The McGraw-Hill Companies (MHP) Q3 2010 Earnings Call October 26, 2010 8:30 AM ET
Robert Bahash - Chief Financial Officer and Executive Vice President
Harold McGraw - Chairman, Chief Executive Officer, President and Chairman of Executive Committee
Donald Rubin - Senior Vice President of Investor Relations
Douglas Arthur - Evercore Partners Inc.
Michael Meltz - JP Morgan Chase & Co
Craig Huber -
Peter Appert - Piper Jaffray Companies
Brian Shipman - Jefferies & Company, Inc.
Edward Atorino - The Benchmark Company, LLC
Good morning, and welcome to The McGraw-Hill Companies Third Quarter 2010 Earnings Call. [Operator Instructions] I'd now like to introduce Mr. Donald Rubin, Senior Vice President of Investor Relations for The McGraw-Hill Companies. Sir, you may begin.
Thank you. And good morning, to our global audience, and thank you for joining us for the The McGraw-Hill Companies Third Quarter 2010 Earnings Call. I'm Donald Rubin, Senior Vice President, Investor Relations for The McGraw-Hill Companies. With me this morning are Harold McGraw III, Chairman, President and CEO; and Robert Bahash, Executive Vice President and Chief Financial Officer. This morning, the company issued a news release with third quarter results. We trust you've all had a chance to review the release. If you need a copy of the release and financial schedules, they can be downloaded at www.mcgraw-hill.com. Once again, that's 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 U.S. Securities and Exchange Commission.
We are aware that we do have some media representatives with us on the call. However, this call is for investors, and we would ask that questions from the media be directed to Jason Feuchtwanger in our New York office at area code (212)512-3151 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 very much, Don, and good morning, everyone, and welcome to our review of the third quarter earnings. As Don mentioned with me this morning is Bob Bahash, he's our Executive Vice President and Chief Financial Officer. And I'll start by reviewing the third quarter results and our new guidance on earnings for 2010. After our presentations, obviously, we'll go in any direction you would like and answer any questions or take your comments about The McGraw-Hill Companies and our prospects.
Earlier this morning, we reported a 15% year-over-year increase in diluted earnings per share for the third quarter, earnings per share of $01.23, now that included a $0.02 gain on some divestitures and a $0.01 dilution on the acquisition of TheMarkets.com. Revenue grew by 5.5% in the third quarter, but increased 6.8% if you exclude the divestiture of BusinessWeek. Based on that strong performance in the seasonally most important quarter of the year, we are increasing our guidance for 2010. We now anticipate earnings per share this year in the $2.60 to $2.65 range, and we expect to achieve the high end of that range. The new guidance excludes the one-time gain of $0.02 from divestitures, but does include dilution of $0.02 from acquisitions. There were many contributors to our strong third quarter. We are very pleased to be firing on so many cylinders. This morning, we'll provide the details on how those results were achieved.
Let's begin with the review of the Financial Services segment. The third quarter is normally the slowest each year in the Ratings business, but not this year, when S&P Credit Market Services produced the most revenue in any quarter so far this year. It is also noteworthy that the growth is coming without the benefit of a recovery in the structured finance market and despite a decline in European issuance. Revenue for S&P Credit Market Services in the third quarter increased by 11.1% based on strong performances in domestic markets. Domestic revenue grew about 20.9%. International revenue was up 0.9%. Revenue for S&P Investment Services grew by 6.3%. For Financial Services in the third quarter, revenue grew by 9.5%, including a $7.3 million pretax gain on divestitures. Operating profit increased by 6.6%. The operating margin was 39.2%, and it reflects the pretax gain on the divestitures and increases in incentive compensation, incremental cost for compliance and substantial staff increases overseas, basically and mainly in India and the acquisition of TheMarkets.com. Our revenue growth was driven by increased refinancing activity, the investors search for yield, a robust bank loan market and recovery in the equity market, which benefited S&P Indices.
Spreads, the excess interest rate over treasury bonds is a key factor in the level of issuance volume. The composite spread on speculative grade bonds hit a two-year low at the end of April at 553 basis points and then began widening, but spreads began tightening in September and as our table shows, that trend has continued into October. At S&P Credit Market Services, the global high yield new issue market took off in the third quarter. After a slight decline in new issuance in July compared to the same period last year, the global high yield markets started climbing in August, and kept on climbing in September. The global high yield market has already produced more new issued dollar volume in nine months this year than it has in any previous single year. Companies are taking advantage of falling yields to refinance debt and repair the their balance sheets, as this S&P report shows, more than 2/3 of the high yield volume in the United States went for refinancing in the third quarter and for the year-to-date. High-yield issuers are finding a receptive market as investors search for yield at a time when cash is producing anemic returns. And as banks continue to deleverage, investment grade issuers are also stepping up their activity in the bond market to lock in low yields.
The composite spread for investment grade bonds widened over the past month when it was 200 basis points. The spread in mid October of 203 basis points is still slightly above the five-year daily moving average of 198 basis points. Global bank loan ratings also soared in the third quarter, although the absolute volume is still on the low end of the historical averages, fundamentals remained strong, liquidity is good in the United States, and only slightly less so in Europe. There is usually a seasonal slowdown in the summer months and in municipal market, but while the dollar volume of public finance issuers declined in the third quarter, deal volume actually increased. It was fueled by refundings, which were up 11% and the taxable Build America Bonds program, the taxable bond program, which was launched last April has been a boon to municipalities. Taxable bond debt year-to-date accounts for 32% of the muni market.
The structured finance market is still struggling to recover. The current residential mortgage-backed securities market cannot compete with the spreads on structured vehicles that benefit from explicit or implicit government support provided to Fannie Mae or Freddie Mac or Ginny Jamie. Refinancing needs have been the source of securitizations for residential mortgage-backed and commercial mortgage-backed securities this year, but re-REMIC activity declined in the third quarter, and the residential mortgage-backed market remains under pressure in the face of continued uncertainty over home prices and a sluggish economic recovery.
We are seeing AAA-rated three-year spreads across major asset-backed asset classes, and this would include auto, credit card receivables, student loans, and we're seeing these spreads continue to tighten. The asset-backed securities market has benefited all year from strong auto and student loan issuance, which helped offset a general slowdown in credit card issuance, new regulatory requirements and higher capital cost of bank securitizations have tempered credit card issuance this year. New issuance in the fourth quarter is off to a solid start for corporate. It appears that high-yield issuers are continuing to find a receptive market, and investment grade issuers are still taking advantage of attractive funding rates. We also expect cash to continue to pour into the leveraged loan market, filling the institutional pipeline. Favorable rates and heavy demands should continue to fuel this market.
The structured finance market will also have to adjust to a number of new measures, resulting from the Dodd-Frank legislation, also the new FDIC Safe Harbor rules and new SEC regulations that impose restrictions on sponsors of securitization and greater regulatory oversight on transactions. Greater disclosure and transparency will benefit investors and after a period of adjustment, S&P expects the use of securitization to be a significant funding tool for many issuers in the years ahead.
At S&P Investment Services, growth at S&P Indices and expansion by Capital IQ were clearly third quarter highlights. Assets under management based on S&P Indices and exchange traded funds set a new record at the end of September, $260.4 billion. That's a 17.9% year-over-year increase and a 12.9% sequential increase over the second quarter of 2010. Growth in spiders and high shares in exchange traded funds were major contributors to the growth.
19 new exchange traded funds links to S&P Indices were launched in the third quarter. That includes nine new Vanguard exchange traded funds based on our core U.S. indices, including the S&P 500. So in the aggregate now, there are 278 exchange traded funds based on S&P Indices. There also was 7.3% growth in the average daily volume for major exchange traded derivatives based on S&P Indices. The daily average in the third quarter was 3,069,000. At the end of each quarterly report, you can expect more new indices from us. This quarter is no exception. You can expect them in various asset classes, including commodities, fixed income and equities. It was also a historic first for S&P Indices in the third quarter. They licensed the Options Clearing Corporation to handle trades of over-the-counter S&P index-based option contracts and to receive royalties. This is the first time S&P has licensed its indices to a clearinghouse for central counter-party clearing.
Capital IQ continued its expansion in global markets, with the acquisition in September of TheMarkets.com. The acquisition positions Capital IQ for significant growth on the buy side. There is only modest overlap between TheMarkets.com's more than 2,000 clients and Capital IQ's 3,300 clients. We expect in the aggregate to add clients, and revenue, great cost synergies and to grow in both domestic and international markets. With this acquisition, Capital IQ now has earnings models, estimates, fixed income, research that are all a part and a key part of the buy side's workflow. This diagram illustrates how the acquisition improves Capital IQ's competitive offering to the buy side, private equity, venture capital, Investor Relations, as well as the business development departments at corporations. Those open circles indicate little or no availability. The acquisition fills in, and this acquisition fills in these circles with a complete investment research and analysis platform for asset managers worldwide based on contributions for more than 1,000 research and estimate contributors.
On the regulatory front, a lot of the uncertainty is now behind us. S&P has filed its application as called for by the European regulations, which took effect on September 7. S&P expects to be registered later this year. S&P received its license in Japan as an approved agency before the October deadline, and we're also discussing new regulatory proposals with Hong Kong, Canada and Taiwan. In the United States, SEC rule making will be required to implement many of the provisions of the new Dodd-Frank Act. We continue to engage with the SEC and market participants as part of the rule-making process.
In anticipation of new regulations, S&P has made significant investments in technology platforms and staffing for quality, criteria, compliance and risk management. We call this our QCCR framework, and again, that's quality, criteria, compliance and risk. And these are four individual groups within S&P that performed these various functions. In 2009, S&P spent about $63 million for QCCR-related items. This year, spending will increase by about $15 million, mostly in the second half of this year and on a preliminary basis, incremental cost next year could be somewhere in the $12 million to $15 million range, and we're still trying to narrow in on that. Price increases have helped us to mitigate some of these costs, including the incremental expenses for QCCR-related items, we expect that price increases will help us again next year.
We also continue to monitor the impact of new regulations on bank lending. Regulators are forcing banks to shrink their balance sheets. It is already apparent that banks are retrenching and ceding out one of the busiest periods in the corporate bond market. With banks expected to keep more capital, it is inevitable that they will support less debt, and reduced bank lending is obviously a plus for the public debt markets.
Our assessment of legal risk facing the corporation is low, and that remains unchanged. 15 of our motions to dismiss complaints have not been granted, and five more cases have been withdrawn, that's 20. Last Friday, there was another favorable ruling in the case of Rice versus S&P and Moody's, a federal district court in California dismissed, with prejudice, a complaint concerning plaintiffs investments in Fannie Mae securities. There was some key points in this decision that we're studying. In dismissing the intentional misrepresentation claim, Judge Cormac Carney wrote, and I quote, "Defendants credit ratings are opinions of the future creditworthiness or value of companies and therefore, are not actionable unless plaintiffs can demonstrate the defendants' representatives who publish credit ratings actually knew that credit ratings were false or did not believe that the credit ratings were true at the time that each credit rating was issued". The judge also recognize that a negligent misrepresentation claim concerning a professional opinion can only be stated by "A narrow and circumscribed group of persons to whom or for whom the misrepresentations were made. The rational for limiting liability to a specific group of persons is to protect professionals, who provide information from unlimited and uncertain liability". In these important ways, this ruling recognizes limitations facing plaintiffs, who seek to assert legal claims concerning to S&P's ratings.
In Italy, there was a development earlier this month in the prime lot litigation, which got started in the fall of 2005. On October 1, two court-appointed expert, both accountants, filed a report that was critical of the ratings assigned to prime lot by S&P during the timeframe of 2000 to 2003. The S&P expert disputed the methodology, findings and conclusions of the accountant report, which is a matter of laws not binding in court. The judge who appointed the two accountants to assist her in her determination has scheduled a hearing in early January. We continue to believe that the outcome of this litigation against two subsidiaries of The McGraw-Hill Companies should not have any material adverse effect on our condition.
Let's sum up for Financial Services. We expect revenue growth in the mid-single digits. We had expected a 100 basis point decline in the operating margin. We are now expect 150 basis point decline in the operating margin, primarily due to the acquisition of TheMarkets.com.
Okay, with that, let's move over to McGraw-Hill Education operations. In the seasonally most important quarter of the year for Education, we grew both in the elementary-high school market and in the U.S. Higher Education markets, and we did so with an operating margin of 33.9% for the segment. And this includes a 40 basis points from the gain on a divestiture. That still makes this year's third quarter performance by McGraw-Hill Education the best since 2007 on an operating margin of 35.0% was reported.
For McGraw-Hill Education in the third quarter, revenue increased 5.5%. Operating profit, including the $3.8 million pretax gain on the divestiture, grew by 19.9%. The operating margin of 33.9% compares to 29.8% for the same period last year. Control of costs and expenses and improved results in the elementary-high school market and the U.S. Higher Education market contributed to this performance. Revenue for the McGraw-Hill School Education Group increased by 6.7%. Revenue for the McGraw-Hill Higher Education professional and international grew by 4.3%. As we had expected, state new adoptions were key to our performance in this year's el-hi [elementary-high] market. We're on track to capture about 30% of this year's state new adoption market at 825 million to 875 million this year, the state new adoption market will grow 65% to 75% over last year. This increased spending is the prime reason why we expect the el-hi market to grow 4% to 6% this year.
According to the most recent AAP, that's the Association of American Publishers' report, sales in the el-hi market were up 8% through August because of a 24.7% increase in state adoption sales. Open territory sales after eight months were down 7.3%. These non-adoption states represented 44.8%, roughly 45% of this year's revenue. Based on the August results, the el-hi market could hit the high end of our 4% to 6% growth forecast if industry sales remained flat with the last four months of 2010. As this marked chart shows, industry sales grew in each of the last four months of 2009, so achieving that level of growth will be challenging. September results for the industry are not yet available, but indications are that overall sales slowed during the month, adding to the challenge. For McGraw-Hill, however, September was another strong month, especially in adoption states.
Reading, literature and math represented the biggest revenue opportunities in this year's state new adoption market. The McGraw-Hill School Education Group did particularly well in the very large K-5 reading market, with strong performances in Texas and California. The school group expects to capture about 45% of the K-5 reading market and approximately 32% of the K-12 reading and literature opportunity. This school group's K-5 Treasures program is the key to its success in reading. In math, the school group expects to win more than 40% of the secondary school market, with programs in Florida, California, Indiana, West Virginia and Oklahoma. But underperformance in Florida's K-5 math adoption will probably hold our overall capture rate in K-12 math to about 28%.
Open territory sales were down in the third quarter for us, as well as for the industry, a reflection of budget pressures in such states as New Jersey, Michigan, Illinois and Missouri. In testing, the third quarter is normally slow and this year, we had the additional impact of the planned phaseout of custom contracts in Florida, California and Arizona. Procedural delays in signing some important contracts were also a factor, but those issues will be settled in the fourth quarter, a seasonally important period in the testing market.
A really fine year is taking shape in the U.S. Higher Education market. For the second year in a row, the U.S. Higher Education market is benefiting from increased enrollments. An important driver is the federal government's huge step up in the student aid area under the new administration, spending on student aid has increased by nearly 50% to $145 billion. We think increased aid is reflected in the growing Higher Education enrollments that we are seeing at the start of the new school year. Preliminary information indicates that fall enrollments at colleges and universities grew by 4% to 5% this year, an increase we had not anticipated at the beginning of 2010. Enrollments in the fall of 2009 grew by 7% to 8%. All of our major product lines produced year-over-year growth in the Higher Education market in the critical third quarter, and there is added impetus from the double-digit growth of digital products and services. Our lineup of homework management, assessment and tutoring products for college and university students is gaining traction and expanding the addressable market.
Through September, registrations for these products have grown to $1.9 million, a 26% year-over-year increase. McGraw-Hill Connect, that's our all digital teaching and learning platform, is our leader in this rapidly growing market, and we continue to strengthen it. That's why we recently acquired Tegrity whose scalable, automated lecture capture service has become a core feature of McGraw-Hill Connect since it was introduced last fall. Lecture capture gives students the ability to review material presented in the classroom any time, anywhere, for replay online or on any mobile device. That is a powerful tool for studying and learning. More than 200 educational institutions already use the Tegrity cloud-based service.
We have also launched McGraw-Hill Create. It is a Google-like search engine that enables instructors to customize quality content for their courses. They can draw in 4,000 McGraw-Hill textbooks, 5,500 articles 11,000 literature, philosophy and humanities readings, and 25,000 business case studies from such providers as the Harvard Business School. Once a customized text has been developed on Create, the instructor can get a digital review copy in less than an hour. Printed review copies will be delivered in only three to five days. Students can purchase McGraw-Hill Create eBooks to the McGraw-Hill eBook store or buy printed copies at the campus bookstore. And through the recently announced partnership with Blackboard, instructors will have access to the full suite of McGraw-Hill Create content through their Blackboard accounts.
If you're looking for a window into our future in digital and international markets, take a look at this next slide. It's a custom site for the Arab Academy for Science, Technology and Maritime Transport in Egypt. It is hosted on McGraw-Hill Education's international Create eBook Store, which is now live around the world. The McGraw-Hill Create eBook store made it possible to deliver 36 titles to this Egyptian institution for students to use in their new semester. The customer selection of 36 titles underscores the scope of McGraw-Hill's global content creation. The list includes titles drawn from U.S. McGraw-Hill Higher Education or U.S. professional catalog, as well as original titles published by our subsidiaries in India and in Europe. Because of the capabilities of McGraw-Hill Create, 30 of the titles will be delivered directly to students using institutionally purchased access codes at the school's request. Six titles will be delivered as eBooks for testing the student experience with the enTourage, that's the Ed.D trademark, it's a new e-reader.
Another site has been established at the Rotterdam School of Business in the Netherlands using McGraw-Hill Create. That micro site will host 29 custom eBooks from our catalog for student purchases. One more observation about using McGraw-Hill Create delivery, is this world, we're not supplying a physical product. That means no printing, no binding cost, no inventory of warehousing cost, no shipping charges, no returns and no used books. Clearly, connecting content and managing digital assets globally is a powerful combination that is creating new opportunities as we shift away from our legacy model to an interactive and digital model.
The same transition is taking place in professional markets. Here, we're seeing an acceleration in the online ordering of hard copies and a huge increase in the sale of eBooks. Since the beginning of the year, our eBook sales through the major eBook retailers to consumers have nearly tripled. Our best-selling eBooks in the third quarter ranged from the Presentation Secrets of Steve Jobs, to the famous Graham and Dodd's work, Security Analysis. We have more than 5,000 professional titles available as eBooks.
Even with the continued rapid growth of digital products and services, the fourth quarter this year will be challenging. Last year, we had a significant upswing in operating profits based on the surge in the second quarter semester orders in the U.S. Higher Education market, and improved results in the professional and international markets. The bulk of second semester ordering in Higher Education sometimes occurs in December and in other years, it comes in January, complicating the balancing between the fourth quarter forecasting in this market. The U.S. Higher Education market is forecasted to grow 8% to 10% this year. There is pent-up demand in the el-hi market, but budget pressures are continued to constraint school district spending in many regions. The arrival of new federal funds could positive factor, however. The McGraw-Hill school education group sales teams are still working on a number of large basal adoptions in the open territories, as well as some excellent fourth quarter opportunities for intervention products across the country. Federal funding will clearly play a part in some of these purchases, but in other cases, it will be harder to identify because large district orders tend to be paid for through a blend of funding sources, so it's difficult to predict what will materialize.
So with that, let sum up our McGraw-Hill Education revenue. We still expect a low single-digit increase, operating margin, we had been forecasting flat margins. We now expect an improvement of 200 basis points to 14% for 2010.
Okay, let's move over to our review our third segment, and that's the Information & Media segment. Key contributors to this segment's third quarter performance were the continued solid growth of our Global Energy Information business, an increase in television advertising and the effect of the business we have divestiture. In the third quarter, revenue declined by 4.7%, but excluding business week, it actually grew by 5.1%. Operating profit increased by 55.1% or $16.3 million. The operating margin was 20.1%, up from 12.4% for the same period last year.
The Business-to-Business Group's revenue declined by 7.1%, but excluding BusinessWeek, increased by 3.3%. In volatile energy markets, the demand for Platts data and information products continues to drive strong growth in both the United States and international markets, and incidentally more than 60% of Platts' revenue comes from outside of the United States. Platts is growing rapidly across a number of commodities. It is continuing to expand its coverage of the refined petroleum markets in the United States, Europe and Asia, with new price assessments in gasoline, fuel oil, naptha, naptha, being the raw material for gasoline.
Platts expanded its suite of daily spot price assessments to include alumina, that's a mineral produced from bauxite ore that is used to make aluminum. The new price assessments, the world's first daily price references for alumina address the needs of miners, smelders, refiners and traders for the independent source of open market spot prices to better determine valuations for short and long-term contracts. Platts also began producing new price assessments in the India coal market. India's thermal coal imports are changing trade flows radically, and increasing the need for expanded more frequent and transparent price information. These new assessments address the needs of power producers, coal traders and ship brokers for an independent source of India-related open market spot prices, making Platts even more relevant in this growing market.
There was some softness in construction, particularly among smaller regional contractors, who have been hardest hit by the declining activity in this market. Weakness in the global Automotive business offset improvements in the non-auto parts of the market at J.D. Power and Associates. Revenue for the Broadcasting Group increased by 23.5% to $23.6 million. The combination of political advertising and improved local and national time sales accounted for the increase. In this political season, the contest for governor and heated race rates for a Senate seat and issue related advertising in Colorado are attracting significant ad dollars.
Therefore, summing up for Information & Media, there is no change in our revenue guidance. We still expect the revenue decline in the mid-single digits, but mid-single-digit growth excluding BusinessWeek. We now expect the operating margin in the mid to high teens. we Had anticipated an operating margin in the mid-teens, and now we're addressing that upwards a little.
That concludes our review of the operations and therefore, summing up for the corporation. We anticipate earnings per share in the $2.60 to $2.65 range, and expect to achieve the high end of that range. The new guidance excludes $0.02 of the onetime gains from divestitures, but includes dilution of $0.02 from acquisitions. Okay, let's hold it there and with that, let me turn it over to Bob Bahash, our Chief Financial Officer, for his results.
Okay, thank you, Terry. It's been an active and productive the third quarter. So this morning, I'm going to focus on strategic acquisitions, divestitures, share buybacks, improved outlook for cash flow and expenses. Now we recently announced three acquisitions: the Research and Estimates Business of TheMarkets.com for Capital IQ; Tegrity, which becomes part of the McGraw-Hill Higher Education Professional and International Group; and PIPAL Research by CRISIL. The acquisition of Tegrity closed in October and Pipal Research is expected to close in the fourth quarter.
We expect to spend approximately $360 million on these acquisitions and a recent equity investment in Ambow Education, a leading provider of educational and career enhancement services in China. The most significant of these acquisitions, of course, is TheMarkets.com, of diluted earnings per share by $0.01 in the third quarter, and will do so again in the fourth quarter. In 2011, TheMarkets.com acquisition is expected to generate approximately $60 million in revenue and despite an anticipated $15 million in intangible amortization, the acquisition will be both accounting and cash flow accretive in 2011. We also had three divestitures in the third quarter, a small secondary school business in Australia, which generated a $3.8 million pretax gain and two by CRISIL. They are a 7% equity interest in the National Commodity and Derivatives Exchange of India. We continue to maintain a 5% ownership, the divestiture of the 7% was required to comply with local regulations regarding foreign ownership rules. And also, CRISIL's remaining 10% interest in Gas Strategies Group, the 90% interest we had sold that back in December of 2008.
The two CRISIL divestitures this year generated $7.3 million in pretax gains. Now because CRISIL is a non-wholly-owned subsidiary, part of the gain is deductive for purposes of calculating EPS, and is shown as a component of net income attributable to non-controlling interest. This was $2.3 million, which represents the post-tax portion of the gain attributable to the minority owners of CRISIL. In addition to the acquisitions, we continued to actively repurchased shares. In the third quarter, we repurchased 2.2 million shares for a total cost of $69 million at an average price of $31.14 per share.
Year-to-date, we are purchased 8.7 million shares for $255.8 million, averaging $29.37 per share. 8.4 million shares remained in the 2007 program authorized by the board. Our diluted weighted average shares outstanding was 309.3 million in the third quarter, a 4.4 million decrease versus the previous year due primarily to the full year impact of the second quarter share repurchases. Diluted weighted average shares outstanding declined 3.9 million for the second quarter, reflecting the full impact of second quarter share repurchases, as well as the weighted impact of third quarter share repurchases. Fully diluted shares at the end of the quarter were approximately 308 million.
We continued to be well capitalized with net cash and short-term investments as of September 30 of $158 million. The shift to a net cash position from a net debt position of $53 million at the end of the second quarter is driven primarily by strong free cash flow, partially offset by funding for acquisitions and share purchases. Cash and short-term investments at the end of the quarter totaled $1.356 billion, while gross debt was comprised of approximately $1.2 billion in senior notes. Our debt is entirely in long term unsecured senior notes, no commercial paper is outstanding.
The outlook for free cash flow continues to improve. Now to calculate free cash flow, we start with our after-tax cash from operations and deduct working, investments and dividends. What's left is free cash flow, funds we can use to repurchase stock, make acquisitions or pay down debt. During the third quarter, our seasonally strongest quarter, we generated free cash flow of $552 million. Year-to-date in 2010, we generated free cash flow of $651 million versus $507 million in the same period last year for an increase of $144 million. The improvement is due primarily to stronger operating results and a continuing focus on asset management. We now expect free cash flow this year to be clearly in excess of $700 million versus our previous guidance of $600 million to $650 million. The improvement is driven by stronger operating results, reduced capital investment projections and more favorable working capital than previously anticipated. Just as a reminder, free cash flow last year was $770 million.
Regarding our U.S. pension plan, we made a $14 million discretionary contribution in the third quarter, and we anticipate making an additional discretionary payment in the fourth quarter, potentially in the range of $50 million, and that is factored into the free cash flow projections.
Now let's look at expenses. As a reminder, I'll
Speak to adjusted expense growth, which represents expense growth, excluding 2009 restructuring charges, as well as 2009 and 2010 gains and losses on divestitures. So let's start with Education. Third quarter adjusted expenses were roughly flat, declining 0.1%. Year-to-date, adjusted expenses declined 1.3%. Contributing to the lower expense levels were two key decisions last year. The first was to combine the core basal publishing operations with our alternative basal and supplemental publishing operations. The second was the planned phaseout of statewide low-margin custom test contracts in California, Florida and Arizona. A $15 million decline in amortization of prepublication cost also benefited third quarter results. Increases in selling and marketing cost for the robust state new adoption opportunities and continued digital investments partially offset these savings. As Terry has indicated, we now expect margin improvement of approximately 200 basis points versus our previous guidance of flat margins.
For Financial Services, adjusted expenses increased 13.3% in the third quarter and 12.8% at constant currencies. Year-to-date, adjusted expenses increased 10.1% and 9.3% at constant currencies. The growth in expenses in the third quarter and year-to-date was driven by increased salaries and occupancy cost, primarily for international hires and higher incentive compensation.
Third quarter expenses were also impacted by TheMarkets.com acquisition, that resulted in an incremental $5 million in expense. There also was $5.4 million in additional cost related to our regulatory and compliance initiatives. Now taken together, these increased total Financial Services expense by 2.7%. The fourth quarter is expected to show a comparable increase in cost related to our regulatory and compliance efforts. We're still projecting additional full year cost of approximately $15 million, as Terry stated.
One last comment on Financial Services. Third quarter expense growth in the beginning of the year, I indicated that total stock-based compensation for McGraw-Hill was expected to increase roughly $30 million versus 2009, due to the three-year earning and vesting period, which is off a depressed base. Due to stronger operating results, we now expect an increase of roughly $40 million. The majority of this increase as anticipated was realized in the third quarter due to particularly depressed levels in the third quarter 2009. As a result, Financial Services had a $10.6 million increase in stock-based compensation for the quarter.
As Terry indicated , we now expect Financial Services margins to decline by approximately 150 basis points, which implies expenses will increased roughly 9% to 10% versus our previous guidance of 7% to 8%, and increases largely driven by TheMarkets.com acquisition.
At Information & Media, third quarter and year-to-date adjusted expenses declined 13.1% and 17.4%, respectively. The divestiture of BusinessWeek reduced third quarter revenue by $22 million and expenses by $32 million for a positive profit impact of roughly $10 million for the quarter. Year-to-date, the divestiture of BusinessWeek reduced revenue by $78 million and expenses by $111 million for a positive profit impact of $33 million. And of course, for the fourth quarter, the divestiture of BusinessWeek is expected to reduce revenue by $22 million and expense by $27 million. The positive impact here is $5 million. This will result in full year savings of $38 million.
For 2010, we expect adjusted expenses to decline in the mid-teens versus our previous guidance of the decline in the low teens. Corporate expenses in the third quarter is $44.4 million, a $16.5 million increase versus the prior year. The increase was primarily driven by increased incentive compensation compared to lower levels in 2009, as well as normal increases due to the stronger operating results. Increased excess vacant space was also a contributor to increased corporate costs.
We are making progress in reducing excess space. We finalized one agreement to sublease some excess space in New York this month and have received several promising inquiries regarding additional space. Because we are subleasing the space at lower rates than what we are currently paying, the accounting rules require us to take a one-time charge for the difference between the present value of the payments we will receive versus the payments we will have to make over the term of the lease. Our new earnings per share guidance excludes this one-time charge, since we are still finalizing accounting for this charge.
Now excluding the charge, we now expect full year 2010 corporate expense to increased $30 million to $35 million versus our previous guidance of an increase of $25 million to $30 million due to additional incentive compensation accruals. Net interest expense was $19.3 million in the third quarter compared to about $18 million in the same period last year and $21 million in the second quarter of 2010. We continue to expect full year interest to be roughly comparable to 2009, which was roughly $76.9 million. The company's effective tax rate in the third quarter and year-to-date was 36.4%, which is unchanged from 2009. We expect a comparable rate for the full year.
Now let's turn to investments. The publication investments were $39.3 million in the third quarter, $5.4 million lower than last year. Year-to-date, pre-pub investments were $99.3 million, a $30.4 million decrease versus the prior year. For the year, we now expect pre-pub investments of approximately $160 million, and that's versus our previous estimate of the $195 million to $205 million.
Now the reduction in our pre-pub investment estimate is due to several factors. First, the timing of the adoption of Common Core Standards by various states. To date, 36 states and the District of Columbia have adopted the standards for K-12 math, reading and language arts. Also, we continued to reevaluate several programs to enhance our digital offerings. These actions have caused timing delays for a number of our pre-pub investments. In addition, we continue to realize savings from combining the core basal publishing operations with our alternative basal and supplemental publishing operations.
Now purchases of prop and equipment were $16.6 million the third quarter, about $1 million higher than last year. And year-to-date purchases were approximately $39 million. We now expect on a full-year basis the expenditures to be in the $70 million to $80 million range versus our previous estimate of $90 million to $100 million. This compares to $68.5 million in 2009.
Now let's take a look at some of non-cash items. Amortization of prepublication costs was $112 million in the third quarter, a $15 million decrease versus the third quarter of 2009. For the full year, we now expect $245 million to $250 million versus the previous estimate of $260 million to $265 million. This compares to $270 million in 2009. The decrease reflects the recent lower level of investments.
Depreciation was $25 million in the third quarter compared to $26 million last year. We now expect full year depreciation to be slightly below last year, which was $113 million. Amortization of intangibles was $9 million for the third quarter of 2010 and $32 million for the first nine months. Reflecting the impact of our recent acquisitions, we now expect it to be closer to $50 million for the full year versus our previous estimate of $40 million. Our unearned revenue continues to grow. We ended the quarter at $1.1 billion, up 4.2% for the prior year. At constant foreign currency exchange rates, excluding the impact of acquisitions and divestitures, growth was approximately 5%. Financial Services represented 74% of the corporation's total unearned revenue. It grew in the low single digits, driven by strong growth in ratings-related information products, S&P Indices and Capital IQ. While still small, unearned revenue at McGraw-Hill Education is showing strong growth due to sales of digital products. For 2010, we continue to expect mid single-digit growth in unearned revenue. Thank you, and now back to Terry.
Thank you. This is Don Rubin again, and just a couple of instructions for our phone participants. [Operator Instructions]
[Operator Instructions] Our first question comes from Brian Shipman, Jefferies.
Brian Shipman - Jefferies & Company, Inc.
First on Education, I was wondering if you could take a stab at sizing the 2011 new adoption market for us. And then second, on the S&P business, you saw the new issuance pick up late in Q3. The comparisons are very tough in the fourth quarter, having grown 63% in the year-ago quarter, so can transaction revenue continue to accelerate here from the third quarter trends into the fourth quarter of 2010, or will growth be tough to attain here in the coming fourth quarter?
First of all, it's a little early to be focusing on 2011. We clearly, obviously, look at the schedule very hard. The calendar is very full. It's going to be a science year next year. And so, if you look at the calendar and just take it from that standpoint, our guesstimate at this point is that we will be at or a little better than 2010 state adoption levels on that one. But we've got to also see what the effect of Common Core Standards are going to be, and if there's going to be changes from that standpoint. So it's a little bit early, but if you look just at the calendar, at or above 2010 is what we're thinking on that one. New issuance, Brian, as you know, coming off of a softer second quarter, we really ramped up, especially the high yield markets. And again, the big number that we watch is the refinancing numbers out through 2014, still it's about $2 trillion in terms of maturities coming due on that part. And of course, there was a lot of refinancing or refundings in the third quarter, a lot of the new issuance that way. We've seen a continued strong corporate market in here. Issuance, a little softer in Europe, but again, one would think that it should be still fairly strong, and we have evidence of that at this point. We'll have to see as we get into November and early December, but so far, it's been pretty good.
Brian Shipman - Jefferies & Company, Inc.
A quick follow-up, if I may, are you seeing any sign of federal money affecting the el-hi market at all?
In the el-hi market, yes, you've seen some on that one. It's hard to, as we're saying, it's hard to trace. Funding is coming from various levels but from what we are hearing, for both ends, both at the stateside and the federal level, both are talking about funds coming into the market.
The next question comes from Peter Appert, Piper Jaffray.
Peter Appert - Piper Jaffray Companies
So terry, the margins of S&P, obviously, is down a little bit year-to-year even in the context of the better revenues. Can you explain where the incremental cost are coming from? But I'm wondering over the next couple of years, how do you think about the potential for margin improvement in the context of a fairly robust debt market? Do you think margins are, at best, flat from here going forward?
Well, as you know, and I'll get Bob to get on this, we reported 39.2% and then when you take out the gains, it gets down to 38.1%. And then if in between -- what is it Bob, between foreign change?
Yes, if you adjust for the unfavorable impact of foreign exchange in the quarter, as well as the impact of the one-month worth of TheMarkets.com, the apples-to-apples margin would be 39.6%.
Yes, and that gets us back to the 40% range. And I think what we're going to see, especially in terms of some of the QCCR compliance network cost, we're going to start to see that abate. And the hope would be then that we would be able to translate that into margin improvement on that part. So we're pleased with where we are relative to the cost associated, but we'll be looking for margin improvement.
Peter Appert - Piper Jaffray Companies
Do you think low to mid-forties is reasonable expectation for the next several years?
Well, again, I mean, there's a lot of uncertainties and what the pipeline would be like and what any additional regulatory issues and compliance cost and all of that. That would certainly be the hope, Peter. But I think we just better take it as it comes right now, just so that we want to keep expectations to where they are.
Peter Appert - Piper Jaffray Companies
One last thing, Terry, on the margins front, in the Education segment, obviously, doing quite a bit than you expected this year with the leverage from the revenue upside, how do you think about the sustainability of margins of Education going into '11 in the context of what presumably will be a tougher year from a revenue standpoint?
Well, I mean, again, I think one of the questions is, we want to take a good hard look at the student aid, the federal government student aid program. That clearly has helped Enrollments, and that's why we made adjustment from Higher Ed grew from 5% to 7%, up to 8% to 10%. It's really going to trigger on enrollments there and if enrollments stay strong, then I think we will continue to benefit from that. And therefore, margins will be reflective of that.
Peter Appert - Piper Jaffray Companies
In the K-12 business, you think it's sustainable margin wise in the context of how you see revenues pointing out?
Yes, again, I think we've got to see what the impact of Common Core Standards are going to be on that part. And my opinion between that and digital, it can only help.
Our next question comes from Craig Huber, Access 342.
Craig Huber -
We'll just stick with Education precisely if I could. What percentage of your elementary-highschool revenues comes from digital, and also what's percent of your college revenues are from digital, I guess, for the first nine months?
Craig, at this point, on the Higher Ed Professional side, we're seeing 15% and growing very rapidly. So we're pleased with that. On the elementary-high school side, it's smaller than that. We're benefiting at the Higher Ed side with McGraw-Hill Connect now, and all of the related pieces to that. But we don't break that out as such, but it would be a smaller number than the 15%
Craig Huber -
If it's like ballpark of around 5%, would that be reasonable, you think?
I would say it's somewhere probably a little higher than that, but probably somewhere in the neighborhood of 6% to 8%.
Craig Huber -
Can you size for us in the U.S., I guess, this year, the open territories in residual sales? What percent, I guess, declined most likely this year, are you expecting that for the whole market?
Well, again, the open territory market has been problematic, really, for the last four years, and we are looking in to see more progress in that area. That will be a big piece of future growth. That's roughly 45% of the whole opportunity on that part. But at this point, we still see it as a hold back.
Our current thinking in terms of where we are and how we factor into our outlook for the full year for all of K-12 is that for residual sales, we're looking at a decline on a full-year basis in the high-single digits and for open territory declines and more of mid-single digits maybe 3% to 5%, with declines in both areas.
Craig Huber -
Could you help us understand better the opportunity here on the digital front as you migrate away from print? What on average, the printing cost, binding cost, warehousing cost, postage cost, what percent of cash cost is that for your print operations in Education you end saving as things transition over to digital?
It's about 25%.
Craig Huber -
Can you just talk a bit further about, I guess, the backlog here for your Ratings business for the fourth quarter? What material changes are you seeing there versus the trends you saw here in the third quarter?
Craig, right now, so as we were saying, especially in terms of corporate governance in that category, we're starting to see still strong transaction growth, a little bit less in Europe on that part. But so far, it's looking promising. We'll be watching it together in all of that, but from a pipeline standpoint, it's looking good right now. And again, the bigger number is the $2 trillion worth of refinancings that have to take place between now and 2014. And that should keep some pretty good activity in that part of the market.
Craig, let me just expand on your previous question. The paper print buying postage elements, of course, are variable cost. So if you elect not to print a product and you move to a digital offering, those costs go away. But you also mentioned warehousing, of course, that's not a variable cost. You're still going to be in an avenue where we're going to be producing product for a period of time, maybe our warehousing structure over time could be reduced, but that's clearly not a variable cost in the short-term.
Next question comes from Michael Meltz, JPMC.
Michael Meltz - JP Morgan Chase & Co
The 2011 Education question was asked a few different ways. Let me try it another way here. At this point, do you think you can grow your total Education segment revenues in '11 just with K-12 trends, as well as what's happening on the Higher Ed side with the for-profit guys?
Yes, well, Mike, it's a little bit early to be forecasting that. I think that what we've done is we've taken a look at where we are in terms of what we're going to be submitting, and we've taken a look at the calendar and just have done some rough estimating, and that's why we say at or above 2010 levels in all these. But I don't want to mislead, and we have to see what Common Core Standards are going to do. And so it's a little premature to come in with a harder number.
Michael Meltz - JP Morgan Chase & Co
On the college side, what about the potential headwind for profit or that portion of the market?
Enrollments. The number we're watching there is clearly enrollments. And as we said, the student aid program has been very robust and very helpful to that part of it, and that's why we've increased our projections on that. That's the number we're going to be looking at. And then if we have a decent enrollment number, you can anticipate a commensurate year.
Michael Meltz - JP Morgan Chase & Co
On the liability side at S&P, we've seen that, that recent ruling is another nice win for you, that Rice ruling you mentioned. There's been some talk in the trade pubs recently about S&P losing some mandates versus Moody's and Fitch, perhaps, because of tougher stance on liability provisions in documents. Can you talk a little bit about that please?
Well, I mean, I think it depends on the area and the like. That's why in the QCCR area, we breakout both the quality assurance aspect, the criteria, the compliance and the risk areas on that part. And we managed the criteria side very hard on that one, making sure that it is as strong, as solid and is appropriate to any particular issue. If there is a particular area, where our criteria is a little tougher or a little more stringent than somebody else, I think it balances out in through the number of issues, but there could be some in that way on that part. But we also are saying very clearly to any issuer that if you were supplying us with information that is going to go into a part of the determination of a rating, then, A, you have to be accountable to make sure that the data and information that you're providing us is reliable and all of that. Now we're going to test in all of those kinds of things. But again, all we're saying is that, you've got to be very accountable that the information that you're giving us that's going to help determine a credit rating is reliable. That's what we're saying.
Michael Meltz - JP Morgan Chase & Co
In terms of free cash flow priorities, you did the TheMarkets.com acquisition, which is, well not all that big, one of your biggest in a couple of years. Can you talk about your priority in terms of M&A versus your repurchase, please?
Both are very viable in all of that. In fact, also in terms of organic growth, a lot of the digital components like McGraw-Hill Create and Connect and those kinds of things, those are very strong organic programs, and you can count on the fact that of the four uses, dividend, share repurchase, organic and acquisition, all are active and continuing. Now again, when you go through the latter part of 2008 and into 2009, activity levels in terms of acquisitions and some of those projects were softer in all of that. And obviously, the focus then was on share repurchase and dividend in all of that. Now given the strength of the free cash flow and improved markets and the like, you can see activity in all four areas.
Our next question comes from Doug Arthur, Evercore.
Douglas Arthur - Evercore Partners Inc.
Yes, Terry, you might have answered because I get distracted for a second. But the 4.3% increase in Higher Ed, Professional and International, that seems light to me in light of your dominance, your strength in college and the fact that you raised the basis for the industry. So what were the offsets there?
International. The international side was a little softer than we had anticipated. But the Higher Ed side, in particular, it's clearly going to come in, in terms of -- or in line with our expectations and maybe even better on that part. But it was the international side that was the softer.
Douglas Arthur - Evercore Partners Inc.
And in terms of the market growth of 8% to 10%, are you going to meet share or gain share?
We'll see. Well, at the very least, we'll meet share. And hopefully, we'd do a little better. But at this point, I think it's safe to say we'll meet.
Our final question comes from Edward Atorino, Benchmark.
Edward Atorino - The Benchmark Company, LLC
I have the same question Doug did on the Higher Ed. One other one, Terry, given what I thought was a surprisingly school growth with all of the budgetary best pressures and et cetera, books sort of, I don't want to say immune, but they're pretty small slice of the budget, and it seems they're holding their own in a very difficult environment. Would you discuss, are the cuts not hitting the book area?
No, I think that again, you still have pent-up demand. Remember, when we talk about the state adoption market, it was half or a little more than half of what it was last year. And so the increase of 65%, 75% in the state new adoption market and also, some of the growth in the intervention market, I think it has been a little bit of a surprise and has held up. Even though at one point, we were thinking 875 to 925 for the state new adoption market, in the second quarter, we came back to 825, 875. And I think that's going to a pretty a good range for this year, and we clearly are benefiting from that.
That does conclude this morning's call. The presenter's slides will be available soon for downloading from www.mcgraw-hill.com, and a replay of this call will be available in about two hours. On behalf of The McGraw-Hill Companies, we thank you for participating, and wish you a good day.
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