Donald Rubin - Senior Vice President of Investor Relations
Harold McGraw III - Chairman, President & Chief Executive Officer
Robert Bahash - Executive Vice President & Chief Financial Officer.
Peter Appert - Piper Jaffray
William Bird - Bank of America
Craig Huber - Access 342
Brian Shipman - Jefferies
Sloan Bohlen - Goldman Sachs
Edward Atorino - The Benchmark Company
[Drew Figdor - Peterman & Co.]
The McGraw-Hill Companies Inc. (MHP) Q1 2010 Earnings Call April 27, 2010 8:30 AM ET
Good morning, and welcome to the McGraw-Hill Companies first quarter 2010 earnings call. I would like to inform you that the call is being recorded for broadcast, and that all participants are in a listen-only mode. We will open the conference to questions-and-answers after the presentation, and instructions will follow at that time.
To access the webcast and slides go to www.mcgraw-hill.com, and click on the link for the earnings announcement/conference call. At the bottom of the webcast page are three links. If you are listening by telephone, please select the first link for slides only. For both slides and audio via webcast, select either windows media or real player. (Operator Instructions)
I would now like to introduce Donald Rubin, Senior Vice President of Investor Relations for the McGraw-Hill Companies. Sir, you may begin.
Thank you, and good morning to our worldwide audience. We thank you everyone for joining us this morning for the McGraw-Hill Companies first quarter 2010 earnings call. I am Donald Rubin, Senior Vice President of Investor Relations for the McGraw-Hill Companies. With me today are Harold McGraw III, Chairman, President and Chief Executive Officer; and Robert Bahash, Executive Vice President and Chief Financial Officer.
This morning, the company issued a news release with our results. We trust you’ve all had a chance to review the release, but 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 those 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. Frank Briamonte in our New York office at 212-512-4145 subsequent to this call. Today’s update will last approximately an hour. After our presentation we will open the meeting to questions-and-answers.
It’s now my pleasure to introduce the Chairman, President and CEO of the McGraw-Hill Companies, Terry McGraw.
Okay. Thank you Don, and good morning and welcome to our review of the first quarter earnings and the outlook for the year. With me today is Bob Bahash, Executive Vice President and Chief Financial Officer, and we are going to start today by reviewing our first quarter operating results and guidance for the segments and for the corporation. Bob will then provide an in-depth look at our financials, and after the formal presentation obviously we’ll be pleased to answer any questions or take comments that you may have about the McGraw-Hill Companies.
Earlier today we reported a 65% increase in diluted earnings per share for the first quarter. That’s $0.33 versus $0.20 for the same period last year. Revenue increased 3.7%, but excluding the divestitures of business week and investor research, revenue grew by 6.7% in the first quarter.
When the 43.2% increase in the fourth quarter earnings per share was announced at the end of January, we said those results set the stage for more growth in 2010. Although the first quarter is seasonally the smallest of the year, we are obviously clear off a good start.
The economy will continue to improve this year. GDP is expected to rise about 3% in 2010. We are encouraged by improvement in the financial markets. Interest rates are expected to remain low. Bond spreads narrowed again in the first quarter, and we still expect growth in our key education markets. With that as an over view, let’s now review operations and our prospects by each of the operating segments, and let’s begin with the McGraw-Hill Education Segment.
In higher education it is called the echo effect. Second semester ordering that echoes the pattern of the first semester orders from the previous summer. In it’s seasonally light first quarter for education, we saw the favorable side of the echo effect, as our higher education group once again reported solid results, including double-digit growth in digital products and services. Revenue for the McGraw-Hill higher education professional and international group grew by 8.3% in the first quarter, to $205.7 million.
Revenue for the McGraw-Hill School Education Group declined by 9%, to $111.6 million in the first quarter. For McGraw-Hill Education in the first quarter, revenue increased by 1.5% and the operating loss was cut by 19.3% to $61.8 million. The first quarter is typically a light one for McGraw-Hill School Education, because of the seasonality of the market that was accentuated this year in the State Adoption Market, because North Carolina did not order.
North Carolina is the only adoption state that usually makes substantial purchases of new materials before the end of March. It did so in 2008, again last year, but not in 2010. As a result, most of the orders from adoption states in the first quarter were for supplemental, residual or intervention products.
The adoption stakes were down slightly from last year, but were offset by stronger results in the open territory. We benefited from large orders from School Districts in Ohio, Maryland, South Dakota that initiated adoptions in 2009, but completed the purchasing earlier this year as funds became available.
The increase in the sale of instructional materials in the first quarter was offset by a decline in the testing market, where we have elected to discontinue custom contracts in Florida, California and Arizona. In a formative market, we continue to make progress with Acuity, our market leading assessment program.
It’s early in the year and we are watching buying patterns closely, and some adoption states, local school districts have two years or even longer to purchase materials in what maybe an indication of the way stimulus funds are reaching districts. We have a year-over-year increase in industry sales for six consecutive months now. It started last September and has continued through February. That’s not intuitive, because historically the fourth and first quarters are the slowest each year for the el-hi market.
Based on early trends this year, we still expect the el-hi market to grow 6% to 7% in 2010, even though we are trimming our estimate for the State New Adoption Market. As you know, previously we had forecasted this market to grow between $925 million and $975 million. We are now forecasting a slight decline in that; $875 million to $925 million, which still represents about an 80% year-over-year increase for the industry.
Although no formal postponements were announced during the quarter, our reduced estimate for state new adoption market reflects pullbacks that have become apparent in several states.
In Indiana, which is officially adopting K-12 math this year, the State Department of Education has recommended that districts delay purchasing until materials are available, that align with the common core standards; even though it will probably take the states several years to implement instruction and assessments based on those standards. The adoption has been funded, so it’s difficult to gage district response to this recommendation, but some effect is probable.
As [an aside] where common core standards are an issue, we have promised to provide online and print supplements to cover any concepts or skills, not presented in accordance with those standards in the newly state approved materials now being sold. As budget pressures drive more district level postponements than originally anticipated, we are also forecasting lower spending in several other adoption states, including Georgia, California Virginia and Kentucky.
In Florida, the math adoption is looking very solid at the K-5 level, but some districts are delaying high school math purchases for budgetary reasons. There is also a possibility that South Carolina will delay the implementation of its 9-12 math adoption. The reduction in the state new adoption market will be partially offset by higher residual sales in these states, as districts buy replacement copies and consumable materials of their older programs.
We still expect a low single-digit decline in the industry’s open territory sales. We are seeing some district level postponements in the open territory, but the field sales force is also identifying new opportunities as the selling season develops and the outlook at this time is reasonably optimistic. We continue to seek pent-up demand in both the open territory and adoption states.
Federal stimulus funding distributed last year helped some districts implement delayed adoptions in the second half of 2009, and will contribute to purchasing in 2010, but the budget pressures are real. So we will continue to monitor market developments carefully. It is early days in the battle for state new adoption dollars, and let me reassure you that our school education group is still aiming for a share of at least 30% or better this year.
In testing, we continue to gain share in the market for formative assessments, which is largely made up of district level adoptions. We also see new opportunities ahead for both formative and summative testing, as the winners of federal race to the top grants, begin to implement their long range plans, and as the movement towards common core standards and assessments continues to gain momentum.
As many of you know that common core movement represents a cooperative effort among the states to agree upon concepts and skills in math and language art, that all students should master at each grade level, in order to meet internationally benchmarked criteria for college and career readiness. Drafts of the standards have been finalized and are now under review.
48 states, plus the District of Columbia are taking part in this movement, which has been endorsed by the US department of education. The only two states that are not included at this point are Texas and Alaska. Applicants that declare their attention to adopt this standard by August of 2010 can earn extra points in the race to the Top Grant competition.
Delaware and Tennessee have already won Phase 1 awards of $100 million and $500 million respectively, and Phase 2 winners will be announced in September. Each state will have four years in which to spend it’s awards, half of which will be distributed as sub-grants to the local districts.
Later this year the department of education will also award a total of $350 million to multi-states consortia, with winning proposals for developing new assessments based on common core standards. All this means that we expect to see a very active market in the testing business over the next few years, with the RFP’s coming from consortia, states and districts.
McGraw-Hill with its outstanding reputation for the psychometric research, and its complete range of assessment and reporting capabilities will be well positioned to benefit for these new opportunities. Present indications are that testing development work will begin in late 2010, or perhaps early 2011, and that common assessments will be implemented from 2012 through 2014.
The common core movement has favorable implication for the instructional material side our business as well. We can expect to see more purchasing as states adopt materials that incorporate the new standards, and we also anticipate delivering more content to the schools in digital four, because most of the states race to the top plans involve building out their technology infrastructures. We should also see cost savings in content development, as there will be a less need for obviously state-by-state customization in the common core environment.
In higher education we continue to benefit from the increased enrollments. According to our own survey and information from other sources, enrollments for the spring semester held steady with the gains recorded last fall.
We believe that federal stimulus dollars also helped to increase enrollments last fall, and did so again this year, although the effect is not easily measurable. The funding has gone to students in the form of increased tell grants, higher allowable tax deductions for college related expenses, and a new post 9/11 GI bill that has provided educational subsidies for more than a 150,000 veterans since the fall of 2009.
Student aid got another boost in March, when Congress passed the Student Aid and Fiscal Responsibility Act. It includes provisions to keep the co-grant program solvent and to continue increasing the maximum awards from $5,550 this year, to $5,975 in 2017.
In the US College and University markets, students are embracing our digital products at a record pace. We saw strong growth in the usage of McGraw-Hill Connect, that’s our new homework management and assessment platform, and implementations of our online courses, and in purchases of e-books. We now have more than 1.2 million registered users of McGraw-Hill Connect, and our other digital study and homework management products, with more to come in fact. McGraw-Hill Connect will add an additional 170 courses in 2010.
Creating original, media-rich digital products in all of our markets is a priority. In the first quarter we introduced our first digital subscription products for the professional business market. They are Kiss, Bow or Shake hands, a global business etiquette database, with information on customs in more than 60 countries, and another one is Perfect Phrases for Managers, a performance support tool, based on the series of successful McGraw-Hill books that helps managers find the right phrase at the right time.
For on-the-spot convenience, these products can be downloaded to virtually any digital device. Also for the business market, we launched a program called Select: eChapters in an instant. This program enables customers to buy downloads of chapters from our best-selling business books as standalone items. More than 750 chapters are currently available from major titles in finance and investing.
In medicine, we added a six specialty site to our internationally successful access medicine suite; it’s called Access Physiotherapy, and broadens our addressable market by going beyond medical education and clinical practice, and goes into the allied health fields. It is a powerful new site providing searchable access to our leading physical therapy and internal medicine trials, interactive imaging content, curricular management tracking tools and tests, and more than 80 videos and exclusive lectures.
We also broadened our market geographically by signing a partnership agreement with the Chinese Education and Research Network, which will make our access suite of products available for the first time to Chinese students, educators and researches, just more a fuel for the double digit growth our digital products are already producing in professional markets.
Let’s sum up for McGraw-Hill Education. Growth in key education markets in 2010, 67% growth in the elementary high school market, 5% to 7% in the U.S. college market, segment revenue growth of 6% to 7%, and an operating margin unchanged from 2009.
Let’s now go to the financial service segment. Here robust growth and transaction revenue was a key factor in financial services start for this year. In a first quarter for financial services revenue increase by 9.3%. Operating profit grew by 12.3%. The operating margin was 39% versus 38% for the same period last year.
The Standard & Poor’s credit market services, the 15.4% increase in the first quarter revenue was driven by record high yield issuance, strong growth in bank loan ratings, a solid gain in public finance, modest improvement in structured finance, 18.4% growth in international markets, and 12.8% growth in domestic markets. For S&P investments services, first quarter revenue declined by 1.5%. The decline can primarily be attributed to the divesture of Vista Research and expiration of contract for the independent equity research, required by the research settlement.
Let’s take a closer look at these numbers. For S&P credit market services, transaction revenue increase by 33.6%, that’s revenue from new issuance and domestic and international markets. The key growth drivers in the first quarter was surging high yield volume, bank loan ratings and public finance. Corporate high yield net issuance grew globally by 565%, to set an all time record for the first quarter and obliviously coming off of a lower base, it was the first quarter for this decade of great issuance since 2007.
The surge was driven partly by private equity backed companies, refinancing the debt they took on for buyouts in the last decade. These companies aim to preempt a so-called maturity cliff, by largely LDO related loans coming due in the next two years. High yield issuers raised billions of dollars in the first quarter as risk premiums tightened.
The increase in the global bank loan activity was primarily amended to extend to push out maturity. Credit spreads, that’s the excess interest rate over treasury bonds decreased dramatically during the past year. Both investment grade and speculative grade spreads continue to tighten in the first quarter, and as this table shows, we are near or just below the five year moving averages at the end of March, and by the way there was more contraction in April.
We have also seen steady and significant contraction in spreads across all asset backed security classes. As this table shows, there has been significant contraction in spread, for auto loans, credit cards, student loans, and that’s all since the beginning of 2009.
U.S. public finance issuance in the first quarter of 2010, of $106 billion, was up 17.4%, and just missed the all-time first quarter record of $112 billion set in 2007. The new market continues to be fueled by the growth build America Bonds. This program enabled municipalities to issue a huge amount of taxable debt. In the first quarter taxable bonds represented 31% of the [muni] market, well about the previous record of 11%.
Structured finance also contributed modestly to the increase, primarily from asset backed securities and increases in re-remic activity in the U.S. residential mortgage backed security market. But the growth of transaction revenue essentially driven by new issuance activity is not the whole story. Non-transaction revenue is a critical component and here too we grew.
Standard & Poor's Credit Market Services solid base of non-transaction revenue grew by 8.1% in the first quarter, and produce 67% of S&P credit market service as first quarter revenue, 67%. To reduce dependency on any single market or asset class S&P created a deferred revenue stream, by emphasizing reoccurring annual fees through frequent issuer programs, surveillance fees, as well as subscription services. That’s how we define non-transaction revenue, and despite changes in debt issuance levels, capital markets and the economic environment, we expect the non-transaction revenue stream to be durable for sometime.
The growth of non-transaction revenue in the first quarter primarily came from increased subscriptions and annual fees. We are also benefiting though from increased demand for products and services, not tied to new issuance such as range evaluation services, an increase in new credits under surveillance, price increases, a modest favorable foreign exchange impact.
Turing to the investment services side of S&P, capital IQ at S&P indusees were primary drivers in the first quarter. Capital IQ continues to add clients, with more than 3000 at the end of the first quarter, the number increased 15.5 % from the same quarter last year, and sequentially 4.8% since the end of 2009.
The growing client demand, Capital IQ is expanding European and Asian operations by opening new offices in Milan and Tokyo. S&P indusees are experiencing a rebound in asset based revenue, which has earned from issuers of exchange credit funds and mutual funds benchmarked to our indusees. Assets under management and exchange traded funds based on S&P industries set a new record of about 254.2 billion at the end of the first quarter, topping the record established at the end of 2009 by 2.9%.
In the first quarter, 21 new exchange traded funds based on S&P industees were launched, bringing the total of 238 exchange traded funds and endless permutations here as an index for every type of investment as our goal, and in March we introduced indusees and commodities, fixed income, equities, strategy and customized for a number of clients and obviously more are on the world.
As we look at the pipeline for S&P credit market services, here is what we see. High yield issuance should continue at a good pace, with proceeds predominantly used for leverage loan repayments. The bank loan market will continue to be active. Refinancing the age will be a factor for sometime, with $2 trillion in debt maturities due through 2014. We anticipate a greater number of investment grade corporate transactions in 2010, all thought at a moderate par amount, compared to the high levels of 2009.
The [uni] markets still looks promising despite constant headlines about the state and local budget deficits. But the financial press fails to recognize that these conditions have not translated in the reduced ability to issue debt. Taxable bonds are expected to drive growth; traditional tax exempt securities will continue to comprise the largest share of new issuance.
The structured finance market has improved, but new federal rules and regulations will increase the cost of securitization and could tamper the new issuances. Longer term, these new rules underscore the importance of securitization as a funding tool.
Now no discussion on prospects for financial service is complete these days without a review of the legal and regulatory outlook. Since our last update on litigation in late January, the courts have begun issue significant decisions and law suites brought against the McGraw-Hill Companies and Standard & Poor’s.
At last count, twelve cases had been dismissed by eight Federal Court Judges; 11 of which have been dismissed since the beginning of the year. During that same period a motion dismissed two related cases alleging fraud has been denied pending discovery, as in the Abu Dhabi case last September.
The court, and by the way the same judge [Shindlin] who issued the Abu Dhabi relief was required by law to assume the plaintiff’s allegations to be true at this preliminary stage of the litigations. We believe both of these cases are without merit, and will ask the court to dismiss them as soon as discovery is concluded.
The 12 dismissals have occurred in all three of the three major categories of claim; and again, the three major categories of claims are one, the underwriter lawsuits that claim that we’re a distributor and seller of securities, which we are not; secondly, the stock drop suits; and third, the suits involving state law claims alleging or including allege fraud.
These recent favorable decisions have not attracted a lot of attention, so let’s review what’s happened, since many of the key allegation against Standard & Poor’s are starting to unravel under judicial scrutiny.
Significantly, none of the dismissals have been based on the assertion of a first amendment defense. Underscoring again, the irony is claim by critics, that Standard & Poor’s uses the first amendment to shied it from all legal claims.
In the first category, plaintiffs allege that McGraw-Hill is liable under the Securities Act of 1933, as an underwriter or seller of residential mortgage back securities rated by Standard & Poor’s. Today, four federal judges have granted our motions to dismiss in six separate underwriter actions.
In light of these favorable rulings in the underwriter cases, class-action council in another underwriter case has recently amended it’s complain, and this is in the fort worth employees retirement fund litigation, by dropping all claims against Standard & Poor’s and two other rating agencies.
In a second category, this is in the stock drop area, our motions to dismiss were granted in three cases, in which purchasers of McGraw-Hill stock alleged the company statements about its earnings and ratings business were misleading, and reportedly violated the Securities Exchange Act of 1934 and ERISA.
In the third category we can report three dismissals of various state law claims, there also have been some significant decision in cases in which Standard & Poor’s and other rating agencies were not parties, in these cases the plan is attempted to assert claims against an issuer or an underwriter on the basis of allegedly misleading statements about ratings included in the disputed operating documents.
Many of these claims were based on much publicize testimony regarding rating agencies given that congressional hears. In three cases the Federal Courts have rejected these legal claims outright. We believe that these decisions constitute meaningful legal president, which should help guides judicial rulings in the remaining cases.
The courts have been clear and unambiguous in their decisions, and here is what I mean, in dismissing the underwriter claims against the rating agencies and in the New Jersey Carpenters Vacation Fund case, judge Baer spelled B-A-E-R wrote “Plaintiff’s allegations do not support and inference that rating agency defendants were involved in the sale or distribution of the securities such that they could be considered underwriters”.
In rejecting claims that the rating agency somehow controlled Lehman, judge [Kaplan] wrote in the Lehman Brothers ERISA Litigation suit “this complaint that we read alleges only that the rating agencies had the power to influence Lehman with respect to the composition approvals of mortgages to be securitized and that credit enhancement though rating agencies regarded as necessary to obtain the decide rate, but these allegations were all considerably short of anything that could justify a reasonable trier of fact in concluding the decision making power lay entirely with the rating agencies”.
In concluding that ratings are opinions and not statements of fact that are actionable under the securities law, judge Baer also pointed out that “credit ratings and the relative adequacy of protective credit enhancements are statements of opinion as they are predictions of future value and future protection of that value”.
In dismissing the allegations based upon alleged purported variance failures to disclose rating agencies complex of interest, judge Kaplan wrote “the securities act does not require disclosure of that which is publicly known and the risk that rating agencies operate under a conflict of interest because they were paid by the issuers has been known publicly for years”. And by the way I might for more than 40 years as a matter of fact on that.
Another critical point was recognized by the court in the New Jersey Carpenters Vacation Fund case, in ruling that investors were adequately cautioned in offering documents about the risk and limitations of using credit ratings, judge Baer wrote “the offering documents adequately be spoke caution about the risk entailed by the credit ratings and credit enhancements and disclose the risk of relying on credit ratings, the potential and adequacy of credit enhancements and that a lack of historical data made future predictions about value inherently difficult. In other words, the offering documents “warned investors of exactly the risk the Plaintiff’s claim were not disclosed”.
Few minutes ago, I said that the Federal Courts were making important decisions in these similar cases in which Standard & Poor’s and other rating agencies were not defendants; they are the Plumbers Union Local versus Nemora as the acceptance corporation. The other one was the Jersey Carpenters Health Bond versus DLJ and New Jersey’s Carpenters Health Bond versus RALI.
Addressing after the fact criticism of rating agencies judge Stearns pointed out in the Plumbers Union Local 12 Pension Fund versus Nemora “none of the purported comments made by S&P and moody’s employees in the wake of the collapse of the sub-prime mortgage market in 2007 “supported the inference that the ratings were compromised as of the date in 2005 and 2006, when registration statements and prospective supplements became affective”.
We think there are some clear takeaways from these recent decisions. The courts are ruling that rating agencies are not underwriters under the Securities Law. Rating agencies are not sellers of the securities under the Securities Law.
Rating agencies are not controlling persons under the Securities Law that ratings are opinions not statements of fact, after the fact criticism of rating agencies such as those that have appeared in the press do not support and inference that rating agencies did not believe that ratings were appropriate at the time they were issued, that rating agencies alleged conflicts of interests were widely known by investors and that investors were adequately cautioned about there is some limitations of using credit rates For example they are not recommendations, obviously to buy, sell or hold securities, they never work.
Clearly the courts are also demonstrating that they understand the difference between credit risk and market risk that others do not is on display almost daily by some sophisticated investors who claim they relied on range to make their investments decisions for themselves or as fiduciaries for others.
Turning to the regulatory situation, it obviously remains a fluid situation. Legislation in the senate is paradoxical and a potential problem. A court tenant in the proposed legislation expressed unambiguously in the preamble to the senate bill says NRSROs should be subject to the same standards of liability and accountability as (1) security analyst who recommend the buying of security (2) the investment banks that structured and sole security and (3) auditors who certify the issuers financial statements and other market participants and yet as currently written other parts of the legislation would lead to the opposite result.
They would impose materially different legal pleading standards for federal securities fraud claims distinguishing NRSROs from all other defendants in the same case, in other words a separate lower pleading standard would apply only to NRSROs in the same cases alleging federal securities fraud violation and let me be clear here, we are not looking for special legal treatment and lawsuits for securities fraud we are simply saying that NRSROs should be subject to the same legal pleading standard as everybody else, no more no less to impose a lower pleading standard just on NRSROs is clearly unprecedented and discriminatory.
We fully support congressional proposals to increase accountability, transparency and oversight of credit rating agency. They should be accountable if they knowingly issue misleading ratings. We will continue to work with Democrats and Republicans to make out position very clear.
Passage of the bill by the Senate and reconciliation with the version passed by the House of Representatives is difficult to predict. Some expect the Senate to vote on this bill before Memorial Day, but there is also uncertainty on when the Senate in the House would convene a conference committee to work out the difference; I guess its stay tuned.
S&P is also focused on new SEC regulations that go into effect on June 2. A key new rule is known as 17-G5, and it requires issuers and arrangers to make the underlying information that they provide on structured financing available to all NRSROs, whether they are paid or not to produce a rating. The goal is to encourage NRSROs, which have not been asked to rate transaction to issue unsolicited ratings.
S&P is working with market participants to implement this new rule. S&P is also working to meet new disclosure rules on its history of rating action. We also continue to work with regulators overseas to ensure timely compliance with their new rules and regulation. We continue to push for a regulatory framework that provides consistent standards across all geographic boundaries and jurisdictions.
So let me sum up for financial service. The market is clearly recovering. We are making progress in the courts. We are proceeding to meet the new regulatory requirement. The outlook for legislation in the United States remains fluid, and by the way Europe is complete, Australia is complete, Japan is Complete. Revenue is expected to grow in high single digits with improvements at S&P Credit Markets Services and S&P Investments Services, and operating profit will grow. The operating margin will decline by about 100 basis points reflecting investments in infrastructures to support the future growth and to comply with new regulatory requirements.
Finally let us take a look at the information in the media area. In the first quarter revenue declined 8.5%, operating profit increased by $25 million to $27.8 million. The operating margin was 13.5% compared to 1.2% for the same period last year. Last year we had a full year margin in this range. The last time we had a full year margin in this range was in 2004. That year the segment reported an operating margin of 14.9%.
In the business to business market we had been building on leading industry positions where information and media products and services represent the standard or provide leading benchmarks. A lot of progress had been masked by deterioration in the advertising market experienced by BusinessWeek.
In the first quarter the impact on operating profit and the operating margin is apparent, and now that BusinessWeek’s expenses have been eliminated, and because BusinessWeek was not divested until December 1, 2009 the positive impact on year-over-year comparisons will be with us for 11 months of 2010.
Excluding the divesture of BusinessWeek revenue for the segment grew by 4.3%, and the revenue for the business-to-business group increased 4.5% instead of the reported 9.5% decline. Revenue growth at Platts was the primary driver in the business-to-business group’s first quarter. Demand for our global energy data and information products produced strong growth in both domestic and international markets.
There also was improvement in JD Power Associates and Aviation. Softness and construction reflect a difficult conditions for smaller regional contractors in the current downturn. The digital transformation of this segment continues to be a positive factor. Business-to-business digital products and services accounted for more than 60% of the groups first quarter of revenue and contributed to margin improvement.
Broadcasting produced a 2.2% revenue increase in the first quarter, benefiting from a pickup in auto advertising and some political advertising. Summing up for information and media, the 2009 sale of business will impact revenue and the operating margin in 2010. Revenue will decline in the mid single digits, but excluding $100 million from BusinessWeek will increase in the mid single digit range, and the operating margin will rebound climbing into mid teen.
That completes our review of the operations and the outlook for the segments in 2010, summing up for the corporation. This year is off to a good start, but until we get a little bit better visibility on some of the trends in our key markets, we’re maintain our original guidance of diluted earnings per share, $2.55 to $2.65.
With that, let me turn it over to Rob Bahash our CFO and go into a little bit more depth on the financials Bob.
Okay, thank you Terry. Maintaining a strong financial position is our corporate priority. We had a healthy balance sheet at the end of 2009 and we ended the first quarter in roughly the same position. Some key measures were virtually flat with our year-end position.
Total debt stood at $1.2 billion and cash and short-term investment at $1.235 billion, which resulted in a slight positive net cash position. That is comprised of long-term unsecured senior notes, as we have no commercial paper outstanding. We will look at the pre cash flow in more detail in a few minutes, but first I want to focus on the expenses for 2010.
Segment expenses were down 2.6% in the first quarter; probably expect some ramp up for the balance of the year as we make investments in technology, incurred additional expense through selling a marketing at McGraw-Hill education, and also incur expenses to increase our talent base in each of our segments to contribute to our feature growth.
Increased investments later in the year are a key reason why we are not changing our guidance after a referring a substantial increase in [substance] for share, in the seasonally slow first quarter. So let’s look at what we anticipate in each of the segments as the year unfolds.
As a remainder, for purposes of full year expense guidance, I’ll speak to adjusted expense growth, which represents expense growth adjusted to exclude 2009 restructuring charges, as well as the loss on the divestiture of Vista, and the gain on the divestiture of BusinessWeek.
Let’s start with McGraw-Hill education. The year is off to a good start. First quarter expense declined 2.6% or 4.7% at constant currencies. The segment benefited from savings from the second quarter 2009 action, to combine our core Basil publishing operation, with our alternative Basil and supplemental publishing operations, as well as reduced expenses due to the planned phase out of statewide custom contracts in California, Florida and Arizona.
For the full year 2010 as Terry indicated, we now expect segment revenue growth of 6% to 7% versus the pervious guidance of 7% to 8% increase. Despite the reduced revenue growth, we are maintaining our guidance of an unchanged adjusted operating margin, as we now anticipate the expenses to increase 6% to 7%, compared to our previous guidance of 7% to 8% increase.
Expense growth was driven by an increase in selling and marketing costs due to the robust statement of option opportunities. Given the seasonality of the business these costs are generally not significant in the first quarter. Additionally, we continue to invest in both technology and personnel to support our digital initiatives, particularly a high rate in professional, in order to provide value and choices for our customers.
For financial services, expense increased 7.5% in the first quarter. At constant currencies and excluding the impact with the divestiture expenses increased 5.4%. Through the full year of 2010, we continue to expect expenses to increase roughly 9% to 10% versus the 2009 adjusted expense.
Expense growth is largely driven by continued investments in our fast growing businesses, the carry over impact of 2009 hires, as well as planned hires in 2010, and additional investments to support our regulatory and compliance efforts. The impact of investments including new hires will be more pronounced as the year progresses.
Our expense guidance assumes approximately $20 million in additional costs, relating to our regulatory and compliance initiatives, while this is obviously highly depended on the final form of regulation.
At information and media, first quarter expenses declined 19.9%, or 20.5% at constant currencies. The divestiture of BusinessWeek reduced revenue by $27.8 million and expenses by $40 million for a positive profit impact of roughly $12 million in the quarter. The segment also benefited from restructuring actions taken in 2009.
For the full year information and media will reflect savings from the business week divestiture of $38 million, as we manage vacant space and certain other support costs within corporate expense, which is increasing approximately $13 million due to the divestiture. By 2010, reflecting primarily the divestiture of BusinessWeek, expenses are expected to decline in the low teens versus 2009 adjust expenses.
Corporate expense in the first quarter was $36 million, a $2.4 million increase versus the prior year. The increase was primarily driven by increased excess space. For 2010, we continue to expect corporate expense to increase $25 million to $30 million. The primary reason for the increase is driven by higher excess space in the year, resulting from the BusinessWeek divestiture, as well as the restructuring actions at McGraw-Hill Education. Excess space will increase later in the year when BusinessWeek moves to the Bloomberg offices.
Now, let’s discuss free cash flow. As a reminder, we could find free cash flow in the following manner. We start with cash provided by operations, due to cash flow statement. We then subtract the following items; 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 is available for acquisitions, share repurchases, or to pay down debt.
The recorder of free cash flow improved to a negative $12.8 million, compared to a negative $56.2 million in the prior year. This is by far our smallest quarter due to the seasonal nature of our businesses. We normally incur a net cash outflow in the first quarter. Improved operating results reduced their cash out way. We continue to anticipate free cash flow this year in the range of $550 million to $600 million.
Reduction of free cash flow versus 2009 is due largely to more challenging working capital comparisons, as well as increased investments, which I will address in a moment. Regarding our US Pension Plan, we still anticipate no cash funding requirements this year, but continue to expect an increase in pension expense of approximately $20 million in 2010.
Earlier I pointed out our investments would grow in 2010, so let’s take a look at some of the growth areas. Pre-publication investments were $30 million in the first quarter, a decrease of $12.8 million compared to the first quarter of 2009, largely due to timing. We expect pre-publication investments to ramp up in the second half of the year. So for the full year 2010, we continue to expect pre-publication investments of approximately $225 million to $235 million, a $48 million to $58 million increase versus 2009, primarily due to opportunities in the growing state new adoption markets.
Purchases of property and equipment were $7.6 million in the first quarter, a slight decrease versus the first quarter of 2009, but we do continue to expect full year expenditures of approximately $90 million to $100 million versus $68.5 million in 2009, and this is largely driven by increased technology spending.
Let’s now review non-cash items. Amortization of pre-publication costs was $26 million in the first quarter of 2010, a $1.5 million decrease versus the prior year. In 2010 we continue to expect $260 million to $265 million versus the $270 million in 2009. The decrease reflects the lower level of investment made in 2009.
Depreciation was $26 million in the first quarter versus $29.4 million in the first quarter of 2009. We now expect depreciation to be closer to $115 million versus our previous estimate of $120 million, due to a shift in the timing of certain capital expenditures.
Amortization of intangibles was $10 million for the first quarter, and we continue to expect it to be approximately $40 million for the full year. Our diluted weighted average shares outstanding was $316.3 million in the first quarter, a $4.2 million share increase versus the same period last year, and a $1.8 million share increase from the fourth quarter of 2009. The increase was driven by stock price appreciation, as well as issuance relating to employee plans. Fairly diluted shares at the end of the quarter were approximately $317 million.
Net interest expense was $22 million in the first quarter. That compares to $20.6 million in the same period last year, and $20 million in the fourth quarter of 2009. We continue to expect full year interest to be roughly comparable with 2009, which was $77 million. Regarding the company’s affective tax rate, the rate in the first quarter for 2010 was 36.4%, that’s unchanged from 2009, and we expect a comparable rate for the full year.
Now, well if those will not impact the tax rate, I did want to point out that in the first quarter we made a cash tax payment of approximately $35 million, due to organizational restructuring actions related to our international operations. Then we’ll largely be recovered to reduce tax payments in the second half of this year.
There has been a great deal of publicity recently regarding the Patient Protection and Affordable Care Act signed into law on March 23, 2010; and to Health Care and Education Reconciliation Act of 2010, signed into law on March 30, 2010, which together eliminate the tax deductibility of employer paid retiring prescription drug benefits, which are reimbursed by the government in accordance with the Medicare Modernization Act of 2003.
Our post retirement benefits program does not include a very significant portion of retiring prescription drug benefits, which are reimbursed for the Medicare Modernization Act. So in short, the impact of this new legislation on our financial is immaterial. All that revenue continues to grow, ending the quarter at $1.1 billion, up 2.8% from the prior year. Constant fund currency exchange rates and excluding the impact of divestitures, most notably BusinessWeek into a 4.3%.
Financial services makes up 75% of the corporation’s total unearned revenue. While comparatively slow, McGraw-Hill education continues to show strong unearned revenue growth, driven by an increase in subscription base products, particularly at higher education. For 2010, we continue to expect mid single digit growth in unearned revenue.
Lastly, I’d like to provide an update on our share repurchase program. In January, we announced that we plan to resume share repurchases in 2010. In the first quarter, we did not make any repurchases so there continues to be 17.1 million shares remaining from the 2007 authorization from the board of directors. We are then committed to resuming the program in 2010.
Thanks, and now back to Terry.
Okay. Thanks Bob and Don. Thank you. Just a couple of instructions for our phone participants (Operator Instructions) We’ll now take our first question.
You first question comes from Peter Appert - Piper Jaffray.
Peter Appert – Piper Jaffray
Thanks. Terry you mentioned in your comments that price increases at S&P were one of the drivers of revenue growth. Can you give us any specifics in terms of what you are doing from the pricing standpoint? Then the second question I just wrote is, in the context of the potential for some change in the pleading standards, how do you think you might respond in terms of business strategy or business practices? Thank you.
Okay, the price increase is again depending upon whatever we are talking about, are all pretty moderate. If you are looking at it overall, it would be in the 3%, 4% range on that.
In terms of the pleading standards and the liability standard that is part of the current senate bill, we are still hopeful that we get more clarification. We are not looking to change anything Peter, and we are certainly not saying that we shouldn’t have a liability standard. We just want a liability standard that’s consistent for all market participants and all of that.
So when they talk about in the legislation “reasonable investigation” they just leave it at that point, and what it’s really doing is leading to the court, what constitutes a reasonable investigation. So all we are pushing for is be a little bit more forthcoming, and clarify the decision, but we think we have a good chance of getting that part done.
If for whatever reason, the pleading standard for rating agencies was lower, it would impact us, because what we would do is, in terms of rating activity, we would probably not rate some smaller more speculative emerging companies, and that doesn’t do anybody any good, and it limits the capital formation process. So we are pushing hard for clarification on what a reasonable investigation is, and I think at the end of the day we’ll get that.
Peter Appert – Piper Jaffray
Okay. Thanks Terry, and then just one follow up for Bob. On the repurchase Bob, any particular reason why you didn’t jump in the first quarter, and do you have a thought in terms of how many shares you might buy this year?
No, if I mentioned on the call back in January, we indicated that we were going to enter the year on a cautious basis. So we really stayed that course for the first quarter, and I did indicate on that quarter that we would repurchase the 17.1 million shares overtime, and did not specify how much in the year, and we are really not prepared to really talk to how much for the given year.
Your next question comes from William Bird - Bank of America.
William Bird – Bank of America
I was wondering if you could talk a little bit to education and how you think about 2010 in terms of residual and open territory sales development. Thank you.
Yes, hi Bird. Yes, as we were saying, we are looking for some modest increases. Overall near a 6% or 7% revenue growth, and that would constitute some recovery in the open territories, which we saw in the first quarter on that one. So again, modest increases in the open territory, and because of Texas and Florida we see some increases there.
Thanks. Let me add some color to that. We are looking at a very robust new adoption calendar as you know, and we feel pretty good about the size of that calendar and hopefully that will hold together.
The overall increase of 6% to 7% is of course weighted to reflect the very significant percentage growth from the adoption state, but for residuals in open territories, although they performed very good in what is a light quarter, that being the first quarter, we still are being cautious for the year.
Hopefully as Terry points out we hope to see some increase, but we are anticipating roughly a decline in open territories in the 3% range on a full year basis on residuals in the high single digits, but I know Terry is encouraged by what happened in our first quarter.
We hope it carries through, but in terms of how we came to the 6% to 7%, its weighted for the very significant increase in the adoption space, with the clients both in residuals and open territories.
Your next question comes from Craig Huber - Access 342.
Craig Huber- Access 342
Incentive compensation, can you speak to how large that number was in the first quarter versus a year ago?
The incentive compensation was not a significant increase, so that’s why we did not talk about incentive compensation in terms of year-to-year change.
Craig Huber- Access 342
Okay, and then also on the non-transaction revenue, if I remember correctly, your first quarter last year was more depressed just given the timing of I guess some annual contrasts that didn’t get booked till the second quarter, usually they get booked in the first quarter. Is that correct; in other words, I assume you are not assuming up to 8% for non-transaction for the year, correct, as you are on the first quarter?
I am not sure, can you ask that again please.
Craig Huber- Access 342
I am sorry. Was your non-transaction revenues in the first quarter a year ago artificially depressed because of timing, that probably 8% growth this year was kind of artificially high?
That’s correct. That’s right. We are expecting growth this year, but last year it was artificially higher, correct.
Craig Huber- Access 342
Okay. Then my last question please, can you just give us a ballpark of your digital revenues within elementary, high school and college, how much does digital represent of the revenues in each of those areas, and your outlook for these unit percentages?
Well, digital revenue overall for McGraw-Hill Education in total that came through professional is still in the single digit levels, and that’s influenced more by the lower percentage of digital coming out of your K-12 space.
On the other hand, when we look at the higher education professional, that’s where we are seeing some significant growth, and that relates to the point I mentioned about the growth and on revenue.
A big contributor to our year-to-year change in higher education revenue in the first quarter is coming from digital, which is getting up close to half of the growth that we saw. Professional represents, because of the nature of that business. Almost 25% of the revenue of professional is digital and higher education is a pre-solid number as well. So it’s roughly in the range of 14%, 15% for the higher education professional international segment and growing.
Yes, and growing at a faster rate.
Craig Huber- Access 342
If I can just ask one other thing Terry, you spoke a little bit about the US bank loan market, what is sort of your outlook for this year for that market, and I guess for Europe as well?
As in the first quarter, and what we project for the rest of the year and probably into 2011, we see a good high yield market, and the bank loan rating market being very solid as well. So both of those markets I think are going to be contributors all year on that one, as is the public finance market.
Your next question comes from Brian Shipman - Jefferies.
Brian Shipman – Jefferies
First question is, what was pricing like in the higher education textbook market? Then second, with respect to financial services, just quickly on capital IQ, what area of this business functionality would you like to improve, fixed income being important, and how would you weigh the bill versus buy decision? Thank you.
Good morning Brian. Pricing on the higher hand, again it differs a little bit by category, but overall about 4%. On the capital IQ side, its across the board, both in terms of the pre-trade and post-trade net aspects of the market, and we are looking for a functionality increased capabilities in terms of a number of portfolio management capabilities, both on the equity and the fixed income side, so it’s across the board.
Brian Shipman – Jefferies
How would you weigh the build versus buy decision on that investment possibility?
Well, first of all you’ve got to have a very very steady and comprehensive organic growth component here. You are constantly working the customer needs and developing product there as well, and obviously being able to add certain data sets and as well as analytic capabilities as well. We like the organic side of this, but are also looking at a number of transactions that could also enhance a customers offering.
Your next question comes from Sloan Bohlen - Goldman Sachs.
Sloan Bohlen - Goldman Sachs
Just two questions; first is kind of an update on the legal liability standards and kind of where you think credit rating agency reform falls within the list of things to be debated. If branch linking is maybe the first thing that people are talking about, how much airtime is legal liability for you guys giving?
Well, again we are talking about the completion of the financial overhaul reform bill, and as the senate version now has it, the legal liability standard is something that we think is very justifiable and important to the bill for us. What we are again looking for is clarification of what? Reasonable investigation leads and if you read leave of these things sort of ambiguous you’re leaving it to the courts to define where they are.
We think at the end of the day that we’ll see some clarification on the language, that’s all we’re talking about. We’re not talking about reducing the liability standards. We think that the liability standard for all market participation should be the same and not different from one of the participants namely us on that one. So if we can clarify some of the language and I think that should be a pretty easy lift on that one, we are fine.
Sloan Bohlen - Goldman Sachs
And then just question on capital allocation and color on the rationale and share repurchases, but is it that financial form that you are working to get through the other and look at putting more capital to work for purchase is a potential acquisitions?
Yes, again we are balancing all aspects of organic acquisition, share repurchase, and so forth. We have been obviously very committed to share we purchase. We announced that we are going to resume it and we will be into that very shortly. We are excited about the share repurchase component.
Sloan Bohlen - Goldman Sachs
Okay, and just a follow on to that on the potential acquisitions, is there a thought to sizing or what potentially could be put to use in 2010.
Yes, I mean again I think that the activity has picked up and we are obviously looking at all aspects of this, but again we have a very large organic component right now, and most of our transactions are smaller in nature that we are looking at.
Your next question comes from Michael Meltz - JCMC.
Michael Meltz – JCMC
Just two quick questions, what was the actual revenue loss from testing contracts and education in Q110 and what should that run in the next few quarters?
We do not disclose that size of that revenue, but we simply are pointing out that we are shifting our focus here very heavily to the formative testing opportunities with our acuity program, which is just growing very, very rapidly.
This is an electronic based program. We are seeing tremendous market gains and shares and such, and some of the contracts that we had was just simply older contracts that where lower margin contracts that we chose to let them wind down, but we don’t break that out specifically.
You know Michael the growth is going to be on the formative side and it is going to be very, very important, and when we start talking about the common core standards and the role that assessments going to be playing, with assessment being embedded into the education materials, it’s going to take on even more significant and so that’s what we are doing. We are concentrating more on the formative side and pulling back from some of that large custom contracts that year before we’ve been in.
Michael Meltz - JCMC
And then just a quick follow up. For the Information & Media business, in 15% to 20% I know you guys gave guidance for the margin for the year, but is that a run rate your comfortable with going forward, 15% to 20% margin?
Yes at this point it’s a little early, but the mid margin range is probably what we are more looking at here.
Your next question comes from Edward Atorino with Benchmark
Edward Atorino - The Benchmark Company
I know television is pretty small, but some broadcasters reported double-digit gains and your reporting only 2%. Was there anything in your markets that kept the growth rate down?
Except for the fact that obviously in some of the network compensation issues for us, we’ve dealt with that net upfront and again as you know, we are paying ABC now. They are in the reverse and there’s that effect, but I think it’s going to be a much-improved year and especially for us in the San Diego and Denver markets, and some of the Hispanic TV affiliations, they are looking good.
I think that the [pogo] advertising one is the wild card for this year, and we are clerical advertising in the first quarter. Usually you won’t see until the end of the second quarter, but we are already starting to see it.
Edward Atorino - The Benchmark Company
What are your pacings for the second quarter in television?
Pacings are running much better than the first quarter Ed.
Edward Atorino - The Benchmark Company
You don’t want to be any more specific in that.
No, it’s just that it’s early in the quarter at this point, but right now our pacings are running pretty good.
Your final question comes from [Drew Figdor – Peterman & Co.]
Drew Figdor – Peterman & Co.
We read in the reports recently about the whole IDP situation thing, and I saw in these reports recently you guys pulled out of, and also if you can help us understand what your current strategy is with relation to M&A, sort of if you like an opportunity that seem to fit with you. So whether you guys weren’t interested in things sue to size or weather it was something more specific?
We are looking hard across the board in terms of all three operating segments, but again any kind of transaction needs to fill a gap that we would have in terms of any kind of customer offering, but we have to stay very active in the market and we continue to look at a lot of different things, and we’ll weight them relative to the other offerings that we have.
That concludes this mornings’ call. A PDF version of the presenter slides is available nor for downloading from www.mcgraw-hill.com. A replay of this call will be available in about two hours. On behalf of the McGraw-Hill company we thank you for participating and wish you a good day.
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