Donald Rubin - SVP of IR
Terry McGraw - Chairman, President and CEO
Robert Bahash - CFO
Fred Searby - JP Morgan
Craig Huber - Lehman Brothers
Michael Meltz - Bear Stearns
Karl Choi - Merrill Lynch
Edward Atorino - The Benchmark Co.
Peter Appert - Goldman Sachs
Ben [Slater] - Glenview Capital
David Einhorn - Greenlight Capital
Katrina [Fallin] – Citi
McGraw-Hill Companies Inc. (MHP) Q3 2007 Earnings Call October 18, 1969 2:30 AM ET
Good morning, and welcome to the McGraw-Hill Companies’ third quarter 2007 earnings 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, and instructions will follow at that time.
To enhance the call for today’s participants, McGraw-Hill has made the presenter’s slides available on the internet. To do that, go to http://www.mymeetings.com/nc/join. You will be prompted to enter you name. The net conference meeting number is PG5401565. The password is MCGRAW HILL, all caps, with a space between MCGRAW and HILL, and the event type is conference.
This call is also being webcast live from McGraw-Hill Investors Relations web site and will be available for replay about two hours after this 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 star and zero, 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.
Thank you, and good morning. We thank you, everyone, for joining us here for the McGraw-Hill Companies' third quarter 2007 earnings conference call. I’m Donald Rubin, Senior Vice President of Investor Relations for the McGraw-Hill Companies.
With me today are Harold McGraw III, Chairman, President and CEO; and Bob Bahash, Executive Vice-President and Chief Financial Officer.
This morning we issued a news release with our third quarter 2007 results. We trust you have 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/investor_relations.
Before we begin this morning, 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-K’s, 10-Q’s and other periodic reports filed with the US Securities and Exchange Commission.
We are aware that we do have some media representatives with us on the call. However, this call is for investors and we would ask that questions from the media be directed to Mr. Weiss in our New York office, at area code 212-512-2247, subsequent to this call.
Today’s update will last approximately an hour. After the presentations, the meeting will be open to questions and answers. Now, my please to introduce the Chairman, President and CEO of McGraw-Hill Companies, Terry McGraw.
Okay. Thank you Don, and good morning everyone; and welcome to our review of the McGraw-Hill Companies’ third quarter earnings, and I thank you all for joining us.
With me, as Don mentioned, is Bob Bahash, Executive Vice-President and Chief Financial Officer.
I’m going to start today’s session with a review of our operations and I’ll provide some comments on our prospects that are going forward. Bob will than discuss some of the key financial information; and, after our presentation, as Don said, we’ll go in any direction any of you would like to go, questions or comments about the companies.
Well, the third quarter is critically important to a successful year for the McGraw-Hill Companies because of obviously the seasonality of our business. In Education, we produced virtually all of our operating profits for the year in the third quarter. In 2007 we also faced an additional challenge because of some of the difficult conditions in the credit markets. So I am especially pleased this morning with the results that we have just announced for the third quarter.
Let me briefly re-cap some of the highlights. Diluted earnings per share increased 26.4% to $1.34, versus $1.06 last year. Diluted earnings per share in the third quarter of 2006 included a $0.03 charge for restructuring. Net income grew by 18.2% and revenue increased 9.8% to $2.2 billion.
I’ll start this morning by reviewing how we achieved these results and then spend some time on the outlook for the McGraw-Hill Companies and our guidance for 2007. But let me begin with our operations; and because education is such an important contributor to the third quarter, I’m going to start the segment review with McGraw-Hill Education.
Double-digit growth in the elementary-high school market, and margin expansion for McGraw-Hill education in the most important quarter of the year, are key takeaways for this segment. In the third quarter revenue increased 9.9%. Operating profit grew by 16.1%. That included a pre-tax gain of $4.1 million on the divestiture of product line for our parochial schools. In 2006, there was a pre-tax restructuring charge of $5.6 million. The operating margin improved to 35%, up from 33.1% for the same period last year.
Revenue for the McGraw-Hill School Education group grew at 11.2%, and revenue for the McGraw-Hill Higher Education Professional and International group increased by 8.1%.
2007 is the first of four robust years in the state new adoption market. To improve our competitive position at the start of this cycle, we reorganized our base of operations a little over a year ago; and we wanted to do that in order to strengthen our sales, marketing and product development initiatives.
We also stepped up our new product introductions, to take advantage of the new opportunities in an expanding market.
Those decisions are starting to pay off. You can see it in our performance in this year’s state new adoption market, which is growing faster than our original forecast for the market. Some numbers will illustrate my point.
In 2006, our School Education Group participated in about 80% of the state new adoption market, and that was worth about $685 million; and we took a 20% share. In 2007, our reorganized School Education Group competed in virtually the entire state new adoption market, which is growing 14% to 20% and will be worth $780 million to $820 million this year. Our earlier forecast called for 10% to 15% growth and $750 million to $800 million range.
This year we are taking an industry-leading 32% market share of this expanded market, and we are very pleased with those results.
To achieve these results, the school education group led all competitors in California and South Carolina for K-8 science and Grade 6 through 8 math in Texas. We placed first in all six states adopting music for the Elementary Grade. Treasures, which is our K through 5 balanced basal reading program, led the market in Indiana and competed very well in Oregon and Tennessee.
It is also worth noting that we had a 30%+ capture rates in both the K-5 and Grade 6 through 12 state new adoption markets, another important indicator of improved across-the-board performance achieved through a reorganized and better-led team.
The breadth of our product offering is another key to our success this year. In an education market that is not wedded to a single instructional approach, we offer a spectrum of products. So, in addition to our success in Texas Math, we had core basal programs, we took share with Everyday Mathematics, at reform based program. Everyday Math took the leading share in New Mexico’s K through 5 math adoption and sold very well in the open territory, winning business in both urban and suburban markets.
Offering this spectrum of products also means we compete in non-academic subjects. In 2007 we captured significant business in small, but very profitable markets, such as health, business education, technical and vocational education, as well as family and consumer science.
Even as we saw greater strength this year in the state new adoption market, we’ve seen a slower than expected growth in open territory.
We have some anecdotal evidence for this slow-down. Basically, it appears that non-discretionary costs in many districts are rising more rapidly than funding. For example, schools are seeing a substantial increase in fuel costs for transportation and heating and cooling. We are examining these trends in the open territory and in more depth, to gain greater understanding into changes that may be taking place there.
But we do expect, you know, to see some improvement here. According to industry statistics, the open territory market is down 1.4% after eight months. Orders in the fourth quarter, and there are some possibilities here, could produce an uptake this year.
The supplemental market has been soft all year. There is less demand for traditional stand-alone supplemental products, especially those that are not clearly correlated with state standards, because the new core curriculum programs in science, social studies, math and reading, are far more robust than ever before. These new basal programs are all standards-based and they now provide extensive ancillary materials for practice, differentiated instruction and other classroom needs formerly met with supplemental titles.
However, there is a steady growing demand for well-designed supplemental intervention programs. That is, they are using the programs for students that are performing below Grade level.
The schools are most interested in intervention programs that can demonstrate their efficacy with research data. That’s why we are having good success with Kaleidoscope Literacy and Numbers World math programs. This is a promising development, and that will help us gain more traction in the supplemental market.
Strength in the state new adoption market will help offset some of the softness in the non-adoption state, which has been expected to grow about 4% in 2007. Because of the softness in the open territory, it now appears that the total high market will grow in the 3% to 5% range this year, instead of the 5% to 7% originally forecasted.
Our school education group is outpacing the competition in both the state new adoption market and in the open territories, and expects to outperform the market for the full year.
In testing, the performance in both custom and off-the-shelf markets has improved. We are seeing some encouraging developments in this market. In Indiana we recently won a one-year extension of our current Summit, those are the high stakes tests contract, plus a two-year contract beginning in 2008 and a renewable for another two years.
We also won a five year renewal in West Virginia. We are seeing some promising gains in the formative, or the low stakes end of the market, for our new acuity product. This program recently won a five year contract valued at $80 million dollars, from New York City.
Earlier, I pointed out that the state new adoption market looks robust for the rest of the decade. Here’s our latest forecast for the state new adoption market through 2010; and obviously, in 2007, we have upped it from $780 million to $820 million. For 2008 it goes from $900 million to $950 million, 2009 $850 million to $900 million, and then in 2010, $900 million to $950 million; the issue being that it is very strong for the next four years and we expect to do very, very well with that.
Our higher education professional and international group continues to make good progress. In international markets we benefited from strong school sales in Canada and in Spain, and a solid higher education selling season in Europe, Asia and India.
In the US college and university market, our business and economics imprint set the pace in the third quarter, with solid gains in four key disciplines; accounting, economics, introduction to business, and management.
We now think the US college and university market will grow between 5% and 6% in 2007; and we expect to keep pace with the industry. Originally, we thought the market would grow about 4% in 2007, and it’s a little bit strong than we had expected.
Digital products are contributing to that growth across all of our college and university imprints, and in professional markets.
We expect more growth in the digital world with a debut this fall of CourseSmart. This is a new college publisher cooperative e-book and e-commerce web site; and this is something really, I believe, to pay attention to. This is a really strong new endeavor. Instructors logging on to CourseSmart will be able to evaluate textbooks and related material in one convenient location. For students, CourseSmart offers a lower cost alternative and all the functionality of a web application. Our higher end group is starting with 148 e-books. Over time thousands of textbooks will be available on this common platform.
Our online product offerings for professionals continue to grow, both here and abroad. Two new subscription-based specialty sites introduced this year; one is called Access Emergency Medicine that was done in January; and Access Pharmacy in April was there; and they’re off to very good starts with growing institutional sales.
Our professional books are also making the best-seller list. In September, one title, Rules for Renegades, a new title that made it onto four best seller lists, was number 1 on USA Today’s business list, number 2 on Wall Street Journal’s business list, number 14 on the Wall Street Journal’s non-fiction list, and number 4 on the New York Times hard cover advice list.
So, summing up for the McGraw-Hill Education, a solid third quarter performance, and market share gains in the elementary high school market. We’re very pleased with that performance. Good growth in higher education, here and abroad. Digital products continue to gain traction in higher education and professional market. We now expect the LI market to grow 3% to 5% this year and 5% to 6% increase in the US college and university market; and operating margin for this segment will improve for the full year.
Okay. With that, let’s go to the McGraw-Hill Financial Services.
The third quarter started strongly and softened in September; but we still met our guidance for this period by a comfortable margin. In the third quarter revenue grew by 12.5%, operating profits increased by 17.3%, and the operating margin expanded to 45.7%, up from 43.8% last year. All this was accomplished, even though there was a decline in the US structured finance market in the third quarter.
Credit quality issue, and the re-pricing and the re-evaluation of risk, due in part to the concerns regarding the performance of sub-prime mortgages, all contributed to that decline. But what kept Standard and Poor’s growing in the third quarter was its resilient portfolio.
The strong performance included international credit ratings, which grew at a double-digit rate and represented 41.6% of ratings revenue in the third quarter; non-traditional ratings in services, which also grew at a double-digit rate and now account for almost 26% of rating revenue; corporate and government ratings had solid performances; and financial information products and services also had very strong performance.
In short, the results underscore the successful action that we have taken over in the past several years, to strengthen Standard and Poor’s diversification and resilience.
Although new issue volume is an imperfect measure of our performance in any one period, recent issuance does illustrate the trajectory of business in the third quarter.
As this chart indicates, after a slow start in July, there was strong acceleration in new dollar issuance in the US industrial market in August and September, and obviously for the third quarter. There also was modest improvement in the public finance sector, which was encouraging. But we saw a sharp decline in new issuance dollar volume in the US structured finance markets as the third quarter progressed.
The following charts illustrate the pattern I’ve just described. You can see year-over-year volume plunging in September for the US residential mortgage backed securities, and also somewhat for the US commercial mortgage backed security and US collateralized debt obligations CEO’s.
The activity that we’re seeing in the US structured finance so far in October, is tracking the level of issuance we saw in September. We have already pointed out that the year-to-year comparisons are challenging in the fourth quarter for structured finance. It is a large quarter seasonally for that business, and the revenue model is heavily transaction-oriented.
We now expect new issue dollar volume in the US residential mortgage backed securities market to decline by 70% to 75% in the fourth quarter versus last year, which obviously was robust.
Declines of 85% to 90% are possible in the new issuance of US CDO’s (collaterized debt obligations) in the fourth quarter versus last year. As these charts illustrate, new issue dollar volume in the fourth quarter of 2006 actually surged in December for US residential mortgage backed security and collateralized debt obligations. The comparisons may not be quite a challenging for asset backed security and possibly US commercial mortgage backed securities.
Despite market turbulence, S&B is encouraged about the prospects in the asset backed market. Credit card issuance continues to show strength. Scheduled refinancing and increased credit card utilization by consumers are reasons for optimism. Solid issuance of auto loans for the remainder of the year is also a possibility, as banks re-deploy capital to fixed-rate short term auto loans instead of mortgage products.
A pick-up in commercial mortgage backed securities is a little bit problematic at this point. Commercial real estate fundamentals remain very strong but activity has been chilled by the sub-prime problems in the residential market. Widening spreads have kept many investors on the sideline, resulting in a reduction in the demand for new issuances. We really believe that in the commercial mortgage backed market, this is a temporary situation because it has been quite strong and we expect that to continue.
The weaker US structured finance will be at least partially off-set by continuing strength in investment-grade corporates, international markets, non-traditional ratings and services, annual contracts and surveillance fees, and financial information products and services and vigorous expense management.
There is reason for optimism in the corporate market. Investment grade corporate issuance really has not faltered. In fact, it has set new records. Industrial issuance will continue to be driven by favorable financing environment, M&A activity, and investments in capital expenditures.
Financial services issuance will be driven by many of the same factors, including balance sheet restructuring activity. Spreads also remain historically tight and rates remain low. In addition, we expect a 10% to 11% increase next year in potential refundings.
S&P anticipates that $47.9 billion of US corporate debt to mature or be called in the fourth quarter of this year. Another $250 billion is potentially refundable in 2008, and that’s about an 11% increase over 2007 levels. The new issuance calendar also looks quite strong for the coming months.
As I pointed out earlier, our diversification efforts continue to contribute to growth and make our business more resilient; so we continue to expand our financial information and index services.
In the third quarter, trading started for six new exchange traded funds based on S&P indices, including our first in the fixed income space. It’s the S&P national municipal bond index, sponsored by Barkley’s Global Investors.
Today there are 133 exchange-traded funds worldwide, based on the S&P indices, and more are in the pipeline.
We are making good progress licensing some noteworthy clients for S&P GSCI index; that’s our commodities index, and that was acquired from Goldman Sachs.
Dated information products are growing rapidly. The Capital IQ product is adding new clients and expanding its base with existing customers. New modules, including portfolio management tools, are increasing demand for the Capital IQ product. Expect more innovation here and more expansion into international markets.
Given all the uncertainty in the credit markets at this time, it’s too soon to start making projections for 2008. Some observers feel a calm is returning to global credit markets and a fragile stability is starting to set in.
Going forward, there will be more, not less, focus on credit quality. Liquidity, worldwide, remains plentiful. We know that from the surpluses from OPEC, Japan, China, Canada, Russia. The benefits of securitization, the liquidity, the economic capital reductions, tradability, will remain strong after the current turbulence has dissipated.
There are also questions about the timing of the next interest rate cut by the Federal Reserve. The changes of a rate cut later this month seem to have faded somewhat, with third quarter growth now appearing to be stronger then expected.
David Weiss, who is S&P’s chief economist, now thinks we could see a fed rate cut in December or, more likely, in January of ’08.
The housing recession still has a way to go. David Weiss projects that housing prices will fall nationally by 11% peak-to-trough, with probably another 6% to 8% still to come. The difficult news is that no rebound is expected before the end of 2008, so we have a little bit more to go with the housing recession.
Areas that experienced the greatest speculative run-up in prices, such as California, Florida, Nevada, Arizona; and states where the economy has been hardest hit by increasing unemployment, such as Michigan, Indiana, Ohio; could experience price declines of 15% or more.
On September 24, the Securities and Exchange Commission granted the registration of Standard & Poor’s as an NRSRO, and that was under the US Credit Rating Agency Reform Act of 2006.
September is also the month the SEC commenced an examination of S&P and other rating agencies’ policy’s and procedures under the Act; and of course, as always, S&P is working with the SEC in connection with this undertaking.
We will continue to work with the SEC, regulators in Europe, and we also work with regulators in Asia, as well as the US Congress, to answer any questions about our policies and procedures; and we obviously welcome the opportunity to discuss any aspect of our business. Transparency, and increasing transparency, is always good.
Based on current information, we don’t believe any pending legal, governmental or self-regulatory proceeding will result in any material adverse affect on our financial condition or our operations.
This is a challenging period for financial services but we believe the issues are being addressed. Equally important, the favorable long-term trends are clearly intact and will continue to drive our business for some time to come.
So, let’s sum up our financial services; a solid performance in the third quarter, despite a tough market environment; worsening conditions for structured finance in the United States in the fourth quarter; but the rest of the business remains strong. A double-digit top and bottom line performance for the full year; and we will have, once again, margin expansion for the full year.
Now let’s review the information and media segment. For the third quarter, revenue increased 2.1% and operating profit grew by 35.8%. In the third quarter last year there was a pre-tax restructuring charge of $5.8 million. The operating margin was 7.4%, up from 5.5% last year. This segment is in transition, as we work to overcome the softness in advertising with increased sales of higher value information products and services delivered to customers on-line.
A weak advertising market was certainly a factor in the third quarter. Revenue in the broadcasting group for the third quarter declined by 7.8%; and revenue for the business-to-business group was up 3.2%, even though Business Week’s ad pages were off 24.6% in the third quarter.
The business-to-business group’s growth came from information products and services. Clearly, the strong performances came from pricing to news for oil and natural gas and power from plats. Expansion of our international research and proprietary studies under the JD Power & Associates brand; products also, and services delivered on-line to the construction industry, which is virtually a 24/7 on-line network now.
I also urge you to take a look at the newly redesigned Business Week, starting with the October 22nd issue. The re-launch of the Business Week is the product of 18 months of research among readers and non-readers, to gain a better understanding of today’s business information consumers. Editor-in-chief, Stephen Adler, has reconceived the publication; and, in the spirit of the new internet age, will direct his editorial team to sort, to clarify, to illuminate the important developments for an audience of more than 4.8 million readers each week. That means offering other smart perspectives from around the world alongside stories developed by Business Week in a multi-channel endeavor.
The goal is to solidify Business Week’s leadership as a multi-platform global business media organization and build on healthy circulation statistics. News stand sales, a key indicator of editorial vitality, are up 25% in the first half. The average price for subscribers is up 1%. Overall circulation is very steady.
So, summing up our information and media segment, advertising remains soft but growth in on-line information product will continue to be, you know, the focus and the push on that.
That completes our review of the operation; and let me now address some of the guidance issues here; and I want to spend a few minutes updating our guidance for the full year, as well as for the fourth quarter.
We are still on course to produce double-digit earnings for share growth for the full year, for 2007. For the full year, we expect improved operating margins at McGraw-Hill Education and McGraw-Hill Financial Services, no change there.
Our guidance excludes the following items: a $0.04 charge for the elimination of the restoration stock option program in the first quarter of 2006; a $0.06 charge for restructuring in the second half of 2006; and a $0.03 gain from the divestiture of a mutual fund data business at Financial Services in the first quarter of 2007. On that basis, after nine months of solid achievement we have already earned nearly as much as we did for all of 2006.
Now, given those charges and gains, on a GAAP basis inclusive of these items, the 2007 earnings growth would be even stronger. But I believe that the non-GAAP financial measures, and excluding those items, provide more useful information to investors due to the unusual nature of those excluded items.
Now let’s review the outlook for the fourth quarter. In the fourth quarter, Financial Services faces the toughest comparisons of the year. Last year revenue for this segment grew at 22.1% in the fourth quarter.
For the fourth quarter this year, we expect a high single-digit decline in revenue and some margin contraction because of the challenging conditions in the U.S. structured finance market.
For McGraw-Hill Education, in a seasonally very, very small fourth quarter, we expect a slight decline operating profit and some margin compression. As a consequence, the corporation’s revenue and earnings in the fourth quarter will not match last year’s results.
So summing up for the corporation, first of all double-digit earnings growth for the full year, even though revenue and earnings will be reduced in the fourth quarter versus last year; and margin expansion for the year in Financial Services and McGraw-Hill Education.
With that let me hold it there, and let me turn it over to Bob Bahash, our CFO, and he will go through some, and then we will go to your questions and comments.
Thank you, Terry. I will begin this morning with an update on our share repurchase program. We planned to repurchase up to 30 million shares this year. We achieved that goal in the third quarter by buying back 10.5 million shares for a $616 million. The company has spent $1.9 billion this year for the 30 million shares. That averages to $63 per share. Since 1996, the corporation has returned $8 billion in cash to shareholders through share repurchases and dividends including more than $2.1 billion in the first nine months of 2007.
There are 35 million shares remaining in the 2007 repurchase program. That was authorized by the board of districts last January. As a result of share repurchase activity, the diluted weighted average shares outstanding declined in the third quarter to 337.7 million shares. This reflects a 12.6 million share decrease compared to the second quarter of 2007, and a 23.2 million share decrease compared to the same period last year.
We ramped up our borrowings to fund the additional share repurchases. At the end of September, we had a net debt position of $879 million which is up from a net debt position of $636 million at the end of the second quarter.
As of September 30, on a gross basis our debt is approximately $1.3 billion, which is offset by $453 million in cash, primarily in foreign holdings. The current debt reflects a mix of short-term borrowings, primarily in commercial paper, with the balance in extendable commercial notes and money market loans.
As a result of increased borrowings, interest expense was $15.4 million in the third quarter, which is more than double the $7.5 million in the same period last year. For the full year, we now expect interest expense in the range of $39 million to $41 million, which is slightly lower than our previous estimate of $40 million to $42 million.
Let’s now look at our corporate expenses. Corporate expenses decreased $9.5 million or 20.1% in the third quarter, as compared to a year ago. Corporate expenses in the third quarter of 2006 included a $4.1 million charge for restructuring. Excluding this charge, corporate expenses decreased $5.4 million in the third quarter compared to a year ago. The decrease is primarily driven by lower incentive compensation versus the prior year, and a one-time gain from the sale of an equity investment.
Regarding operating segment performance, there are two items that influence year to year comparisons in the third quarter. In the third quarter of 2007 we sold a non-strategic product line -- Terry mentioned that -- within our K-12 business that resulted in a pre-tax gain of $4.1 million. And in the third quarter of 2006, we incurred pre-tax restructuring charges of $15.4 million or $0.03 per share. That was primarily for employee severance in McGraw-Hill Education, information and media, and at corporate.
The effective tax rate in the third quarter was 37.5% compared to 37.2% in the same period last year.
Let’s take a look at our capital expenditures, which include prepublication investments and purchases of property and equipment. Prepublication investments were $77 million, compared to $64 million for the same period last year. For 2007, we continued to project that pre-pub investments will be about $310 million.
Purchases of property and equipment were $63 million in the third quarter, compared to only $25 million for the same period last year. This is of course being driven by the construction of our new data center which is underway and expected to be completed in the first half of 2008, along with technology investments we are making to digitalize our products and services. We continue to project $250 million for 2007.
Now for some of the non-cash items. Amortization of prepublication costs was $110 million in the third quarter, compared to $103 million in the same period last year. We now expect to be about at a level of $250 million in 2007, which is down slightly from our previous estimate of $260 million. Depreciation was $26 million in the third quarter, that compares to $27 million in the same period last year, virtually flat. We now expect it to be $120 million in 2007; again this is also down slightly from our previous estimate of $130 million due to a change in the timing of capital expenditures in 2007.
Amortization of intangibles was $12 million, that’s also flat with last year. We expect 2007 to be about at $50 million.
Finally unearned revenue was just over $1 billion in the third quarter, which is up from $884 million for the same period last year. This reflects a $121 million or 14% year-over-year growth. This revenue will be largely recognized over the next 12 months.
As Terry pointed out, with a softer revenue forecast it is likely that it will impact some of the growth related to unearned revenue for the fourth quarter.
Thank you. Now back to Terry.
Thank you, Bob. That completes our review. Let me just say again, I am very pleased with the solid results for the third quarter, coupled with the very strong results in the first half of this year. In Education, we delivered in the most seasonally obviously important quarter of the year. I’m very pleased with the McGraw-Hill School Education Group that we reorganized a year ago. For them to come out with such a strong performance and a 32% share in the new adoption market, we were pleased with that.
In Financial Services again, another very strong performance in a lot of areas, although we are facing obviously some very challenging market conditions in the U.S. structured finance market. We understand the issues here, and trust me, we are riveted on those issues and we will be doing everything we can to bring that back to an acceptable level for us. The long-term trends though in the market are so strong, and are obviously very intact and we are buoyed by that. So again, we will deal with whatever challenging market conditions and we feel very good about our overall position in the portfolio.
With that, let me turn it over to Don Rubin and we will go to your questions and comments.
Thank you. Just a couple of instructions for our telephone participants. (Caller Instructions) We are now ready to take our first question.
Your first question comes from Fred Searby - JP Morgan.
Fred Searby - JP Morgan
Congratulations on the quarter. Can you give us some sense of what percent of S&P’s revenues were non-rating business and how fast they were growing in the quarter?
Can you also give us a sense, it looks like some of the issuance from 2Q spilled over into 3Q and that’s why there is partially precipitous fallout expected in the fourth quarter. Can you confirm that or just give us some color around that?
Thanks, Fred. As you know, in terms of Standard & Poor’s we don’t break out the individual components on that. The financial information and services side is strong and doing quite well. Also on the fixed income information side coming out of ratings as well, with RatingsDirect and RatingsXpress and things like that.
No question everything was impacted by the U.S. structured finance market, most notably the residential mortgage-backed market and the collaterized debt obligation markets. It had a little bit of effect on other issuance as well as I think everybody that started took a little bit of a pause. But the corporate and government side is quite strong, and we are already seeing significant pickup in opportunities there. Again, for the obvious reasons, because of M&A activity and capital expenditures and so forth on that part.
Also, as we were saying, the non-traditional areas and the international side has not abated. I just came back from an Asian trip and they are not experiencing any of these kinds of issues. So it has had an effect for sure, but for the quarter, July and August were quite strong and September is where it really had its effect. It will have an effect going forward into the fourth quarter, but we see that turning around and it is too early to start to get into 2008 projections. We will see. We will see how some of this unfolds. But at this point anyway, that’s how we are looking at it.
Your next question comes from Craig Huber - Lehman Brothers.
Craig Huber - Lehman Brothers
What do you think the average maturity is of the stuff you rate on the structured side versus the investment grade leveraged loans and syndicated loans, all of that. What’s the average maturity on both sides?
Craig, I think I better get some better information for you than what I currently have. For the most part we are seeing most things with intermediate terms on that one; ten years, in that area. When you start talking about specific instruments, obviously it would all be different in the residential mortgage-backed depending upon whether it was fixed or whether it was adjustable and all those kind of things. Those are all packaged loans. So I don’t want to give you an answer that I’m not comfortable with, so we will get back to you with more information on that. I would be thinking more in intermediate terms.
Craig Huber - Lehman Brothers
What I’m getting at here is because this is perhaps uncharted territory, the so-called bubble on the structured side. What happens here if it takes multiple years for structured finance to level off and start growing again? Because then you are not replenishing the stuff that’s already matured. If this goes on for a few years so the surveillance fee would start to take a little hit and that has been a nice buffer for you guys. If this thing drags on long term, is that going to be a problem here?
Well, we are into subjective territory, Craig. My opinion is just one. I personally don’t think a two-year timeframe for a credit crunch in the structured finance market to return is realistic. We are already seeing signs of things like the commercial mortgage-backed market starting to pick up again and I think it was just a pause that has been taken there because we had seen, since early 2005 that market do very well.
I think we have to assume that there is going to be some softness, certainly with CDOs and residential mortgage-backed securities, going forward here. I don’t think that we are going to see an extended credit crunch. I think that would have implications on the economy overall, and I don’t think that would be in the best interests of the major lending institutions either. So I just don’t see that taking place.
There is an enormous liquidity, as you know, that still exists in the system because of all the worldwide surpluses and that still has to be employed. So I see this as more temporary in nature rather than long-term in nature.
Craig Huber - Lehman Brothers
Can you just talk a little bit about your cost based within Financial Services? What kind of flexibility you have there for next year if this does drags on into next year in terms of the bonus accruals you could play with, head count et cetera. I know it is largely fixed costs but what can you do on the cost side next year on financial services?
As you know, in terms of the rapid growth that we have had in areas like the U.S. structured finance market, what we have done is developed lots of cross-training programs and the like because you just don’t want to be hiring and hiring and hiring and then all of a sudden, things like this happen and then all of a sudden you are doing a lot of changes on that.
So we do a lot of cross-training so that we can move people around to the other areas and so we have analysts that are being redeployed into the corporate and government area or into some of the other international opportunities. We have latitude on this one. But I can guarantee you that everything is being looked at. We will take appropriate action as we size the revenue opportunities.
Our next question comes from Michael Meltz - Bear Stearns.
Michael Meltz - Bear Stearns
I have three questions. Can I just get a better sense as to the guidance for the fourth ? quarter? About a month ago you were guiding to roughly flat or flat to slightly down in financial services and now you are saying down high single-digits. Can you just talk a little bit about what has changed in your expectations? It sounds like structured finance; what are magnitude you are thinking about now?.
Secondly, implicit in your guidance are you expecting international revenues to be up double-digits still?
Thirdly, at the Education Group your margin was pretty strong in the quarter, but your pointing to decline year-over-year in the fourth quarter. Can you talk a little bit about what is going on with the expenses there?
Really, in terms of the guidance or the fourth quarter, we are trying to give you the best look that we have on it. When we were doing the second quarter earnings and when we updated our guidance -- I think it was September 18th -- we were looking at a situation that was evolving at that point. So we were saying it looked to us at that point that the fourth quarter would probably be flat for Financial Services.
Clearly given the September results and what we are seeing in October, the residential market and the CDO market has really come to a grinding halt. I don’t think that is going to last a long time, but it is certainly there.
What we are giving you is an extrapolation of what we are seeing right now; if there is some upside to that, great. But at this point, we are just extrapolating out what the current environment is giving us. We are buoyed by the fact that the corporate and governments is doing well and that international side is also doing well.
Now, on the international, double-digit on that one; again, we are going to have to see what effect -- the Asian markets are not affected at all in this area, or for the most part, at all on that one. The European markets are affected somewhat on that one. Again, what creates a credit crunch in that one is more of an uncertainty and almost a panic to say hey listen, let’s just lay low for a while until we see what activity takes place. We are already seeing a pick up in activity in certain areas. Our thinking is that things are starting to calm down a little bit in all of that. But in terms of projections so that you have got the best possible information from us, we are extrapolating out what we are seeing in September and October to date.
On the Education side, and on the expense side, we are very, very tough on that it. We watch that very, very carefully. The fourth quarter is so small for Education, the third quarter is where it’s at. There are always timing issues. Do sales orders coming in run over between the end of September, into October and all of those kind of things. Sometimes there are those kind of issues. But the third quarter needed to be very strong, and it was and we were very pleased with that. The fourth quarter, it is just, it’s really very small. From an expense standpoint we are always watching that very carefully.
Michael Meltz - Bear Stearns
Terry, so just to put parameters around it. To understand the high single-digit revenue decline, can you put parameters around what you are expecting out of your Structured Finance business?
Well again, in terms of specific again, guidance on anyone component, we are not. But you can go to your own CDO desk and mortgage backed area and you know that the activity right now is obviously very light on that one. I think that will probably remain that way at least until the end of the year.
It is the U.S. structured finance part of the market that is being impacted.
Michael Meltz - Bear Stearns
Do you think your international structured finance business can grow in that environment?
Well again, we will see. It has not been impacted at the same extent that it has been here in the U.S. but again we are in real-time now and we are monitoring activities just like you are. Will somebody come back into the market more rapidly in the European markets than here? Don’t know on that part. But we are obviously monitoring it, and I would think that, but until we get a little better evidence… again, as we start looking at early ‘08 and all those kinds of things, I need to see what the activities over the next six weeks is to be able to started making any kind of predictions on that.
Michael, if I could just add a couple of points here. With regard to the fourth quarter and how we constructed our guidance here, as Terry pointed out it is an extension of really what occurred in September and what we are experiencing here in October; but when we look at external data as we gather market volume forecasts looking at Thomson Financial Securities data, Harrison Scott data, et cetera, when we look at the U.S. RMBS and CDO forecast there are declines on a year-over-year basis because last year was so strong, in the 70% to 80% range. Europe on the other hand is not as dramatic but there are declines especially in RMBS and CMBS in the 30% range. That was the basis in guidance we used to instruct our forecast in the guidance we gave to you.
Your next question comes from Karl Choi - Merrill Lynch.
Karl Choi - Merrill Lynch
I also have three questions. First regarding structured finance revenues, I think Terry you mentioned that is mostly transaction driven. I believe that Moody’s talked about 25% of restructured finance revenues coming from annual fees. Can you give us a sense of a similar percentage at S&P? Is it similar, higher or lower?
A second question is related to the supplementals. It sounds like from the trends you talked about, does it mean the supplemental softness can actually continue into 2008?
Bob, can you give us the basic shares outstanding at the end of the quarter?
Yes, in the structured finance area, as you know again, and especially towards the end of the year, it is more transaction driven on that one. Everything that we do is we try and push things towards a broader surveillance there. I would say and I will get you a number on that, but I would say that we are higher than the 25%. But again, right now given the fall off, at this point of the year it is more transaction-focused. On a yearly basis, we would be much heavier towards surveillance on a fee basis. But at this point in time it is going to be more transaction driven.
On the supplemental part, what we are seeing is a little bit of a mix change between the basal side and the new adoption market and the supplemental market. With big programs now and especially focused on social studies, math and science, reading, the requirements that are coming from the State are inclusive of a lot of different add-on products; online products, assessment products, all sorts of things. What we are seeing is a little bit of a shift this year towards the bigger programs, the adoption programs.
The supplemental market is an important market, and it’s really focused on the sort of alternative basal, or the intervention and remedial kind of products that support the adoption market. We are seeing that as a focus in ‘07 more than we saw that before.
So we are picking it up and that’s why we saw the State new adoption monies. We were talking about $750 million to $800 million. We upped it to $780 million to $820 million because some of those monies that were in the alternative area we are moving into the new adoption market.
So the total opportunity is not going away. It is a mix shift. Supplemental is going to be very important to us. We will continue to focus on the remedial intervention there.
Basic shares outstanding at the end of the quarter was 329 million.
Karl Choi - Merrill Lynch
I believe testing revenues last year was down around 13%. Can you give us a sense what your expectation is for this year?
Well, we honestly don’t break out, Karl, the testing revenues per se but in talking in general about our testing business, we are very excited about some of the shelf revenues. Obviously we gained some significant share on custom contract revenue with some of the wins that Terry had pointed out. But the Acuity product is very exciting for us, and we are seeing significant growth in that category. We don’t break that area out in particular, but we are really excited about the web-based Acuity offering that we have.
Karl as you know, we have been spending a lot of investment on this area and it’s very encouraging to go see the results that we are getting here. As you know, we were a high stakes testing business, and the growth is all in the low stakes or the formative side and Acuity product, as Bob said, is doing really well. We are building more enhancements on that.
Testing assessment is going to be an important component. We are on the right track with that.
Your next question comes from Edward Atorino - The Benchmark Co.
Edward Atorino - The Benchmark Co.
The press release talks about weak revenues and softness in education. You went down in education in the fourth quarter. Why would that be?
Ed, as you know, you know, the fourth quarter is relatively very small. The third quarter is where it’s at. The upside that we are looking for is on the higher education side because that is obviously a more global business and we’ll see from that.
But it is just that in terms of K-12, we did extremely well in the third quarter. I don’t see any real timing issues here that it is into the third quarter and there won’t be much spillover on that one. So we are just saying that it’s in a very small quarter for education. We are not going to see a lot of upside. Where we are looking for, and it’s not in the numbers, is higher education. Higher education could be some upside for us in the fourth quarter.
Let me clarify one point here. The guidance called for a decline in revenue for the corporation, really much driven by financial services. As Terry points out it is a relatively weaker quarter for MAG.
Edward Atorino - The Benchmark Co.
It is softness in education?
Revenue, we are projecting revenue will increase. But it is really driven the profit pressures are driven by digital products and services.
Your next question comes from Peter Appert - Goldman Sachs.
Peter Appert - Goldman Sachs
Terry, you are seeing in ‘07 obviously some impressive improvement in the profitability within the education segment. I’m wondering if in ‘08 do we see another equally dramatic step-up in profitability in the context of the revenue expectations you have outlined, or will the spending requirements for the new products mute the margin gains next year?
Again, it is a little early to start getting into ‘08 but it is a little bit clearer on the education side because the new adoption market opportunity is big. As you know, next year we have got science, we have got reading, we have got mathematics. We have got California, we have got Texas. You have some huge opportunities out there.
The important thing to us about ‘08 is how we perform in ‘07. Because of the restructuring of the School Education Group, we needed to see strong, strong performance. With the 32% market share and leading every state that we are in, we are very upbeat about that. As you know, the investment in ‘08 product is has already taken place. I would expect to continue to build on that in next year and that will be an important part for us.
Peter, one of the influencing factors that we are going to experience next year in 2008, as I mentioned earlier, we will have completed the construction of our new data center, which will house -- it is really critical for us in terms of the movement to our digital product offerings. The migration of our products and services, and all the platforms from the existing data center to the new data center will occur throughout pretty much part of the first quarter, second, third and fourth quarters of next year. Those will be additional costs.
We are really looking at them as one-time costs that will influence obviously performance next year. But it helps us to establish the right kind of platforms for our 24/7 delivery across all our product lines. That’s the only extenuating item that would influence our forecast for next year.
But again it is early on, as Terry pointed out. We are not really into the budgeting process but I wanted to point out that is one item we are looking at for next year.
Peter Appert - Goldman Sachs
How big would that item be?
Again we are not really into the budgeting side of things, but you are migrating all of the systems that exist for education, for the most part, are being migrated to the new center. So we will be incurring duplicate application costs, duplicate equipment costs as we do that migration and wind out of some of those leases that is we may have when we complete that effort. So we were’ formulating that now, but it is a one-time item that we are going to be faced with next year.
There are offsets to that and there will be savings associate associated as well.
Peter Appert - Goldman Sachs
The capital spending obviously has taken a big step up in ‘07. Do you have a thought in terms of what the run rate should look like on a go-forward basis in cap spending?
The big step up this year, of course, was driven by the data center getting up to 250 million so would I tend to think that next year, absent the data center, we are back down to the, most likely the $120 million to $140 million range.
Your next question comes from Ben [Slater] - Glenview Capital.
Ben [Slater] - Glenview Capital
I was hoping you could provide a little more color on the guidance in Q4 for higher education versus K-12, and what sort of growth in higher education is coming from price versus volume?
Again, the higher education side is a more steady. The contribution quarter by quarter by quarter is more steady than it is in the K-12 area. In the K-12 area, as you know, the first quarter you are reflecting all the investments and that’s why you are recording losses and you have to make it up in the third quarter.
What we have seen is a very obviously strong third quarter for K-12. The upside for us is on the education, the higher education side. And we are seeing a stronger market this year than we had forecasted coming into the market.
So again, it is early on. If there is upside on the education side in the fourth quarter it is going to come from the higher education piece. And again, that’s both price and volume.
Ben [Slater] - Glenview Capital
Is it fair to say that your guidance for the education segment in total relates more to the K-12 segment and is due to timing more than underlying weakness in the actual market?
Again, what we saw was mix shifts in the education this year. The strong, strong new adoption market in the K-12 side, we did very well with. We saw some softness in this supplemental area. We picked that up in the new adoption market.
Also, the other one that we are watching very careful, are the open territories. The open territories have not grown over the last several years anywhere near where we think they should be. We think that’s going to be upside for ‘08. But right now we also expect that we might get a little uptick in the fourth quarter from the open territories side.
It is still very big; you are talking about almost $2 billion that is being spent. The question is, is the growth on that? Again, that’s why we said 3% to 5% growth for the market and we will do a lot better than that.
On the higher ed side, it is a little bit stronger than we expected, and so we moved that up to 5% to 6% for the market.
Your next question comes from David Einhorn - Greenlight Capital.
David Einhorn - Greenlight Capital
As you look at the structured finance market, are there parts of it that you feel, looking back, it is not a question that there is a temporary issue but maybe some of this just wasn’t such a good idea to begin with?
Second, I’m wondering how you view Standard & Poor’s from a brand and what might be happening to the brand as a result of what’s gone on in the structured finance market. Thanks so much.
David, the market is what the market is and what we do is provide access to the capital markets and provide, in the structured area, credit ratings that relate to the risk a particular instrument has in terms of defaulting on its interest or on its principal payments.
The structured finance market is a market that institutional investments like, and a lot. The reason is because with structured product, you can divide them up into tranches and you can get just the risk/reward characteristics or attributes that you are looking for in terms of your own portfolio construction on that one.
If the market wants those kind of products and the institution investors want those products, then we move with the market and we are going to rate whatever on that part. Given the current environment, I think what you are going to see is more of a flight to quality and less to speculative grade on that. We are reflecting that now.
In terms of Standard & Poor’s as a brand, no; I mean, you are constantly growing, you are constantly learning, you are constantly involved in not only the ratings side of the market but providing the transparency in terms of all the financial information products.
We take that responsibility very seriously and the credibility that S&P has as a brand in terms of serving the markets in a lot of areas, here and around the world, is only going to grow with the growth of the capital markets. The long-term trends here -- privatization, securitization, the whole global movement, the disintermediation away from the banks into the capital market -- those trends are undeniable. That’s what is growing this. That is why the U.S. capital markets are extremely sophisticated and solid, and so too are the European markets and the Asian markets.
Those trends are what are driving it and we are a centerpiece right in the middle of all that.
Your next question comes from Katrina Fallin - Citi.
Katrina Fallin - Citi
I was hoping you could broaden your comments a little bit about your buyback plans. With 35 million shares left in the ‘07 program, what’s your philosophy around continued buybacks? Should we expect a similar pace of buybacks in Q4 that we saw in Q3?
When we start talking about share repurchase now, this is a board of directors’ authorization and that’s where it that is to come. I can give you my own sentiments that I think that in terms of what we see, in terms of our growth trends and our opportunities going forward, I think they are solid, they are strong. We very much like a share repurchase program. We have completed our authorized portion so far in ‘07. We have a board meeting coming up and I guess that might get discussed.
Katrina Fallin - Citi
Just one further question on the ETF on S&P indices. Nice growth there, $209 billion. How much of that is through organic growth of the funds versus acquired growth through some of the new indices that you purchased? What are your thoughts around additional opportunities for acquisitions there?
Well again, most of what we do is organic. We are constantly developing those capabilities. Where we can accelerate that through an acquisition such as the Goldman Sachs indices on commodities and so forth, we will do that.
So most of it is organic. It is a wonderful area and what you are doing is you are creating investable benchmarks and there are endless permutations to the type of benchmarks that you can develop.
So here, around the world, that effort will continue and we are working with lots of different exchanges and large institutional investors to develop whatever they want in that area. Because you can measure things in any dimension; so again, with benchmarks you can go in a lot of directions. Most of that is organic.
Katrina Fallin - Citi
Do you give any color around the contribution margin for that business?
Yes. It is high.
Your final question comes from Michael Meltz - Bear Stearns.
Michael Meltz - Bear Stearns
Bob, I think you said the corporate line benefited from a one-time equity gain. What was that, and can you size that? Following up on Peter’s question, this is, I think, the first time I’ve heard about these redundant costs next year. Understanding they are one-time, it would be helpful if at this point you could put it into context. Is this a $10 million charge or is this a $50 million type of hit?
First off, it was an equity investment that we had. I’m not going to go any further than that. But it was roughly $3.6 million was the gain that is embedded within corporate expense. We have been talking about the construction of the new data center now for the past year or so. Obviously coming with a new data center is, implicit in that is the movement and shifting of all our technical capabilities, our applications and such, fitting it with hardware, moving it into that. That’s simply a big process.
I’m simply highlighting that there is an item here. This is not something that is astronomical and is going to influence the overall performance of the enterprise. It is just something that I’m just pointing out. We will size that for you as we go further in the course of the year, but just simply pointing out that this is an effort that’s going to go on next year and it is the transition costs that are one-time. That’s all I’m referring to.
Michael Meltz - Bear Stearns
Your comment on shares out, the 329 million, was that a diluted or basic number at the end of the quarter?
That was a basic number.
We do have another question from Karl Choi - Merrill Lynch.
Karl Choi - Merrill Lynch
Just within Financial Services, wondering if there was any reversal in incentive compensation accrual in the quarter?
Bob, if you have a figure for how much headcount would be up year-over-year in the fourth quarter for Financial Services?
With regard to incentive compensation, an influencing factor -- without getting into how much -- was simply because of the performance and the outlook for the year as it relates to last year, you may remember last year was very, very strong and the expectation was for a very strong fourth quarter. We were building incentive accruals as we went through the course of the year.
Now this year, with the weaker performance in September and the outlook going forward, the incentive accruals are lower. So that influenced the overall performance. I’m not going to get into the specifics of numbers. But it did influence the performance and did influence the fact that our margin was higher are on a year to year basis.
With regard to headcount, as Terry pointed out, we are looking very, very hard at the organization, but keeping in mind that we have a responsibility to provide quality products and services. We have surveillance that we are going to be adhering to. But we are looking across other parts of the lines to be certain that we are staffed accordingly, based on what we are facing in the next six to nine months.
Karl the other aspect is the whole cross-training initiative within the ratings division. They move things around depending upon where the revenue growth is but everything is being looked at.
Thank you. This does conclude this morning’s call. On behalf of McGraw-Hill Companies we thank you for participating and wish you a good day.
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