal to 35% of their interest costs. Muni sold $84 billion in taxable debt in 2009 about 18% of total issuance.
S&P expect sales of taxable bonds to help drive growth in this market in 2010, although tax exempt securities will continue to comprise the largest share of overall issuance. Lower tax receipts and added expenses for pensions and infrastructure needs should keep state and local governments active in this market.
The outlook for structured finance in 2010 remains more problematic with asset backed securities showing the most promise. In the US, residential mortgage backed securities market we expect to see a continuation of the re-remic activity in 2010 as financial institutions continue to seek ways to improve balance sheet capital requirements.
In the commercial mortgage backed securities market we saw a small but marked note of confidence as issuers bought single borrower instruments to market in the fourth quarter 2009. For the near term, S&P expect very modest pick up in the activity of this part of the market.
The asset backed securities market continues to be a positive story. Volume began to grow last March as the TALF stimulus program took hold. By the end of 2009 there was activity outside of the TALF program. Dollar volume issuance in the US market grew by 179.1% in the fourth quarter 2009. Although our outlook for the US asset backed securities issuance is relatively flat in 2010 there’s a healthy pipeline as we move into the first quarter with a good mix of TALF and non-TALF activity. Tighter spreads have limited the economic incentives for using TALF leverage for many issuers. The collateralized debt obligation market will continue to be soft in 2010.
About 33% of Financial Services revenue was produced last year by Standard & Poor’s investment services. Fourth quarter revenue was down 4.8% in 2009 but was down only 1.7% excluding divestitures. For the full year 2009 revenue declined 4.2% to $861.9 million but was off 1.5% if you exclude divestitures. The expiration of the independent equity research settlement in July also was a factor in the fall off in revenue. In some key markets the year ended strongly. A new high of $247 billion was established at the end of 2009 for assets under management based on S&P indices. The previous high was $235.3 billion and that was set at the end of 2007.
From a small family of equity indices, S&P has expanded into commodities, fixed income, real estate, custom, thematic indices. S&P indices have successful relationship with exchanges literally around the world. At the end of 2009 there were 217 exchange traded funds based on S&P indices, five were added in the fourth quarter and more are coming in 2010 and they’ll be in the areas of commodities, equities, fixed income, and alternative investments. It is our strategic goal to provide an S&P index for every type of investment. In 2009 S&P introduced 90 new indices. We expect more new products and more growth from S&P indices in 2010.
In a challenging market, Capital IQ added new clients in 2009 to end the year with more then 2,900 an increase of 9.9% for the year. Sales to new customers and increases from current customers are expected to produce another year of growth for Capital IQ in 2010. With more growth from S&P indices and Capital IQ, we expect revenue to increase in 2010 at S&P Investment Services. The divestiture of Vista in May of 2009 and the expiration of the research settlement last July will be mitigating factors in the first part of the year.
Let’s complete our review of the Financial Services with a few comments on the current legal and regulatory situation. The regulatory situation is still evolving and we continue to strive for global consistency trying to avoid a patchwork of regulatory frameworks. This is very, very important. The good news is that we’re getting close to the finish line on global regulation.
In November the European Union issued its final regulation for credit rating agencies. By next September, S&P will need to apply for registration in Europe. Regulations are being developed in Europe by the Committee of European Security Regulators, better known as CESR. We are following that process closely. In general, the proposed regulations are based on the International Organization of Security Commissions Code of Conduct, that’s IOSCO out of Madrid. That’s a very good thing for them to take the leadership in terms of providing those code of conduct principles.
Starting on January 1, 2010, S&P has been licensed in Australia to provide its ratings to wholesale investors. We continue to work with regulators in Canada, Japan, and India. In the United States, both the House and Senate continue to consider regulation of the rating agencies as part of the omnibus financial markets reform legislation. We continue to work with Congress on draft legislation. We are somewhat concerned that the proposed discriminatory liability standards would create an uneven playing field and have unintended consequences for financial markets.
In the legal arena, there’s not much to report. In the underwriter cases we continue to make applications seeking dismissal and oral arguments have been proceeding in several of them. In the stock drop suits, motions to dismiss have been fully briefed and oral arguments have been held in two of these cases. In the state law claim cases we also are making application or awaiting decisions on motions to dismiss. We are in the discovery phase of the Abu Dhabi case.
Summing up then for Financial Services, in 2010 there will be a return to growth in revenue at S&P Credit Market Services and S&P Investment Services. The segments operating profits will grow but there will be pressure on margins as S&P makes investments in the infrastructure of its business to support future growth and to comply with new regulatory requirements.
The majority of these costs support the credit ratings business; they include investments in surveillance systems and the infrastructure for quality, criteria, compliance, as well as risk management. We will also continue to invest in key S&P Investment Services business so that they are well positioned to take advantage of an improving market.
There’s an additional factor, S&P Investment Services is primarily subscription based. In a challenging market in 2009 the S&P Investment Services added fewer net subscribers then in 2008 and that will have some impact on revenue in 2010. Prospects look good for increasing net subscribers this year which will lead to a more favorable impact on revenue in 2011. Revenue for this segment is expected to grow in the high single digits. Operating margins will decline about 100 basis points.
Now let’s shift over to Information and Media. In that area, continued strength in the global energy markets, a soft advertising market and the divestiture of BusinessWeek were major factors in the fourth quarter performance. In the fourth quarter, for Information and Media, revenue declined 11.4% including a pre-tax gain of $10.5 million from the divestiture of BusinessWeek in December.
Operating profit increased 40.6%, however, excluding the pre-tax gain on the sale of BusinessWeek and a prior year restructuring charge, operating profit declined 6.8%. The operating margin was 18.1% compared to 11.4% in the fourth quarter of 2008. Reflecting a gain on the sale of BusinessWeek, the operating margin for the year was 9.7% but it excluding the gain, and the 2009 restructuring charge of $4 million it was 9%.
The weak advertising market and problems in the automotive sector were evident in the 9.5% revenue decline in our business to business group in the fourth quarter. Revenue for the broadcasting group was off 26.6% in the fourth quarter and obviously especially with absence of political advertising. In 2009 advertising represented approximately 3.5% of total corporation revenue down from 4% in 2008. Virtually all of it is in this segment.
With the sale of BusinessWeek, our exposure to the cyclical advertising market will be reduced to approximately 2% in 2010. Political advertising in the broadcasting group will be a positive factor in 2010. There are US Senate and House races in Indiana, Colorado, and California. There will also be races for governor in Colorado and California plus spending on issues and propositions.
The outlook for political spending on local television stations also got a boost from last weeks US Supreme Court decision to remove campaign spending restrictions from corporations. The broadcasting group also recently renewed its affiliation agreement with ABC; the new agreement will have adverse but immaterial impact on the segments future revenue and profitability.
With all the reporting on problems of the big three auto companies in Detroit, it’s easy to lose sight of the fact that JD Power operates successfully in a recovering global automotive market. Here’s a snapshot of JD Power’s latest forecast for the global market. Global light vehicle sales are expected to rise to 65 million units and that’s an increase of 1.6% over 2009 after a decline of 3.1% last year. Growth continues in China, an increasingly important market for JD Power.
The recovery begins in North America with volume up 10% to 13.9 million units in 2010. JD Power will also complete the migration of its syndicated study deliverable to an online platform which will reduce costs and improve the quality and the utility of its research data. A digital transformation of this segment will continue to be a plus in 2010. Business to business digital revenue grew again in 2009 and now represents more than half of the B2B group sales in 2009. In 2008 it was under 50% of the B2B group’s revenue.
Platts continues its global expansion, strengthening its benchmark status in core commodity markets. Platts has launched a series of new oil price benchmarks for Indian markets. In December, Platts announced the launch of a new price assessment of the very first Russian petroleum stream that’s flowing through the Eastern Siberian Pacific Ocean pipeline for Asian markets.
It’s an interesting example of how Platts keeps abreast of the developments in this market. The pipeline rail and port facilities in Russia’s Far East provide the country with the logistics to target increasing amounts of oil to Asia rather then to the West. Over time, the operation is well positioned to serve the market as a major price indicator of spot oil values in the Far East. The exports are set to grow and the oil has wide equity ownership, key elements for an emerging benchmark.
Summing up then for Information & Media, the sale of BusinessWeek will impact revenue and operating margin in 2010. Revenue will decline in the middle single digits but excluding the $100 million from the BusinessWeek divestiture, revenue will increase in the mid single digit range. Operating margins will rebound, climbing into the mid teens.
That completes our review of the three operating segments and the outlook for the segments in 2010. For the McGraw-Hill Companies we expect diluted earnings per share of $2.55 to $2.65 in 2010.
Let me turn it over to Bob Bahash and let’s get the inside detail on some of the financials.
A major focus during 2009 was our balance sheet management. We did that in order to maintain and enhance our strong financial position to ensure adequate and appropriate access to capital. This morning I want to review how we maintained and improved upon the corporation’s financial strength in 2009. We’ll also look at our plans for this year 2010.
We start 2010 in a strong financial position due to very strong free cash flow we ended 2009 with cash and short term investments of $1.23 billion. Total debt at year end was $1.2 billion, this comprised entirely of long term unsecured senior notes and there was no commercial paper outstanding at the end of 2009. As a result, we’re now in a slight positive net cash position versus a net debt position last year of $796 million.
Keeping a tight grip on costs and expenses was a year long priority. Terry has discussed revenues and margins so I’ll concentrate on providing some additional color on expenses. For purposes of this discussion I’ll deal with adjusted expenses which represent reported expenses adjusted to exclude restructuring charges in both years as well as the loss on the divestiture of Vista and the gain on the divestiture of BusinessWeek. Adjusted expenses are shown on exhibit three of the press release.
Despite increases in incentive compensation, consolidated adjusted expenses, that’s segment expense as well as corporate expense, declined 0.3% in the fourth quarter and 4.7% for the year. Now to exclude the impact of currency, adjusted expenses declined 3.3% in the fourth quarter and 3.4% for the full year.
Now let’s look on a segment basis. For McGraw-Hill Education, adjusted expenses declined 4.2% in the fourth quarter and 8.4% for the year; at constant currencies adjusted expenses declined 6.2% in the fourth quarter and 7.3% for the full year. Full year expenses declined despite higher incentive compensation as declining revenue opportunities resulted in lower cost of sales and a reduced selling and marketing costs. This segment also benefited from savings from previous restructuring actions.
For 2010 we expect McGraw-Hill Education expenses to increased 7% to 8% versus 2009 adjusted expense. Expense growth is driven by an increase in selling and marketing costs given the robust new stated option opportunities that Terry mentioned. As I have mentioned in the past, we incur significant promotion and marketing expense in the first year of a new adoption. Profit contribution increases in the subsequent years from residual sales.
Additionally, we’re investing in both technology and personnel to support our digital initiatives, particularly at higher education and professional in order to provide value and choices for our customers. Expense growth is partially mitigated by savings from our second quarter 2009 action to combine our core basal publishing operations with our alternative basal and supplemental publishing operations.
Core Financial Services adjusted expenses increased 10.3% in the fourth quarter and 1.6% for the full year. At constant currencies, adjusted expense increase 4.1% in the fourth quarter and 3.4% for the full year. The full year expense growth was driven by increases in incentive compensation and compliance costs, mitigated by the benefits of restructuring, tight expense control, and the impact of divestitures.
For 2010 we expect expenses to increase roughly 9% to 10% versus 2009 adjusted expense. Expense growth is largely driven by continued investments in our fast growing businesses, the carry over impact of 2009 new staff hires and planned new hires in 2010, and additional investment to support our regulatory and compliance efforts.
For the full year 2009 costs related to regulatory and compliance initiatives resulted in approximately $20 million of additional costs versus 2008. Our expense guidance assumes a comparable increase in 2010 though this is obviously highly dependent on the final form of regulation.
For Information & Media, adjusted expenses declined 12.1% in the fourth quarter and 8.7% for the full year. At constant currencies, adjusted expenses declined 12.7% in the fourth quarter and 7.9% for the full year. Restructuring savings and lower cost of sales due to reduced revenue were key drivers for the full year expense decline. Fourth quarter expense, of course benefited from the divestiture of BusinessWeek.
For 2010 reflecting primarily the divestiture of BusinessWeek, expenses are expected to decline in the low teens versus 2009 adjusted expenses. You’ll recall from our third quarter call that we expected the BusinessWeek divestiture to benefit 2010 pre-tax profit by approximately $20 to $25 million. We refined our estimate now and expense the benefit to be roughly $25 million.
Information & Media, the segment I’m referring to now, will actually reflect savings from the BusinessWeek divestiture of $38 million as we manage vacant space and certain other support costs within corporate expense which is increasing by approximately $13 million due to the divestiture.
As we’ve indicated on previous calls, Information & Media’s 2009 results were negatively impacted by the non-cash accounting impact of converting studies onto Compass, JD Power’s online reporting and analytical tool. Revenue previously recognized at the time of our syndicated studies release will now be recognized ratably over the 12 month life of the subscription. This again of course is similar to the Sweets transition activity in 2006.
For the full year there was an $11 million decrease in revenue and $7 million decrease in profit due to the impact of Compass. In 2010 we expect all customers to be accessing this digital delivery platform and the impact in 2010 is expected to be similar to 2009.
Corporate expense in the fourth quarter was $36.4 million, a $7.4 million increase versus the previous year, excluding the 2008 restructuring charge. The increase was primarily driven by a $10.3 million increase in incentive compensation. For the year, excluding the 2008 restructuring charge, expenses were up $21 million driven by a $23 million increase in incentive compensation.
For 2010 we expect corporate expense to increase $25 to $30 million. The primary reason for the increase is driven by higher excess space in New York resulting from the BusinessWeek divestiture as well as excess space generated from the restructuring actions at McGraw-Hill Education.
Incentive compensation has increased in previous quarters and again in the fourth quarter when compared to a depressed 2008. Inventive compensation increased by $96 million for the full year 2009 and approximately $57 million in the fourth quarter, driven primarily by stronger then anticipated results and reversals taken in accruals in the previous year.
For 2010 incentive compensation should now grow in normal patterns with projected performance. However, stock based compensation is expected to reach about $50 million compared to $22.3 million in 2009 and that’s due to the three year earning and investing period which is off, of course, a depressed base.
Foreign exchange had a significant impact on our operating results in 2009. For nine months, foreign exchange decreased revenue and expense but had a minimal impact on profits. In the fourth quarter the trend reversed, benefiting revenue by almost $26 million while increasing expenses by $36 million resulting in operating profits declining by about $10.5 million. For the year, foreign exchange decreased revenue by $70.4 million and expense by almost $61 million, resulting in a decline in operating profit of $9.5 million.
Prudent management of investments and tight cost controls contributed to a strong free cash flow performance. For the year, free cash flow was $770 million compared to $503 million in 2008. We define free cash flow in the following manner. We start with cash provided by operations per GAAP cash flow statement, we then subtract the following items which would be pre-publication investments, purchases of property and equipment, additions to technology projects, and dividends paid to our shareholders. The result is free cash flow that would then be available for acquisitions, share repurchases, or to pay down debt.
Let’s spend a moment reviewing the changes in free cash flow in 2009 compared to 2008. As the table highlights, cash provided by operations increased $152 million over 2008 despite a reduction in net income. The primary drivers of the strong free cash flow were a significant reduction in cash incentive compensation payments, lower inventory purchases reflecting decreased revenue opportunities for McGraw-Hill Education, significant improvement in accounts receivable collections generating $50 million as the company’s day sales outstanding was reduced by nine days.
Investments declined $116 million primarily driven by a reduction in pre-publication costs of $77 million, reflecting the continuing efficiency gains in the development process as well as lower investments due to a lighter adoption calendar. Based on our operating guidance for 2010 we anticipate free cash flow in the range of $550 to $600 million. Reduction in free cash flow versus 2009 is due largely to more challenging working capital comparisons as well as increased investments that I’ll discuss in just a moment.
We took advantage of our strong free cash flow to contribute approximately $50 million to our US pension plan. US plan continues to be an under funded position following the significant market declines in 2008, though it has improved since last year end. Based on current projections we anticipate no funding requirements in 2010. However, we do expect an increase in pension expense of approximately $20 million in 2010.
Our strong cash flow generation and balance sheet leave us well positioned to fund investments and return cash to shareholders while maintaining financial flexibility. Last week we announced a 4.4% increase in our dividend the 37th straight increase. We’re one of fewer then 30 companies in the S&P500 that can make that statement. We also announced that we plan to resume share repurchases it’s our 17.1 million shares remaining from the 2007 authorization from the Board of Directors.
Unlike previous years we have not indicated either a share or a dollar repurchase target for the year. I reiterate, it is our plan to resume the program but the economic environment remains uncertain so we’ll watch this carefully in determining when we will commence share repurchases.
We plan to increase our investments in 2010 take advantage of the opportunities we see in our growing global markets. Pre-publication investments for 2010 are expected to be $225 to $235 million versus $177 million in 2009, primarily due to opportunities in the growing state new adoption market.
Purchases of property and equipment for 2010 are projected at $90 to $100 million versus $68.5 million in 2009 and largely due to increased technology spending.
Let’s now review our non-cash items. For 2010 we expect amortization of pre-publication costs to be $260 to $265 million versus $270 million in 2009. The decrease reflects the lower level of investments made in 2009. We expect depreciation to grow to $120 million in 2010 versus $113 million in 2009. Amortization of intangibles was $16 million in the fourth quarter due to the acceleration of the amortization of certain acquired intangibles. That brought the total for 2009 to almost $53 million.
For 2010 we expect amortization to decline and to be approximately in the $40 million range. The decline is due to the accelerated amortization of certain intangibles in 2009 as well as other items being fully amortized also in 2009.
Our fully diluted weighted average shares outstanding was 314.5 million in the fourth quarter a 1.6 million share increase versus the same period last year and a 0.8 million share increased from the third quarter 2009. Full year WASO was 313.3 million shares, a 5.4 million share year over year decline, driven largely by the full year impact of the 2008 share repurchases. Fully diluted shares at the end of 2009 were approximately 315 million.
Interest expense was $20 million in the fourth quarter compared to $15.4 million in the same period last year and $17.8 million in the third quarter. For the full year, interest expense was $77 million compared to $75.6 million in 2008 and we expect 2010 to be roughly comparable to 2009.
Regarding the company’s effective tax rate, we finished 2009 with a full year rate of 36.4% and we expect a comparable rate in 2010.
I’ll end with a recap of growth in unearned revenue. Unearned revenue ended 2009 at $1.1 billion up 1.5% from the prior year. At constant foreign currency exchange rates and excluding the impact of divestitures, most notably BusinessWeek, it grew 2.8%. Financial Services makes up 74% of the corporation’s total unearned revenue. Financial Services unearned revenue was roughly flat as strong growth for subscription products, including ratings direct was offset by reductions in equity research due to the end of the independent equity research settlement, as well as declines driven by lower structured finance revenues.
While comparatively small, McGraw-Hill Education strong unearned revenue growth was driven by an increase in subscription based products, particularly at higher education, where digital products are growing at a double digit rate. For 2010 we expect mid single digit growth in unearned revenue.
Thank you and now back to Terry.
Just a couple of instructions for our phone participants as we start the question and answer period. (Instructions) We’re now ready for the first question.
(Operator Instructions) Your first question comes from Craig Huber – Access 342
Craig Huber – Access 342
Can you update us on what your under funded pension at the end of the year, where did that stand and why don’t you compare it to a year ago?
What’s your appetite in 2010 given your very strong balance sheet for both significant acquisitions versus share repurchase, how do you balance that?
That’s a forever question, how you allocate the capital between dividends and share repurchase and organic growth projects and transactions is what we do. It really depends on what the transactions possibly could be, how attractive strategically it would be and at what kind of price. If we thought that it could get more growth and better returns going that direction then we would do that.
It’s a forever balance question. We’re excited about the announcement on the share repurchase. Obviously with the dilemma, the third quarter 2008 we needed to cancel that but we’re very excited about getting back to it. The level will depend on whatever the attractiveness of other activities are. It’s a forever balance.
The under funded status at the end of 2009 is approximately $450 million. That compares to $560 million at the end of 2008.
Craig Huber – Access 342
Can you update us on your thoughts for textbooks elementary; high school here in the US how you think the open territories will do versus 2009? More importantly how you can get residual sales, can you also size those markets for investors?
As you know, we’ve been watching those areas very carefully. We think the open territories are once again in 2010 going to show a decline. The number is a little big of guess work. I’ve seen numbers of down 7%, 8%, 9%, I think the higher end of that is a little harsh. We’re probably looking a little less then that, so mid single digits. Residuals also a little bit soft, again given some of the new adoption activity of 2008 and 2009.
Of course the bright spot is the new adoption opportunities for this year. Right now, unless we see some changes in all of that we see a decline in the open territories and residuals on that part, again, probably mid single digits on both of those. New adoptions in 2009 are probably somewhere between $500 and $510 we’re looking for $925 to $975 for new adoptions for 2010. Residual is about $3 billion in 2009 and we see a little bit of a decline to somewhere in the neighborhood about $2.8 billion maybe $2.85 billion for 2010.
Craig Huber – Access 342
Could you size the open territories?
That included open territory as well.
That was a combination number.
Residuals in open territory Terry just gave included it too.
Your next question comes from Peter Appert – Piper Jaffray
Peter Appert – Piper Jaffray
Should we assume that the guidance does not include any stock repurchases?
In what regard?
Peter Appert – Piper Jaffray
In terms of the EPS number, the $2.50 to $2.65 does not include the impact of any stock buy backs since you’re doing any buybacks?
We’re committing to buybacks it’s just not the timing. The EPS guidance that we’re giving does not reflect any benefit from the share buybacks. Depending upon when we start the impact will probably be relatively small.
Peter Appert – Piper Jaffray
I understand the impact of increased marketing costs for education in 2010 but given you’ve got fairly optimistic revenue expectations, I’m slightly surprised you wouldn’t expect to see a little bit of positive margin leverage in 2010. I’m wondering if there’s anything else I’m missing. Secondly, longer term in the good old days you’ve talked about the potential for maybe approaching high teens or 20% margins in Education. How do you think about the margin leverage in that business longer term?
Target margin levels are going to increasingly improve because of the digital capabilities and the reductions of cost also in terms of the acceleration of revenue opportunities. When you go back with us and we talk about we were looking at the 20% margin target on that part, over the next couple of years that’s exactly where we would like to continue to focus on. We think that the digital investment that we’ve been able to make is going to help us get there.
In terms of margin, for 2010 we really have to see as we were saying with Craig, what the open territories and what some of the residual numbers are. Again, we have it somewhere around mid single digit decline. If it’s a little bit more that might put a little bit more pressure on us on that part. Our hope is that the new adoption is going to carry the day and that we’re going to do better in open territories then we’re currently thinking which will give us a little bit more optimism. It’s a little too early to tell.
I’d reiterate the comments that I did make did emphasize digital investments. I mentioned in my remarks higher education and professional clearly those are areas of big opportunity. As well, we’re making significant continued investments in our Washington K-12 Development Center. This is pretty much across the board.
Your next question comes from Michael Meltz – JP Morgan
Michael Meltz – JP Morgan
Following up on Craig’s question on acquisitions, I think since I’ve been covering McGraw there haven’t been many large acquisitions. There’s been Tribune Education, JD Power, Capital IQ but nothing of substantial size. When you talk about a balance would you consider billion dollar plus acquisitions going forward?
The answer to that is yes. The question would be what that target is and what we thought the return potential over time and we’d have to equate that back to what we thought the return potential in doing other things would be. From a balance sheet standpoint and all of those kinds of things we obviously have capacity. We want to maintain flexibility in this kind of environment and we’ll be cautious in doing so. We could do a size but again it would have to be the weighing of what the potential returns are for it.
Michael Meltz – JP Morgan
Within the Education business, the three testing contracts that will not recur, what is the estimated revenue hit in 2010? I assume that’s incorporated in your guidance?
We’re not really disclosing what the revenue is. Clearly we’re seeing a decline in revenue as a result of that. We’re not really breaking out revenue components within the segment. Rest assured that we’re seeing a decline in revenue as a result of the loss of contracts that Terry mentioned.
Michael Meltz – JP Morgan
At S&P ratings did you raise prices in January or whenever your typical period for raising prices for the forward year?
Modest increase in price.
Michael Meltz – JP Morgan
You mentioned the ABC affiliate agreements; I think you said adverse but immaterial revenue impact. Can you please discuss that a bit further?
As you know and as we’ve seen with the whole local broadcasting station business, network compensation for local programming has gone in the other direction. It’s a small amount for us in that one that’s why the immaterial comment. Instead of being paid you’re paying for that content now. That’s a trend that you’re going to see continue. We also want to be very careful in terms of re-transmission rights in terms of negotiations on cable suppliers on that one and we’ll see what that effect is as well and that’s being played out as well.
Your next question comes from Edward Atorino – Benchmark
Edward Atorino – Benchmark
You mentioned some adverse effects in TV, I know it’s a small thing, was that the affiliation agreement with ABC? Did you give any back and would you give us some color on that?
That’s right. Without getting into it, it was a very small amount but it was a give back rather then a take on that one which is the first time that’s taken place. I think you’re going to continue to see that kind of a relationship.
Edward Atorino – Benchmark
Did you get anything for giving up something?
As far as the negotiation back and forth there were a number of things inside it. Again, the number is a very small number.
Edward Atorino – Benchmark
It seems like you’ve lowered your growth outlook in the school area. I haven’t gone back and checked the last comments you made but it seemed like you’re looking for a little bit less growth in the school area this year then last. You mentioned its going to depend on funding. Could you elaborate a little bit on that, are you concerned that the dollars will or won’t be there?
Actually I’m pretty upbeat about it because of the fact that the solidarity of both Florida and Texas in the market. Also with some upside look with California because they only funded 10% of their opportunity in 2009 from we thought about 40% is what they were going to do. We feel good about that part of it. The unknown part really is the open territories and the residuals. We’re sizing that opportunity and relative to Craig’s question we were saying mid single digits. We know that some people have a higher decline then that and some lower but we think that’s a go in position on this thing. That’s where it’s coming from.
As we see that materialize and if we see it improve its certainly going to improve our guidance for el-hi. I think 6% to 7% for the market is a pretty good number for that, higher ed 5% to 7% and for the McGraw-Hill segment we’re looking for 7% to 8% growth.
Edward Atorino – Benchmark
Will testing continue to be a drag in 2010?
Not as much because as we unwind some of the summative contracts all the focus is going to be on the formative side. With the success that we’ve had with Acuity and that continuing that will take on some of the emphasis there. There’s no question that the summative side is creating problems for us and as we unwind those we’ll improve those numbers.
Edward Atorino – Benchmark
On digital, obviously it’s a very high growth area; would you quantify some way how big is it? I know there’s a billion dollar school business so it may not be all that dramatic, ballpark on the digital revenues.
From our standpoint both at the higher end level where we’re having terrific success with McGraw-Hill Connect, Learn Smart, Tegrity, those are great areas for us. We’re very excited about the prospects for McGraw-Hill Connect. We haven’t broken out the revenues specifically from that on this one.
We’re focused at the community college level and we’re very excited about that. The elementary side, as white board penetration goes up, as supplemental materials improve, digital is becoming a bigger, bigger part of it for us. Still, obviously the lions share is print in all that but as more devices and more capabilities and the like, the digitization opportunity becomes that much more attractive.
Your next question comes from Brian Shipman – Jefferies
Brian Shipman – Jefferies
Normally in advance of a big new adoption schedule we’ve typically seen a big increase in pre-publication investments. In 2009 we saw a big drop so how should we view that drop in spending with respect to your guidance for 2010. Would that not bode more strongly for margin expansion next year, how will we foot that difference from historical patterns? Historically you’d pointed to that as a reason for being a drag on margin expansion into a big upturn in the spending cycle.
With regard to the pre-publication investment and resulting amortization, in my comments I indicated that we expect amortization on pre-pub costs for 2010 to be in the range of $260 to $265 million versus $270 million in 2009. Remember the amortization costs it really is a multi-year amortization schedule depending upon the type of product that we’re creating for K-12 its generally five year sum of the digits, for higher education it can range anywhere from four year sum of the digits down to two year sum of the digits, and profession faster. It’s a mixture of a number of properties.
I think the point that we’re making here is that the marketing costs, the complementary copies free with order costs are much more robust then the first year of an adoption. In order to secure that 30% plus share that we’re after we’re going to be very aggressive in that marketplace and that’s where we’ve pointed out that those costs are very significant in that first year. In years two, three, four, five, etc. you don’t have those same costs, that’s where your margins expand.
Brian Shipman – Jefferies
Is your aggressiveness this year indicative of some new competitor or some other more aggressive competitor then you’ve seen in past years? You’ve normally been very strong in Texas and Florida.
Its not different in any which way but we want to be certain that if we feel we have the winning and competing products here and we just want to be very aggressive in securing the adoption opportunities where we see them.
Your next question comes from Michael Meltz – JP Morgan
Michael Meltz – JP Morgan
Within S&P your margin guidance for 2010 what is the base percentage, you’re saying you’ll be down 100 bps is that a little over 39%?
Michael Meltz – JP Morgan
Understanding the compliance costs in 2010 and the lag effect of the subscriptions, where do you see margins going there over a three to five year period?
We’ve got to make some assumptions on revenues and structured finance revenues and the like. When we were at 45% margins and we were targeting that as the level, we now think that the new level is probably 200 basis points below that. Now you’ve got to start making assumptions on the return of structured product and the like to get there. We’re looking at about 200 basis points in terms of the regulatory and compliance aspect.
That concludes this morning’s call. (Operator Instructions) On behalf of the McGraw-Hill Companies we think you for your participation and wish you a good day.