The McGraw-Hill Companies Q1 2007 Earnings Call Transcript

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The McGraw-Hill Companies, Inc. (MHP)

Q1 2007 Earnings Call

April 24, 2007 8:30 am ET

Executives:

Harold McGraw, III - Chairman, President, and Chief Executive Officer

Robert J. Bahash - Executive Vice President and Chief Financial Officer

Donald Rubin – Senior Vice President, Investor Relations

Analysts:

Peter Appert - Goldman Sachs

Lisa Monaco - Morgan Stanley

Michael Meltz - Bear Stearns

Karl Choi - Merrill Lynch

Drew Crum - Stifel Nicolaus

Frederick Searby - JP Morgan

Brandon Dobell - Credit Suisse

Presentation

Operator

Good morning and welcome to McGraw Hill Companies first-quarter earnings conference call. At this time I would like to inform you that the call is being recorded for broadcast, and that all participants are in a listen-only mode. At the request of the company, we will open the conference to questions and answers after the presentation. Instructions will follow at that time.

To enhance the call for today's participants, McGraw Hill has made the presenters' slides available on the internet. To view that, go to http://www.mymeetings.com/nc/join. You'll be prompted to enter your name. The net conference meeting number is PG6816259. The pass code is “MCGRAW HILL”, and the event type is “conference”.

This call is also being broadcast live from McGraw Hill's investor relations website, and will be available for replay about two hours after the meeting ends, both by phone and on the web for seven days. If you need assistance at any time, including having your volume adjusted higher or lower, press * and 0, and I will assist you momentarily.

I will now turn the conference over to Donald Rubin, Senior Vice President of Investor Relations for the McGraw Hill companies. Sir, you may begin.

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Donald Rubin

Thank you, and good morning, and thank everyone from around the world for joining us today for McGraw Hill Companies’ first-quarter 2007 earnings conference call. I'm Donald Rubin, Senior Vice President for Investor Relations for the McGraw Hill Companies. With me today are Harold McGraw, Chairman, President, and CEO, and Robert J. Bahash, Executive Vice President and Chief Financial Officer of the corporation.

This morning we issued a news release with our first quarter 2007 results. We trust you have all had a chance to review the release. If you need a copy of it and financial schedules, they can be downloaded at http://www.McGraw-Hill.com/investor_relations.

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 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 10Ks, 10Qs, and other periodic reports filed with the US Securities and Exchanges Commission.

We are also aware that we do have some media representatives with us on the call. However, this call is for investors, and we ask that questions from media be directed to Mr. Steve Weiss in our New York office at 212-512-2247, subsequent to this call.

Today's update will last approximately an hour. After the presentation we'll open the meeting to questions and answers.

Now it's my pleasure to introduce the Chairman, President, and CEO of the McGraw Hill companies, Terry McGraw.

Harold McGraw

OK, thank you Don, and good morning everyone and welcome to our review of the McGraw Hill Companies first quarter results. Joining me today is Bob Bahash, Executive Vice President and Chief Financial Officer, and we'll begin by discussing our results for the first quarter and the outlook for the rest of the year. Bob will then review our financial performance, and obviously, as always, we'll then go in any direction after that anybody would like to go.

Earlier this morning we announced our first quarter results. We reported earnings per share of $0.40. That includes a $0.03 gain on the sale of a mutual fund data business in March. Revenue grew by 13.7% to $1.3 billion and margin improvement in all three segments.

Historically, the first quarter is the smallest each year, but clearly we're off to very good start to achieve our goal of producing double-digit earnings growth in 2007. As we look ahead, we see that inflation is under control at 2.5%. The US Gross Domestic Product is growing at about 2.4%, and the unemployment rate is holding at about 4.4%. This makes all in all, a pretty good situation.

David Weiss, the chief economist at Standard & Poor’s, was looking for a Fed rate probably going down, probably by mid year. He now thinks that's closer to the end of the year, but that the next move will still be down.

Again, David Weiss our chief economist believes that the housing starts and sales are bottoming out after a 30% decline. Housing prices are down 3%, and will probably decline another 5% between now and the end of the year. Non-commercial construction is doing very well, state revenues are solid, bond rates are stable, and the Federal Reserve has held the funds rate at 5.25% since last June, and no change is expected soon. One cut to 5% again is possible by the end of the year.

With that as background, let us look at our operating results. We'll begin with McGraw Hill Education. With that background, we expect Education to be an important contributor to our performance in 2007. We are encouraged by the start this year, even in a seasonally slow quarter. Revenue increased 5.6%. The operating loss was reduced by 6.6%. Costs and expenses are under tight control, and rose only about 2.7%.

The higher education professional and international group revenue grew by 11.5%, to $186.9 million, and contributed 56% to the first-quarter revenue. School education group revenue was up 1.2% to $144.8 million.

Let's take a closer look at those results. In the K-12 instructional market, the first quarter represents, as we all know, less than 10% of the full year. Sales in this period tend to consist largely of residual or supplemental orders, plus some early new adoptions, which may arrive toward the end of March. The pattern was skewed in the first quarter last year, because we booked 9 million in late orders from Texas for music, health, and some online programs. Obviously, this did not repeat in 2007.

We closed most of the gap. A key driver was March orders from North Carolina for our K-5 music program and vocational, family, and consumer science programs for grades 6-12. More important are the earlier indicators that our newly integrated school team is performing effectively, and that the strength we expected in the state adoption market is starting to materialize.

These trends take on added importance this year because we have stepped up our participation in a growing state new-adoption market. In 2006 we participated in only 80% of the state new adoption market. This year we have products for virtually the entire state new adoption market, which we expect to grow 10-15%, or between $750-800 million.

As this chart shows, we believe the state new adoption market is poised for growth for the rest of the decade. It's much too soon to make predictions on our results this year. Sales campaigns are running at full throttle, but I can report that we are very pleased with the early feedback. Science in California and South Carolina, math in Texas and New Mexico, and music in North Carolina look very promising at this time.

We are also encouraged by the early showing of our middle school products in the second year of the California social studies adoption taking shape in some large urban market and that would include New York City, Boston, Milwaukee and Washington D.C. We’ve already realized some substantial sales in Washington D.C. for K-5 Science and 6-12 Social Studies. We’re optimistic about our opportunities in the open territories. We’re competing with new products in K-5 Science, 6-12 Literature, and the new editions of everyday mathematics and open court reading. We are also pleased with the early showing of a new supplemental product called science snapshot.

Science poses its own special challenge to elementary school teachers who typically are trained as reading specialists. Today, these teachers must help students learn the concepts and language of science so that they can score well on the new high stakes test as mandated by ‘no child left behind’. These science tests start this academic year in elementary, middle, and in high school. Preparing students for those tests is not a simple matter and when you realize that the complex concepts like photosynthesis are introduced in the curriculum as early as the third grade.

To provide a classroom solution we combined video, DVDs, and print, to create a new program called ‘Science Snapshots’ for use in the third, fourth, and fifth grades. The program includes 15 hours of video, so students will have a familiar way to see and hear, as well as read about science. And once again we provide materials students can use to work independently on the computer. We believe that creating materials that address multiple learning styles of today’s students is the route to success in the classroom and to the market place.

In the testing market we’ve benefited from increases in custom work for statewide assessment programs in Georgia, Colorado, Indiana, and Florida. Sales of off the shelf test products were flat in the first quarter.

As I pointed out earlier, we had double digit growth in the first quarter at the higher education, professional, and international levels, and we’re quite pleased. In the U.S higher education there is a phenomenon that we call the echo effect, second semester ordering late in the year that echoes your success in the peak third quarter.

When the second semester business arrives is not entirely predictable. Some years it shows up in September, other yeas it shows up in January. Our higher education group heard the echo in January. We had a very strong January and that contributed to the solid growth that we experienced with higher education products around the world in the first quarter.

As you may know, we have three major imprints in this market: Science, Engineering and Mathematics; Business and Economics; and Humanities, Social Sciences, and Languages. All three produced solid gains in the first quarter. We’re seeing increased demand for our digital homework manager products, particularly in world languages, accounting, math and economics.

Our new on-line courses are getting a favorable response in the market. Using technology to create new products and incremental revenue is a key strategy. We also are making real headway in the professional markets where we have launched a number of new on-line products.

Last July we introduced Harrison’s practice which marked our entrance into the emerging patient care market. Harrison’s practice combines content from the Harrison’s editorial team and experts in the field of internal medicine, with an easy to use interface on a mobile platform which makes it a true work flow tool for physicians in an ambulance in an emergency room or in a doctor’s office.

Last week we launched Access Pharmacy, an on-line product designed to keep pace with the changing demands of pharmaceutical education. This is a growing market. It is estimated that in five years nearly 300,000 practicing pharmacists will be needed to serve our aging population. That’s a 30% increase compared to 2002 and that statistic is from the Department of Labor.

For Access Pharmacy we are leveraging the content of some of our classic reference texts, including Good and Gillman’s ‘The Pharmacological Basis of Therapeutics’.

Access Pharmacy also offers a fully integrated drug database in English and Spanish. Access Pharmacy joins Access Surgery and Access Emergency Medicine in our line up for ready access resources for medical professionals. More digital products for major medical specialties are on the drawing board.

So let’s sum up the outlook for education. In the market we expect 10-15% growth for the state new adoption market. We expect 3-4% growth in the open territory and industry growth of 5-7% based on our new products and greater market participation in 2007. We expect to outperform the industry. In the U.S. college and university market, we expect growth at about 4% based on our plans we also expect to outperform this market and we expect margin expansion for this segment in 2007.

One final point about the education market, the competitive landscape is changing. Some are exiting, some are arriving. We have our plans in place to take advantage of growing global opportunities and the increased enrollment in the years ahead and it is clear to us that you can’t sustain a knowledge economy without knowledge workers and that’s why education today more than ever before is a necessity for our world and a growing opportunity for our team of professionals who know this market so very well.

With that, let’s turn to the financial services side. By virtually any measure, financial services has had an exceptional first quarter. Revenue increased 21.5%. Operating profit was up 38.3% and the operating margin expanded to 47.7%. Now that includes a $17.3 million pre-tax gain on the sale of the mutual fund data business in March.

There were many contributors to this outstanding performance. Certainly world liquidity is extremely plentiful. We continued to operate in a very favorable interest rate environment. Spreads remain tight, investor demand for fixed income instruments is strong. Our diversified portfolio fired on all cylinders. Both our domestic and international rating revenue grew a double digit rate with international outpacing the U.S performance. Corporate and government ratings were strong. Structured finance was robust again and globally. Products and services such as bank loan ratings that are not tied to the public new issue market grew substantially. Data and information products grew rapidly. Index services continued to expand.

We expected double digit growth on the top and bottom line this year in financial services even though we forecasted a 10-15% decline in the issuance of the U.S residential mortgage bank securities. Clearly we have gotten off to a very strong start in 2007, and let me be clear there will be more double digit growth and margin expansion throughout the balance of the year in financial services although probably not at the exceptional rate of growth that we enjoyed in the first quarter but still very solid double digit growth.

Let’s look at the situation in more detail. Corporate Issuance in the United States set a record in the first quarter. It was up 43% to $336 million. Both investment grade and high yield markets were strong performers. Strong merger and acquisition activity in a favorable financing environment are making this possible. The demand for corporate continues unabated this year. Insurance companies and pension funds have been consistent buyers, snapping up bonds at five and ten year maturities in portfolios that are coming to term.

As well, innovation in derivative markets is also attracting a growing number of new high yield investors to participate in this market. Corporate fundamentals remain sound and we look for continued growth both here and abroad in this important market.

Public finance benefited from a pick up in refunding and new money issuance. The environment is favorable. There’s an expanding group of buyers and an increase in asset allocations to higher quality investments by aging baby boomers. We expect a good year in public finance although refunding is expected to moderate somewhat.

Structured finance produced another strong quarter, despite a 10.8% decline in the U.S residential mortgage bank securities issuance. As I pointed out earlier we anticipated a 10-15% decline in the U.S residential mortgage bank securities issuance this year. A slow in-housing sector, rising mortgage rates, and fewer housing starts were factors in shaping our forecast. As part of its ongoing ratings and surveillance process for residential mortgage back securities, S&P carefully monitors trends in the housing and mortgage finance market, consumer credit, and in the economy overall.

Last spring, little over a year ago, S&P foresaw the trend in the quality of mortgage lending that led to the concerns that had arisen in the sub-prime market today. As a result of the deteriorating credit quality of certain sub-prime mortgage loans of 2006, S&P (inaudible) the credit support necessary for a rating by 50% compared to transactions from 2005.

While there is a lot going on in this sub-prime market, nothing has occurred so far this year to cause us to materially change our expectations on the level of issuance that we originally anticipated for 2007. It's also worth pointing out that the US residential mortgage backed securities market has not come to a dead stop in 2007, not with the $254.1 billion in issuance in the first quarter.

In Europe, residential mortgage backed securities had a very strong quarter and the outlook is positive. Stable economic conditions combined with moderate home price growth in most European countries continues to feel the demand for mortgage credit. We also anticipate some residential mortgage backed securities activity in a merging market, including Russia and South Africa.

And we start the second quarter with a very good pipeline. The commercial mortgage backed securities market issuance was also strong in the first quarter. We saw steady improvement in Europe. Drivers of US commercial mortgage backed security include strong commercial real estate fundamentals, historically low interest rates, the refinancing of the maturing deals, and rising property values. And the pipeline looks very good.

In the US asset backed securities market, credit card and student loan activity offset the slump in auto loan asset backed securities. Credit card and student loans should keep this market growing. Growth in the European asset backed securities market was driven by small business loans, auto loans, leases, and equipment leases.

The outlook in Europe is also solid. Basil should have a positive influence on this market as consumer banks restructured the risk on their balance sheets to adjust to capital adequacy ratios.

We also saw robust growth in the US and European collateralized debt obligation market. In the United States, collateralized debt obligation issuants, or CDOs, was up 154% in the first quarter. Our expectation coming into this year was that the growth rate in CDO issuance would slow from the torrent pace that we saw in 2006. While the first quarter was strong, we expect the growth rate to slow in subsequent quarters and the assumption is already baked into our expectations.

Key factors in the US CDO market in the first quarter were concerns about widening spread resulting from credit quality deterioration in the sub-prime market and an increase in collateralized loan obligations resulting from the strength in the corporate loan market.

Although spreads did widen in the first quarter due to the sub-prime issuance, they have lightened a bit since the end of the quarter. There's a general agreement that spreads may not change or if they do they could widen slightly during the remainder of the year. Our current estimates for the CDO market are based on such a scenario. S&P does not expect dramatic widening of spread unless there is a shock of some sort to the system triggering some dramatic deterioration and that we don't have baked in.

US CDOs will continue to benefit from strong investor demand and broader acceptance of structures such as collateralized debt obligations of commercial real estate. There's a constant innovation taking place in the CDO space with respect to structures and the use of underlying collateral. This is not limited to the United States by any means and we also see more growth in Europe.

S&P produced significant gains in products and services that are not directly linked to the public debt issuance. These services which account for 26.3% of ratings revenue in the first quarter are another important measure of the diversity that we have created in the S&P portfolio. Bank loan ratings were a key driver of this growth. We anticipate more growth this year from bank loan ratings, outer party credit ratings, financial strength ratings, derivatives, and risk services.

S&P also benefited from solid growth of its product and services for equity market. The capital IEQ product continues to grow rapidly and now has more than 1,900 clients. We have also increased the number of subscribers here and abroad from some of our other information products: ratings direct, ratings express, and compustat express B.

We continue to expand our index services. At the end of the first quarter there were 113 exchanged traded funds linked to S&P indices, 85 in the United States and 28 outside the United States. Our S&P Citigroup indices form the backbone of a new fast growing business for bench mark indices, index data, and custom indices.

At the end of March, assets under management in exchange traded funds based on S&P indices increased 23.7% to $170.3 billion. We also benefited in the first quarter from the increased trading of derivative contracts based on S&P indices especially the E-mini which is traded on the Chicago mercantile exchange. Average daily vibe for the E-mini contracts for the first quarter was $1,376,979.

So summing up for financial services, more double digit growth and margin expansion for the balance of the year although probably not at the exceptional rate of growth produced in the first quarter.

And now let's go over to the information and media segment.

Revenue increased 4.1%. Operating profit was up $9.9 billion up from $1.7 million for the period last year. The operating margin improved to 4.2%. An important factor was the transformation last year from a primarily print catalogue to a bumble print and online service for the construction industry.

Because of the change, revenue is now earned throughout the year. As a result of the change, Sweets contributed $6.5 million in revenue and $5.8 million in operating profit to this segment in the first quarter.

Revenue for the business to business group grew by 7.5% in the first quarter to $212.3 million. This group includes some of our best known brands: Business Week, JD Power and Associates, Platts, Royal Construction, and Aviation Week. Sweets' transformation in growth and (inaudible) real time new services for oil, natural gas, and power market were key contributors.

Business Week's Global Edition was off 3% in the first quarter. Broadcasting revenues fell 18.8% in the first quarter. For broadcasting there were three major influences in the first quarter, certainly the absence of political advertising, the loss of the Super Bowl, and the decision not to renew Oprah Winfrey shows in two of our markets, and pacing for the second quarter is off about 14%.

This segment is in transition. We pointed out that before that the internet is reshaping the business to business market to add value to our audience. We're making progress in the new digital world.

I've already recited the transformation in Sweets in the construction market. In the energy market, traders are looking for better tools to help them work with real time information. Earlier this month we took an important new step to increase the efficiency and the transparency of physical oil markets.

Platts E-window is a new online tool using leading net technology to significantly improve our service to traders who use our daily price assessments as bench marks in the oil market. This is a solution with real promise. Benchmark prices are increasingly used as the basis for industry contracts, financial risk management, and for cash settlement of future contracts, traded at commodity exchanges literally around the world.

With globalization and technology making markets more dynamic than ever before, the need for reliable transparent benchmarks and other critical news and analysis of such strategic commodities like oil and steel are helping to drive growth in our real time subscription services.

We're also expanding by licensing our intellectual property for use in broader financial and future markets. The most recent example is last week's announcement by the Intercontinental exchange.

It has selected one of our bench marks, Platts Divide price assessment, as the basis for cash settlements on a new crude oil futures contract. BusinessWeek.com continues to improve its performance with increases with advertising and unique visitors compared to last year and we continue to make investments in this product.

Building communities is an important aspect of our new digital world. That's why ArchitecturalRecord.com now makes it possible for architects to post their work on its website. The site includes blogs and a rating system that encourages readers to participate by evaluating the projects that appear online and in the publication. Our objective is to make it easy for readers to share their work and to interact with their peers and with our editors. Not bad for a 116 year old publication.

OK, summing up for the information in media, a soft start in advertising particularly on broadcasting as it was a non-political year. And to complete for the corporation overall, summing up, some very encouraging indications in education, a strong start in financial services, progress in information and media, market expansion in all three segments, and our guidance for 2007, double digit earnings growth in 2007.

OK with that let me hold it there. Let me turn it over to Bob Bahash, our Chief Financial Officer and his report.

Robert J. Bahash

Thank you Terry. We mentioned during our January conference call that we intended to purchase 15 million shares in 2007 under the share repurchase program that was approved by the board of directors in January of 2006. We elected to accelerate our program and purchase 13.2 million shares during the first quarter on a trade date basis at a total cost of $842 million. We expect to purchase the remaining 1.8 million shares during the balance of 2007. Of the $842 million total amount, approximately $231 million was settled and funded at the beginning of the second quarter. There are now remaining 6.8 million shares that are available to be purchased under the 2006 buyback program.

Earlier this year the board provided additional flexibility by authorizing a new buyback program of 45 million shares. Since 1996, the corporation has returned 6.8 billion to share holders through dividend payments and share buybacks, which includes approximately $915 million returned to shareholders in the first quarter of 2007.

The diluted weighted average shares outstanding for the first quarter 2007 are 361.5 million shares. That's a 15.8 million share decrease compared to the first quarter of 2006 and a 2.7 million share decrease compared to the fourth quarter of 2006. The quarter only benefited modestly from the first quarter buyback of 13.2 million shares since the bulk of the repurchases occurred near the end of the quarter.

We have resumed borrowing in the commercial paper markets to fund our seasonal cash requirements and ended the first quarter in a net debt position of approximately $178 million. This compares to a net cash position of $351 million at year end 2006. And as of march 31st on a gross basis, our debt position is $607 million, which is offset by about $430 million in cash, primarily in foreign holdings. We expect to return to a net surplus cash position by the end of the year.

Interest expense was $1.2 million for the first quarter. Last year we were essentially debt free in the first quarter and had net interest income of $2.5 million. Interest expense for the second quarter will increase since it will reflect commercial paper borrowings for the full quarter. For 2007, we now expect a full year interest expense to range from $24–26 million. This is higher than our previous estimate due to the timing of funding cost related to the accelerated share repurchases as well as additional interest expense resulting from the implementation of FIN 48.

Now FIN 48, or FASB interpretation number 48, which is accounting for uncertainty in income taxes, became effective for the company on January 1st, 2007. GAAP based financial statements must account for taxes including an analysis of all tax positions. FIN 48 clarifies the accounting treatment of uncertain tax positions taken or expected to be taken at any income tax returns. FIN 48 also clarifies the rules regarding accruing interest on certain tax positions. We will continue to accrue interest within the interest expense category.

Last year, as Terry mentioned, we transformed Sweets from real construction groups properly building products database from a primarily print catalogue to a bundle print and online service. The associated accounting change benefited year-over-year comparisons for information and media. For the first quarter 2007 the results reflect $6.5 million of revenue and $5.8 million of operating profit resulting from the sweets transformation.

Let's have a look at our corporate expenses. Corporate expenses decreased $5.6 million or 13.8% in the first quarter compared to a year ago but there were several one time factors that influenced this decline. Last year's first quarter corporate expenses included a $14.8 million charge relating to the elimination of the restoration stock option program. The year-over-year comparisons are also impacted by a $4.6 million gain on the sale of an office and printing facility that also occurred in the first quarter of 2006.

Categories with incorporate expense that increased are the following: expenses associated with the new business process management program that was implemented this year designed to strengthen our core processes and ensure alignment with customer needs while improving operational efficiency; increase in vacant space form downsizing; business rationalization initiatives that were implemented in 2006; and hiring setup compensation.

The effective tax rate in the first quarter was 37.7%. The 50 basis point increase from the prior year is driven the change to the accounting for uncertain tax positions FIN 48, the gain in connection with the sale of the company's mutual fund data business, and a state tax audit settlement. Based on these factors, the operating effective tax rate for the balance of the year is projected to be 37.5%.

Now let's take a look at capital expenditures which include prepublication investments and purchases of property and equipment. In the first quarter our prepublication investments were $57 million compared to about $61 million for the same period last year. For 2007 our prepublication investments will now be about $310 million. We anticipate a reduction in spending from our original projection of approximately $330 million through efficiencies, technology, global sourcing, and simply firming up our forecast for the year.

Purchases of property and equipment were $23 million in the first quarter compared to $12 million in the same period last year. This increase is due to the construction of our new data center which has now begun along with technology investments we are making to digitize our products and services. We continue to project $250 million for 2007.

Now for non-cash items: Amortization for prepublication cost was $28 million in the first quarter compared to about $23 million for the same period last year. We ramped up our publishing schedule last year in anticipation of the strong new state adoptions in 2007, 2008, and 2009. We continue to expect $260 million in amortization of prepublication costs for 2007.

Depreciation was $29 million in the first quarter compared to about $28 million for the same period last year. We still expect it to be $130 million in 2007 reflecting the higher level of capital expenditures of 2007 and a fuller year of depreciation of capital expenditures made in 2006.

Finally amortization of intangibles was about $12 million in the first quarter which is about the same amount as compared to last year. For 2007 we continue to expect $50 million. Thank you and now back to Harry.

Harold McGraw

OK. Thanks Bob and let me go to you Don.

Question-and-Answer Session

Donald Rubin

Thank you. Just a couple of instructions for our phone participants. Please press "star one" to indicate that you wish to enter the queue and ask a question. To cancel or withdraw your question simply press "star two". If you've been listening through a speaker phone but would now like to ask a question, we ask that you lift your handset prior to pressing "star one" and remain on the handset until your question has been answered. That would ensure good sound quality for all of us.

We’re now ready to take the first question.

Operator

Thank you. This question comes from Peter Appert of Goldman Sachs. You may ask your question.

Peter Appert - Goldman Sachs

Thank you. Good morning. Terry, you cited the second quarter starting with a good pipeline at S&PND in terms of new issue volume. Could you give us any additional color on that in terms of category strength or geographic strength you’re seeing?

Harold McGraw

Yeah, again it’s very appealing Peter because it’s across the board. We talked about the corporate governance side and it’s strong here mainly because of the M&A activity but also in Europe and Japan as well so that part is doing well. The structured finance market is doing exceptionally well. The only piece within that that’s off is the US residential mortgage bank market. The European residential mortgage bank market is actually doing pretty well. And that market in the United States, we predicted it to be off 10-15% and it was off 10.8% but everywhere else, the commercial mortgage bank market continues to be very very strong. It’s been strong since early 2005 and continues. You’re seeing it in the debt obligation market and you’re seeing it in the non-traditional areas as well especially in terms of the bank loan ratings areas. So it is again a very very strong pipeline and we’re very pleased with the start.

Peter Appert - Goldman Sachs

OK great. Thanks Terry and then one unrelated question. I was impressed you were able to post a first quarter decline in the seasonal education business. Might we read into that you’re spending less on marketing and promotion than you otherwise would have anticipated this year or is it all a function of the upside coming from the college business.

Harold McGraw

Well, you’ve got both. There’s a timing issue certainly according to those expenses but also as you rightly say the higher education market was very strong. As you may recall Peter, we had a little softness in the fourth quarter last year in terms of unit sales and we think that there were some timing issues associated with that. We were really glad to see the pick up especially in early January.

We were talking about that echo effect and because we thought that it should have been a little bit stronger in the fourth quarter last year and there really was a timing issue into January, but it’s strong and the professional market is also doing very well, and particularly I’m very pleased with the innovation part but as you correctly say this is, 2007 is a very important year for the education market. 2008, 2009, and 2010 are too but this is the first year of a multi-year period and with the adoption schedule so strong we really want to really be able to do a good job here.

Peter Appert - Goldman Sachs

And then one thing Terry, you noticed the ownership changes for some of the competitors in the market. Do you see some indication in the market that maybe some of these other players are less aggressive from a marketing and promotion spending as a function of these changes?

Harold McGraw

I that that probably all…and I wouldn’t want to speak for some of them but they’re probably all different reasons, but one of the things that we’ve talked about and when we’re talking about major market transformation in the educational instructional material business, you need to see some turmoil. You need to see some people deciding not that they want to make investments and play and others that want to get in. And so I think that they are all very good signals that the market transformation that we’ve been talking about is well under way.

Peter Appert - Goldman Sachs

OK, Thanks Terry.

Harold McGraw

Thanks.

Operator

The next question is from Lisa Monaco from Morgan Stanley. You may ask your question.

Lisa Monaco - Morgan Stanley

Good morning. Terry, could you just comment a little bit, this is a bit of a follow up to Peter’s question, just on the debt issuance in the first quarter. How much of that was related to potential deals being pulled into the future March period? And then if you could just talk to the strength, the CDO market and what’s driving that and if you could just quantify what percent of the CDOs that you rate are related, are tied to RMBS in the sub prime market and given the slow down in RMBS how is the growth in CDO issue going to be resolved? Thanks..

Harold McGraw

OK, thanks Lisa. Bob, did you get that last point? Between us we’ll get these. A lot of questions here.

There always is timing issues, Lisa. The pipeline has been strong in ’05, ’06 and again the phones worked very hard to get it all completed but there are timing issues on that one. But again it’s just very very strong at this point. There is just no let up on that.

The CDOs are very attractive because it is the instrument of choice for so many financial institutions because of all of the variability that CDOs have in terms of being able to break up into various attributes and various risk rewards capabilities and the like, and it just gives portfolio managers more flexibility to do more things in terms of the constructions of those portfolios so the CDO strength that we’re seeing now is a continuation of the attractiveness of those investments.

With residential mortgage bank, the US market was down 10.8% and again the sub-prime market was down 24.4% on that part. Now, you know the thing on the sub-prime, it has gotten, in my opinion an awful lot of spotlight in the general press and I don’t think it’s as warranted or as deserved. I don’t want to understate it but you know when you're talking about an economy that’s in its sixth year of expansion, you know the Fed reserve worked hard to bring down the growth rate with the 17 rate hikes from last year.

The housing sector has been most affected and therefore with the rise in those rates we have seen some faults on the sub prime (inaudible. Yes, there were some lenders that were way too aggressive and that is why over a year ago, S&P changed some of the lost coverage criteria for those lenders and put those into effect such that it reflected the fact that some of these lenders were too aggressive.

Of the outstanding mortgage loan volume sub-prime is about 13% of that market and yes, I think the housing market slump has bottomed (inaudible) that one in terms of sales and new start, but we will see throughout the year certain defaults on some of the sub-prime loans, but it won’t have a material impact in our opinion, on our results.

So we just think that these are in the housing sector, these excesses…we all know get into the market and we see that those that are least able to afford certain things, you know you’re going to see some defaults on that. Bob, you want to add anything?

Robert J. Bahash

Yeah, Lisa the growth in the CDO area continues in our case to be driven by some of the new structures, the hybrids, the opportunities within the cash flow and synthetic sectors and clearly sub-prime issuance is part of some of the CDO packages but as Terry pointed out it’s a small piece relative to the total issuance volume.

Lisa Monaco - Morgan Stanley

OK. And then just quickly on El-Hi? Terry could you just give us some adding total evidence why you feel comfortable with the 10-15% growth in the new adoption markets you cited early indications from some of the large states. What specifically are those early indicators? Thanks.

Harold McGraw

Well, again, I gave you some of the heads-up in some of the areas: New York, Washington DC, Milwaukee, and so forth. But again, it's a very full calendar. The state new-adoption market will be up in the 10%-15% range. And you've got some major disciplines in major states. You've got K-12 science in California; K-12 health and world languages in Florida; K-8 math in Georgia; in Indiana, you've got grades 1-8 reading and literature; in Texas, grades 6-12 math; and Tennessee is doing a K-5 reading. So you've got a broad representation in that market, and that coupled with a growing open-territories market, is pretty attractive.

Now, it's too early to start making calls on capture rates. We'll probably get into that toward the end of May and into June. But the early indications of some of these sales campaigns are telling us that the product is right, and it's getting very strong receptivity. So we're encouraged. But that's the right word, Lisa: encouraged. And again, it's an important year for us, and we really want to post some very good results.

Lisa Monaco - Morgan Stanley

Great, thank you.

Operator

The next question is from Michael Meltz with Bear Stearns. You may ask your question.

Michael Meltz - Bear Stearns

Great, thank you. I think I have three questions on S&P. Terry, I think there was a slide where you talked about the outlook, specifically for the CDO areas, and you mentioned growth should decelerate, or might decelerate. Can you just talk a little bit though…are you still expecting revenue growth from CDO business for the rest of the year? I know it's a general question, but I think it's important.

And then Bob, on the margin side, can you just talk a little bit about S&P in the accruals. Did you normalize things this quarter? Is there anything we should be aware of on the margin side?

And then, last question: Can you just say the 21% revenue growth in the quarter was (inaudible)? If we examine ratings versus non-ratings, which grew faster? Thank you.

Harold McGraw

Ok, Michael. On the collateralized debt obligation market, again, this has been a very strong market, and multi-year, and it has been growing as the acceptance of CDOs and the availability of CDO usage, has taken hold of the marketplace. The CDO market was up 154% in Q1, and that's coming off a pretty good base. That is pretty stunning growth. I just don't think that we can expect 154% growth in each quarter going forward.

So we are just saying that we think there's a slower growth rate in the subsequent quarters, but it is going to grow, on that one, and we see nothing to hold that back. Bob?

Robert Bahash

Yeah, just to expand upon that point. Our second quarter estimate at this point in time, based on external data, calls for significant growth in the US in the CDO area, in terms of par value are up over 60% and that's in the US. In Europe we're forecasting close to 23% growth in the CDO marketplace in the second quarter. So those are very strong.

The question with regard to margins and accruals, wwe're very fine there. What you're seeing is what you're getting. There's a very strong quarter, the margin improvement clearly driven by the higher revenue elements, as well as the containment of costs.

Michael Meltz - Bear Stearns

OK, and on that growth rate, ratings versus non-ratings?

Robert Bahash

As you know, we do not break those components out. But as Terry pointed out earlier, we saw strong growth across the board in our ratings area: the traditional area, the non-traditional ratings data and information index services. As you know, we don't break it out, but clearly we had very strong performance across the board.

Michael Meltz - Bear Stearns

OK Bob, on your point on the forward look, do you have a feel, as we stand here right now on the second half? Do you guys accumulate a forecast for that?

Robert Bahash

Well, as we're looking at the full year, I have full-year data in front of me now – again, based on external information, CDO growth in the US forecasts to be about 30% and in Europe, about 28%, so clearly very positive through the balance of the year. As Terry pointed out, we expect to grow financial services double-digit, top and bottom line, for the balance of the year.

Michael Meltz - Bear Stearns

Sorry, one last clarification. Maybe it's a seasonality issue, but if you're saying +125 in the first quarter and +60 in the second, or +30 for the year, wouldn't that imply down in the second half?

Robert Bahash

Well, yeah. I think the key to focus on here is that this is a very broad portfolio, and you're focusing on one particular element within the portfolio. We see significant growth in other sectors. Again, with data and information that has been growing very strong we feel very, very comfortable about our forecast for the full year.

As we've pointed out earlier and as you well know, we have forecast a decline in the marketplace in 2007, and we continue to hold to that. So that is within that structured area. We do expect a decline, we expect a decline in the second half of the year. No question about it. Nevertheless, we feel very comfortable about our forecast for the balance of the year.

Harold McGraw

And I would also say, Michael, that when you're talking about year-over-year, the decline of 10%-15% that we're predicting for the US residential market, it's still a sizable market. And the year-over-year comparisons obviously just get a little bit difficult.

Michael Meltz - Bear Stearns

OK, thank you for your time.

Operator

The next question is from Karl Choi from Merrill Lynch. You may ask your question.

Karl Choi - Merrill Lynch

Hi, good morning. A quick question. I wonder if I heard it correctly, Terry, you're now expecting (inaudible) high industry growth to be 5-7% for the year, which I think is a little bit higher than 4-6% previously. I'm wondering what drove that to change? I have a follow up.

Harold McGraw

OK. Again, as we go we'll give you our best thinking on that one. We see the market growing at 5-7%, and we see ourselves outperforming the market.

Karl Choi - Merrill Lynch

Similar question for college, given the strong start in January or in the first quarter overall, and the seasonality of the business, does a 4% growth for the industry seem a little bit conservative, given the fact that it seems like is was double digit in the first quarter?

Harold McGraw

Yeah, again, in terms of some of the timing-related issues, I go back to the question about the fourth quarter. College sales, higher-education sales, were just a little bit lower than what we thought they were going to come in at. And we were trying to put that into context, on that one. And the echo effect that we talked about happened in January rather than in December.

So I think the first quarter numbers benefited from some of the follow-through coming out of December. But again, maybe you're right, maybe it is conservative. But I think that right now, the best information we have on the market is 4%. And given what we're seeing at this point, and how well the products are doing, we think we're going to beat that.

Karl Choi - Merrill Lynch

And Bob, I don't know if you have this, but do you have the deferred revenues at the end of the year quarter? And if you have the growth rate year over year, that would be great, as well.

Robert Bahash

OK, let me just look for that. I do have it. I'll have it in just a moment.

Karl Choi - Merrill Lynch

And lastly, Terry, you have the 20% operating margin goal for education. Is there any update on what progress you can make on improving the margins on the whole year, given the good start that you had in the first quarter?

Harold McGraw

Well, again, you know all the components we're looking at, in terms of that goal. And there was the global transformation project, and there was the resource management project, and the market itself, and so on. I think that's our goal, and this is an important year. So let's see how this year starts to unfold, and then we can tighten that up for you. But that's the goal.

Robert Bahash

Karl, with regard to the unearned/deferred revenue you asked me about, at the end of the quarter it's about $978 million.

I should just point out that in the base year last year would have included an element form the divested funds business so the growth rate would be higher because of course we don't have that in this year. So this is almost 13% with funds in the base year so it's something higher than that, so nice performance here.

Karl Choi - Merrill Lynch

Great. Thank you.

Operator

Your next question is from Drew Crum from Stifel Nicolaus. You may ask your question.

Drew Crum - Stifel Nicolaus

Great. Thanks. Good morning everyone. Harry I was wondering if you could share with us if there was any update on the regulatory front for the credit rating business.

Harold McGraw

Yeah and I'll make sure that I've got these dates right. At this point we've gone back and forth with the FCC. They're in the final stages now of developing their final positions. I believe those have to be completed by May 23rd. On that one I'll get that date exactly for you but I think they need to be completed by May 23rd for implementation in June on that part.

From our standpoint, it has been a fairly good outcome. We have gotten the things that we want. There was some discussion on a couple of issues going on but the FCC is on schedule and so far we're very comfortable with the way it's working.

Let me see if I've got June 26th. June 26th and I think May 23rd was the deadline for them to complete their work but they have to be implemented by June 26th on that one and we don't see any, and again all along we've been working very comfortably with them, we don't see anything that materially would effect us.

Drew Crum - Stifel Nicolaus

OK, question for you on the L-high business. You talked about last quarter cutting some less than profitable testing contracts and based on the due diligence we've done you guys appear to be maintaining share and picking up some nice contracts along the way. I was wondering if you could comment directionally the profitability for this business. You talked about margin erosion the last several consecutive quarters. At what point do you reverse that trend and get the margin going in the right direction?

Harold McGraw

OK. We are sitting on some very big contracts that will be coming due in the second quarter. And we're waiting for the outcome of some of those and we're very hopeful on that one.

Let me put it into the broader context again. Again you have two types of tests. You have the sum of the test, the high stakes test and you've got the formative test which is the low stakes test. The growth in this market is in the formative side. In the past our strength has always been on the very large high stakes tests. The information management systems designed to create those tests are different than the ones to do the formative.

The formative low stakes tests for teachers, for principals, administrators, whatever, you need to have and you have to have customization to what they're trying to measure. And those two require different information management systems, and as you were saying, that's where the investment is going, in creating the capabilities such that we can compete very quickly in those markets. Now the brand that we're using on the formative side is Acuity and Acuity is up again and some big contracts and we should probably hear fairly soon on a number of them. So that would be a second quarter issue. But again the investment, and a lot of it is P&L investment, is still ongoing in terms of building the kinds of systems to do that.

Drew Crum - Stifel Nicolaus

OK thanks for the color, Terry. And Bob, one question for you, is there any updated guidance for free cash flow for the year?

Robert J. Bahash

No, we haven't made any adjustments. We're in the range of $750–775 million. We're holding to that in this point in time. The sharing purchase activity was simply a timing issue in terms of the acceleration earlier in the year versus what we probably would have done over the balance of the year, but no impact over the $750–775 million.

Drew Crum - Stifel Nicolaus

OK. Thanks guys.

Harold McGraw

Thanks Drew.

Operator

The next question is from Fred Searby of JP Morgan. You may ask your question.

Frederick Searby - JP Morgan

Hey thanks guys. Great quarter. Question for you Terry. Just to drill down a little bit on the margin expansion you saw at Standard & Poor’s, clearly that was extremely positive. How much is fixed cost solution? Bob you mentioned that some of it was fixed cost solution and some of it was changes. Are we seeing as you ramp up in some of these non-ratings businesses, particularly Catholic Union as actually having a meaningful impact on margins as you kind of gain scale and secondly what should be the progress there throughout the year? It sounds like you're expecting some ongoing strength in margins at Standard & Poor’s. Thank you.

Harold McGraw

Yeah thanks Fred. Let me take the first whack and then follow up Bob.

You're going to get margin expansion at financial services in 2007. You're not going to get a lot of contribution more than from investments like Capital IQ. Capital IQ, we are really driving hard in terms of customer penetration and market acceptance. And therefore they're in a full investment mode. We are very excited about the prospects for Captial IQ and the progress they're making. And again in terms of the overarching strength the margin expansion is coming from a higher level of efficiency and the robust growth. We expect for 2007, quite frankly in terms of our own plans going forward, it's to continue to see margin expansion on S&P.

So I think the guidance I would give you is that we're definitely going to do better than 2006 and let's see how the year starts to unfold where we are. But $477 million for the first quarter includes that $17.3 million gain on that mutual fund gain but still it's showing good growth and we expect as Bob said to show double digit top to bottom and margin expansion in the remainder of the year. Bob do you want to add anything?

Robert J. Bahash

Yeah. Fred, the margin improvements came really across the board with regard to our various products and services whether it's in ratings, data information portfolio services, and performance evaluation side. So we're seeing very very good performance across the board with very prudent expense management. As Terry pointed out, we're allocating resources, we're allocating our expenditures for those particular growth areas where we have an opportunity to significantly expand platforms and we're going to continue to do that and at the same time looking prudently at managing cost in other areas. So we have very solid performance on the revenue side and very prudent management on the cost side.

Harold McGraw

One of the areas, Fred, that we institutionalized throughout the corporation last year, and it was a consolidated business process management function, there's a business process operation in each of the segments and corporate. And they're all coordinated but they all have a number of projects that they're working on therefore when we start talking about efficiency and process improvement we expect to see more and more based on those kinds of initiatives.

Frederick Searby - JP Morgan

Just this one follow-up: You have made what looks like a very (inaudible) call on buying crystal and some of these other agencies around the world and I wondered how margins are impacting the overall business at some of these smaller but albeit fairly exciting rating agencies around the world. How we should think about that as they continue to grow and at some point start growing faster of course than your domestic business?

Harold McGraw

Again Fred, the international growth rates are higher and that's why you're seeing more and more participation in the United States. Building that global network is extremely important.

Crystal is a much larger operation that has been added for a while. We have had a relationship with them since 1996 and it is very strong and doing extremely well. And that's also because of the Indian market that it is doing so much better.

When we start talking about some of the smaller and as you got to get the revenue base up to be able to get the same level of participation and therefore they're in varying degrees again of development and they would have different margin levels. But they will have comparable margins, as all will have comparable margins to the US as they gain size and critical mass. But again the growth outside the United States is much faster.

Frederick Searby - JP Morgan

Alright thanks.

Operator

We will now take our final question from the line of Brandon Dobell of Credit Suisse. You may ask your question.

Brandon Dobell - Credit Suisse

Thanks. I'm going to repeat the debt horse one more time. If I could frame the CDO growth expectations question a different way if Q1 was up 150% and Q2 expectations are up 60% and all of Q1 came in all above of what we were expecting it to, the two part question would be wouldn't that necessitate either a change to the year estimate if it started out so strong, wouldn't that 30% now have to be higher?

Or if in '06 the first half of the year was roughly 40% of the volume, with your projection for Q1 and Q2, it seems like the math would have to work out that the back half of the year would have to be roughly flat or down a little bit for that 30% number to be the right number. Just trying to put all of those things together to understand how it is. If the forecast is too low and quite materially too low if we see continued strength or if the implication is that 30% is the right number there should be an offset to the strength that we saw to the first quarter out of the box? Thanks.

Harold McGraw

Bob's got some specific numbers for you Brandon. But remember you have 154% now as a Q1 over Q1 growth rate and the other numbers that Bob was giving you were the same. And the market strong and will be strong and we're going to be participating right along with it. Bob you want to get the specific number on that?

Robert J. Bahash

Yeah when you go through and do that math and 30% which I indicated was the full year, the second half of the year would work out to be roughly flat as compared to the second half of the previous year.

Again as I point out, imbedded within that forecast were elements of the RMBS issuance and such that we had forecast to be down on the year to year basis by roughly 15% which we expected to see pretty much across the board and if not possibly accelerating in the second half of the year. So that clearly is an influencing factor but again that's one part of the market.

The CMBS area is growing significantly. We expect corporates to do very well, the nontraditional markets bank loan ratings and such to do very well. And we continue to be very very bullish about our non-ratings products and services being data information, portfolio services, etc.

As well as high yield by the way. High yield is expected to do very well through the balance of the year. So again this is a portfolio look and as we looked at the portfolio, we looked at issuance, we looked at future revenue streams and such, that's how we came up with our balance of the year double digit top and bottom line.

Brandon Dobell - Credit Suisse

OK. I appreciate the clarification. That's great help. And you guys have a more diverse portfolio than I think people realize sometimes. In the education space, as you look forward over the '07, '08, '09 timeframe you gave some color about what percentage the adoption market you expect to compete in this year. Should we anticipate that the '08 – '09 timeframe that you guys also go after that much of the adoption market or is it materially different in those two years that your portfolio fits better this year than it might in '09 let's say?

Harold McGraw

No that's certainly the game plan, Brandon. When you start talking about '08 and we're into '08 product now and you know '08 and '09 you still got very big in a state and very big disciplines. This year you've got California K-12 science. In '08 you've got California K-12 math. And then in '09 you're going to have California K-12 reading and literature so those are big. Florida not only do you have the Help the World Languages for this year, in a way you've got K-12 reading and reading intervention which will be big and in '09 you're going to have 6-12 literature in Florida and so forth.

So the plan with this kind of major adoptions and especially with the reading, math, and the science, you can count that we are going to be looking to participate in all of those.

Brandon Dobell - Credit Suisse

OK, great, thank a lot.

Harold McGraw

Thanks.

Operator

That concludes this morning's call. On behalf of the McGraw-Hill Companies we thank you for participating and wish you a good day.

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