Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

The McGraw Hill Companies (MHP)

Q4 2005 Earnings Conference Call

January 25th 2006, 8:30 AM.

Executives:

Donald Rubin, SVP Investor Relations

Harold (Terry) McGraw, Chairman, President and Chief Executive Officer

Robert Bahash, EVP and Chief Financial Officer

Analysts:

Doug Arthur, Morgan Stanley

Clawrence Seniors, Carson Investments

Peter Appert, Goldman Sachs

Brian Shipman, UBS

Fred Searby, JP Morgan

Steven Barlow, Prudential Equity Group

Michael Meltz, Bear Stearns

Brandon Dobell, Credit Suisse

Karl Choi, Merrill Lynch

William Bird, Citigroup

Presentation

Operator

Good morning and welcome to the McGraw-Hill Company's fourth quarter 2005 earnings call. Operator Instructions To enhance the call for today's telephone participants, McGraw-Hill has made the presenter slides available on the internet. To do that go to http://www.mymeetings.com/MC/join. You will be prompted to enter your name. The net conference meeting number is PG 1181535. The password is MCGRAW HILL. All caps with a space between McGraw and Hill. The type is conference.

This call is also being simultaneously webcast for 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. Operator Instructions 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.

Donald Rubin, SVP Investor Relations

Thank you. Good morning and thank everyone for joining us here at McGraw-Hill's headquarters building as well as those on the phone and on the web here and abroad for the McGraw-Hill Company's fourth quarter 2005 earnings call. I'm Donald Rubin, Senior Vice President for Investor Relations of the McGraw-Hill Companies. With me this morning are Harold McGraw III, Chairman, President and CEO and Robert Bahash, Executive Vice President and Chief Financial Officer of the corporation. This morning we issued a news release with our fourth quarter results. We trust you've all had a chance to review the release. If you need a copy of the release and financial schedules they can being downloaded at www.mcgraw-hill.com/investor_relations. Once again that is, 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 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 forms 10Ks, 10Qs and other periodic reports filed with the U.S. Securities and Exchange 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 would ask that questions from the media be directed to Mr. Steve 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 our presentation we will open the meetings to questions. Now pleased to introduce the Chairman, President and CEO of McGraw-Hill Companies, Terry McGraw.

Harold (Terry) McGraw, Chairman, President and Chief Executive Officer

Okay. Good morning, everybody. Welcome to our review of McGraw-Hill Company's fourth quarter and the full year earnings and our outlook for 2006. If you're listening in as Don said, we are very appreciative of the support and we welcome you as well. As Don said joining me is Bob Bahash, our Executive Vice President and Chief Financial Officer.

I will kick off today's review by discussing the performance of our three segments and the outlook for 2006 and Bob will then discuss our financial performance for 2005 and our expectations for this year. After which, of course, we'll go in any direction you would like, any comments and/or questions.

Let me begin with the announcements that we made yesterday. Yesterday the board of directors approved a 10% increase in the regular quarterly cash dividend. They also approved an authorized,a new stock purchase, repurchase program for 45 million shares or approximately 12.1% of the outstanding shares. The dividend has now been increased for 33 consecutive years. We're very proud of that. That represents an average compound annual growth rate of 10.3% since 1974. Since 1996 the McGraw-Hill Companies as part of its commitment to creating total shareholder value has returned more than $4.1 billion, to investors through stock repurchases and dividend increases. That record has helped us produce a better return than the S&P 500 for more than a decade. In 2005 we again out paced the S&P 500 with a total return of 14.4% versus a 4.9% for the S&P 500.

Now, this morning's announcement completes another very successful year. Revenue for 2005 increased 14.3% and takes us to $6.0 billion, diluted earnings per share grew by 12.8% to $2.21, $2.21 and that includes a one-time gain of $0.01 on the sale of corporate value consulting, it also includes $0.04 for the restructuring charge announced on January 5th, and a $0.03 increase in the income taxes on the repatriation of funds. With the reported 2005 results, let me review the guidance now for 2006. In discussing our operating performance earlier this month, we also reviewed one-time items that would be factors in creating a baseline for 2005. Because it wasn't clear how some of these one-time items were being treated by some analysts, we said that our performance for 2005 would include a $0.04 restructuring charge. It would include a $0.03 increase in income taxes on the repatriation of funds and of course that was made possible this year by the passing of the American Jobs Creation Act, But it would exclude a $0.01 gain on the sale of CBC which was a third quarter item.

In closing our books and reflecting the treatment of the above items, we produced a non-GAAP earnings of $2.20 or just about where we expected to finish 2005, that was the base used to suggest earlier this month that in 2006 we would be growing about 5% to 8% or $2.31 to $2.38 per share and of course that includes the expensing of stock options. We have now completed our planning process for 2006 and with the authorization by the board, approval of an expanded share repurchase plan, as a result of those, we are increasing our guidance for 2006. With a benefit of $0.03 from the expanded buy back plan in 2006 and with the completion of our planning process we expect earnings per share of $2.36 to $2.41 this year, and again that excludes the expensing of stock options. In addition, with a more robust market outlook the preliminary estimate for 2007 is an expected return to double digit earning growth.

Let's now take a closer look at how we achieved these results and how we assess our prospects in 2006. Two points before I get started. First, in 2006 we start expensing stock options. If we had expensed stock options in 2005 it would have cost us $0.13 per share. With the implementation of a stock option expensing, or with the implementation of stock option expensing in 2006 the incremental expense will be $0.13 per share and it has a different mix of stock options and restricted shares. The second point is that the growth rate for the operating profits that I'm about to review this morning exclude the impact of the expensing of the stock options. I'm also going to review the segments in a different order this morning because this is a more challenging year in education, I will start with that segment. Then I will turn to the information in Media Services area and I'll conclude with our Financial Services segment. Okay. With that let's get started and let's begin with McGraw-Hill Education. McGraw-Hill Education in 2005, what a terrific year.

Revenue increased by 11.5%, operating profits grew by 20.6%, the operating margin increased to 15.4%, up from 14.2% in 2004. In an elementary high school market that grew by 10% to 11% in 2005, we produced outstanding results and we gained share. The McGraw-Hill School Education Group increased revenue by 18.5% last year and 23.6% in the fourth quarter. This group accounted for about 57% of the segment's annual revenue. Our performance in a very strong state new adoption market was a key factor, obviously, in creating this outstanding record in 2005 and Texas was pivotal in 2005 since Texas plans to purchase 2 years of materials under proclamation 2001 and proclamation 2002. It represented about 40% of the state new adoption market in 2005.

We estimate that the McGraw-Hill School Education Group was the market leader in Texas capturing about 33% of the available funds. Texas was slow to fund part of the adoption program. That was proclamation 2002 because the state legislature could not resolve issues involving the use property taxes to finance public education. As a result of the delays in funding, we were still fulfilling Texas orders in the fourth quarter. There may even be a little bit more coming in the first quarter of this year. Our success in Texas is only part of the 2005 story. In social studies the biggest opportunity outside Texas in 2005, we led the market at the secondary level, taking a 49% share in all states adopting the subject for grades 6 through 12. We had outstanding capture rates in K-12 health, science, art, and music, and in grade 6 through 12 math.

To sum up, our School Education Group won about 33% of the available dollars in the new state adoption market. We also grew in open territories in the supplemental market as well as in testing. The new mandatory testing requirements created by the No Child Left Behind Act continue to stimulate top buying growth, but the increased demand for customized tests is eroding margins at this point as we make that shift. That's a quick recap for 2005. The question is what about the prospects for 2006? So let's review 2006 and the next few years because in this market you must have a longer term horizon if you're going to time your investments correctly to prepare for these future opportunities, as you know it takes sometimes two to three years into the development of programs for some of the larger subsidive disciplines in the adoption market. We certainly benefited this year from our previous investments for a 2005 El-High market.

That was the biggest and fastest growing in the last five years. But as this particular chart shows the state new adoption market declined about 25%, 30% from a robust $925 to $950 million in 2005 to $650 to $700 million level in 2006. Simply put the opportunity in 2006 is not as large as the one we capitalized on in 2005. We believe our programs for the key state new adoptions this year will be very competitive, and we also have new programs focused to maximize our opportunities this year in the open territory and to start positioning us for growth when the market accelerates again in 2007, and for the rest of the decade for that matter.

As we look ahead, the state new adoption calendar improves substantially in 2007, in 2008, and again in 2009 when it could hit a billion dollars or more. We have been investing to prepare for the new opportunities shown here and will ramp them up some more in 2006 to get ready for the next year and beyond. In a short run, the confluence of a declining market in 2006, at best the LI market will be flat this year and could be in decline as much as 4%, and due to also the increased prepublication costs and prepublication amortization, this will make it a very challenging year for the McGraw-Hill School Education Group. But the products we are developing will strengthen our position for the rest of a very promising decade. We believe they will also enable us to bring new solutions to a market where one size does not fit all, participate more of the market than we currently do, become even more competitive in math, reading, and science, the key disciplines representing the biggest opportunities in the El-High market.

With testing starting in all 50 states this year in reading and math and next year in science, student performance in these disciplines is getting increased attention. In this environment it is our goal to provide educators with programs that represent the most effective learning solutions that we can create. This year we are introducing new math, reading, and language art programs and two products for the rapidly growing intervention market. Those programs would be real math for the pre-K grade 6 market, is a new skills based program with a fully integrated suite of technology tools. It incorporates the latest research on how children learn math.

Another program is treasures. Treasures is a new basel reading program for the elementary market. This new program is also being well received by Reading First adopters since it meets all their requirements, and of course to support Treasurers we will introduce supplemental reading products as well in the spring. The intervention products are Numbers World, Numbers World is an intervention program in mathematics for students in the elementary grade who are already falling behind. Another is Jamestown Reading Navigator. It is an online intervention product focused on the struggling adolescent reader who has fallen behind by two or more grade levels based on our successful Jamestown line of print products it was created specifically for students in grades 6 through 12.

Jamestown Reading Navigator is the first product in a suite of programs that we are developing for grades 6 through 12 that are designed to help students become proficient readers, master standardized tests and to be able to utilize their reading abilities to improve in other discipline. There will be more new products later this year and next. One of the most important is Every Day Mathematics. Every Day Mathematics is a very successful pre-K to grade 6 product that has been the best-selling research based math program in the United States. It is used in nearly 175,000 classrooms with more than 2.8 million students. The program was developed in association with the University of Chicago School of Mathematics program to enhance math education. It surely has come that.

In 2007, we will introduce a new version of this program also developed with the University of Chicago for grades 6 through 12. We will emphasize problem solving, every day application, the use of technology in reading, the preselling campaign for this program is already under way.

There is much more in the pipeline, but today I wanted to give you some notion of our focus, our time horizon and our level of activity as we ramp up for the opportunities just ahead of us in this El-High market. We also like the opportunities in higher education, professional, and international markets. This business grew at 3.5% last year to produce revenue of $1.2 billion. It's been ten years since we acquired the higher education businesses from Times Mirror and that was a strategic acquisition that helped us create the size and the scale that we required to compete successfully in this market. We used that new base to grow steadily over the years in the U.S. college and university market. We took share again in 2005 by out performing a market that grew by about 6%.

We're expecting 5% to 6% growth in this market in 2006 and our goal is to out perform it again. We continue invest here, too. Technology is enabling us to create new products in services that can produce the incremental revenue. That ability to create incremental revenue to the application of technology is also true in professional markets where we continue to make progress in medicine, science and engineering. As the global demand for education and the creation of skilled work forces continues to grow, so will our opportunities, and that's a broad view of our prospects and programs there.

So summing up for 2006, we're clearly in transition and investing for new opportunities and a promising future even while we cope with a one-year decline in the El-High market. In 2006, in this segment that adds up to modest revenue growth, a decline in operating profits, maybe as much as 10% and after a 20.6% increase in 2005 and a decline in our operating margin. In 2007, we expect to snap back with high single digit revenue growth, a return to a double digit increase in operating profit and margin improvement.

Now let's shift to the Information Media Services Segment. Revenue increased 16.4% and however $145 million came from J.D. Power and Associates and obviously was the key factor in that gain. Operating profit declined by 49.2%, and the operating margin was 6.5% versus 14.9% in 2004. A declining advertising market was chiefly responsible for this performance. Revenue at the broadcasting group slipped in a non-election year by 1.7% to $112.2 million. Solid growth in the base businesses reduced much of the short fall in political advertising. This year we broadcast the Super Bowl and first quarter pacing is up 18%. There will also be mid-term elections in 2006, so the outlook for political advertising is obviously better.

The business to business groups revenue increased 19.4% to $818.9 million, and that gain again is chiefly attributable to J.D. Power and Associates. With ad pages declining in 2005 by 12.8% at Business Week, ad revenue accounted for 5.6% of the corporation's total revenue last year, it was 6.9% in 2004. We're still looking for some strength in advertising in 2006. After four issues, by the way, in January, Business Week's ad pages are up 19% and the pipeline's starting to look good here, but obviously it is way too soon to suggest an ad recovery here, but one reference point is nice to have and we need to add to that.

For top line growth this year Business Week must replace about $22 million in revenue from the Asian and European print addition which were shut down at the end of 2005 and will be converting over to Business Week.com, and overcome lower ad rates for the North American addition after a 7.2% reduction in the rate base to 900,000 in response to a new audit bureau circulation rules.

These actions which also included the elimination of 65 positions will also lower costs and help Business Week to improve its bottom line. We also expect increased contributions from Business Week Online which finished last year with an average of nearly 4 million unique users per month, an increase of 44% over 2004, and Business Week Small Biz which raised its rate base by 30% to 650,000 readers. But, the major influence on this segment's results this year will be the transformation of suite sweeps within our construction group which for 100 years has been largely a print based service.

We are merging suite's content with the McGraw-Hill Construction network to create a new platform connecting products with projects and customers. The transition to the online service will affect revenue recognition this year. It will be reduced by about $15 million in 2006 since online revenue is recognized as a services provided and more evenly across the year and of course the print edition revenue is recognized at the point of when it is shipped. That will also impact earnings per share by $0.02 to $0.03. We still expect improvement from the McGraw-Hill Construction network and the outlook for energy in our energy group is also very good. We are very pleased with the performance of J.D. Power and Associates. The increased focus on customer satisfaction and retention placed at J.D. Power and Associate's strength.

Political advertising will help broadcasting. Business Week starts the year with a lower cost base, and we believe the promise of some improvement in the ad market. So summing up for the Information and Media Services, we now expect mid-to high single digit revenue growth this year, a slight increase in operating profit after absorbing the impact of $15 million and the reduction in revenue at suites.

Now moving over to our final segment, the Financial Services Segment, we completed a record year with a strong fourth quarter. In 2005 revenue increased by 16.8%, operating profit grew by 21.4%. The operating margin expanded to 42.5% and that's up from 40.8% in 2004, a growing and diversified lineup produced outstanding results in fixed income and equity markets. Structured finance was the biggest driver of our global growth in 2005. The ratings also benefit from the improvement in corporate finance and from ratings products and services that are not linked to new issuance.

In ratings, 37% of the revenue came from offshore, just over 21% of the revenue was produced by rating services that are not tied to the new issue buy out. A lot of attention has been focused on the U.S. residential mortgage backed securities market, but to appreciate the breadth and strength of the market, it's worth noting that the commercial mortgage backed issuance market, the asset backed issuance market, and the collateralized debt obligation market as well as U.S. Residential Market all contributed quite handsomely.

Without exception issuance of each of these asset classes showed year-over-year growth in each quarter of 2005 compared to 2004. Very impressive. The fourth quarter growth rate for dollar volume issuance in the United States commercial mortgage backed securities market was at 111%. It was 82% at asset backed securities which eclipsed the 24% increase in the U.S. residential mortgage backed securities market. New dollar volume issuance in all four asset classes grew substantially this year in the U.S. market. 37% for the residential mortgage backed market, 89% for the commercial mortgage backed, 32% for the asset backed securities and 64% for collateralized debt obligation. These statistics are based on reports from Securities Data Corporation and Harrison Scott Publications.

New issue statistics don't tell the whole story. U.S. corporate dollar volume issuance was down 8.2% in 2005, but we showed solid growth in corporate finance. That's another indication obviously of the resiliency that we've been creating in this portfolio through the growth, the frequent issuer and surveillance program. Standard & Poor's data and information products also showed good growth, but the focus now is on the prospects for 2006. For Financial Services we are looking for double digit top line growth, excluding revenue from corporate value consulting. Before the divestiture at the end of the third quarter last year corporate value consulting contributed more than $100 million in revenue to Financial Services.

We also expect double digit growth in operating profits. The operating margin will be similar to what we achieved in 2005 which was 42.5%. Structured finance will be the pace-setter again in 2006. International ratings are expected to grow faster than domestic ratings. International ratings as we said before accounted for about 37% of ratings revenue in 2005 and that proportion should increase again this year. We will also benefit from the growth to products and services that are not tied to the new issue market in 2005, products such as bank loan ratings, counter party credit ratings accounted for more than 21% of the revenue. We start the year with a very strong pipeline so let's look at the prospects and in how we expect that to unfold in more detail.

In the U.S. structured finance market we anticipate a decline in residential mortgage backed security issuance. Albeit, it probably won't occur immediately based on the latest information issuance could decline 10% to 15% this year as comparisons, given the strength in previous years, gets tougher. But we think S&P will benefit from the fact that non-conventional mortgages will continue to dominate the mix. The pipeline for commercial mortgage backed security looks extremely healthy. The shift in how commercial mortgages are financed is expected to continue moving away from lenders who keep loans in their portfolios to those who securitized the loans.

Real estate fundamentals, invest or demand and refinancing opportunities, all remain strong. Asset backed activity will probably get off to a slower start in 2006, but we expect moderate growth for the year as auto manufacturers continue to use securitization as a source of funding and there is a pick up in credit card activity as consumers rely less on home equity loans. The pipeline for collateralized debt obligations, CDOs is healthy and investor demand remains robust. The outlook for the year is very positive here with more new structures and arbitrage opportunities.

In Europe we also expect a solid start to the year. S&P anticipates that covered bonds both structured and traditional will grow in popularity in Europe this year. Pricing of these instruments is attracting issuers who use covered bonds either as their primary issuance or as a complimentary funding tool to securitization. In short, we expect solid growth this year in Europe. Our largest overseas region. We also like our prospects in other regions, Asia Pacific, Canada and Latin America and we expect growth in all of them this year.

We're also encouraged by the outlook for the corporate market in the United States. Early reports indicate a good start to the year. Issuance related to M&A activity is picking up. The Banc of America estimates that $600 billion in investment grade debt is due to mature this year, twice last year's total, which could lead to significant refinancing activity. In public finance, comparisons will be tougher after a very good year in 2005, but some are predicting an increase in new money bond issuance to at least partially offset the decline in refunding. We also expect more progress this year from S&P's non-ratings products and services since most of these products and services are sold by subscription or based on assets under management. They add to the diversity, stability and of course the growth of S&P's revenue strength.

We continue to create new indexes and new opportunities to grow in this area. In the past we have created SPIDERS, S&P depository receipts, based on market capitalization and sectors. Next month we will see the launch of industry SPIDERS trading in home builder, biotech, semiconductor SPIDERS. These will all start next month, the sponsor here is State Street. Trading is also expected to start next month on futures contracts based on the S&P Asia 50 index. The new futures contract will be listed on the Chicago Mercantile Exchange, Globex platform. We have added new firms and new coverage as part of a global research settlement.

Sales of data and information products will continue to grow as we leverage the combined client basis, content and delivery platforms. This is all having to do with the capital IQ and the compustat configuration. So, summing up for the 2006 outlook for Financial Services, another year of double digit revenue growth, another year of double digit growth in operating profit. An operating margin in 2006 that will be at least similar to the margin achieved in 2005. Strong international growth in ratings and that will continue as a trend for the rest of the decade, and another solid year in structured finance and growth in non-rating products.

Okay. That completes the review of the three segments and so therefore summing up for the corporation we expect diluted earnings per share of $2.36 to $2.41 this year and again that's excluding the expensing of stock options, and in addition based on our analysis now the preliminary outlook for 2007 is for an expected return to double digit earnings growth.

With that, let me turn it over to Bob Bahash our Chief Financial Officer and he'll review the financial conditions and some of the aspects of 2006 and then we'll go in any direction you'd like with your questions. Bob?

Robert Bahash, EVP and Chief Financial Officer

Okay, thank you, Terry. Terry has given you guidance for 2006. Now I want to take this opportunity to provide additional information on some of the key assumptions that shaped our guidance for this year.

So let's start with dilutions. In 2005 dilution from acquisitions we made in 2004 and 2005 came in at $0.06 and that's in line with previous forecasts. In 2006 we now expect dilution of $0.03 to $0.04 from these acquisitions and they'll be cash neutral. That's a little bit higher than the original projection of $0.01 to $0.02 and cash positive for 2006 that we previously stated. As we're expanding our capabilities more rapidly in some of these markets, in 2007 we expect these acquisitions to be cash positive. Dilution from changes in pension plan assumptions was $0.02 in 2005 just as we had projected and it will be $0.02 again in 2006 mainly due to lower discount rates for our U.S. and U.K. pension plans. It's worth noting that our U.S. pension plan remains in an over funded position. This brings me to the stock buyback program. We started 2005 with a goal of buying back up to 10 million shares. After meeting that goal by the end of September the board of directors gave us permission to re-enter the market. We started buying again in November and finished the year by repurchasing an additional 4.3 million shares. For the full year we repurchased 14.3 million shares at a cost of $671.9 million.

The diluted, weighted average shares outstanding for 2005, with 382.6 million shares, 3.3 million share decrease compared to year end 2004. Yesterday board of directors approved a new repurchase plan for 45 million shares or 12.1% of the corporation's outstanding shares of 372.7 million shares as of the end of 2005. This year we expect to buy back the 3.4 million shares remaining in the 2003 program and up to 15 million shares authorized under the program the board just approved. Now that the board has clearly set forth guidelines for repurchasing shares, the earnings guidance for this year that Terry mentioned earlier in his remarks, assumes a benefit of $0.03 from the 2006 repurchasing program. As Terry pointed out, stepped up prepublication costs and prepublication amortization will strongly influence results in the education segment this year.

Our prepublication investments were $81 million in the fourth quarter, and $258 million for 2005 which is about $20 million higher than in 2004. For 2006 our prepublication investments will be about $340 million. This number is driven mainly by the new El-High products we are developing to realize significant opportunities in 2007 and subsequent years. You've already heard about the broad strategy in some of the key initiatives so let's look at these expenditures in a little more depth. It usually takes two to three years to develop and produce large and complex programs for the elementary, high school market. So timing is an important factor in our decision to increase prepublication costs now.

You've seen the calendar for 2007 to 2009. Big states are going to buy major subjects and that's why we're investing in new and expanded programs in reading, literature, math, science and social studies. For key adoption states we will customize programs to create a competitive advantage. Just as we did for the California social studies core this year, we will employ the same proven formula when California buys science in 2008. We are also producing national editions of these titles for the El-High market. These investments will extend our product lineup and increase our participation in the potential market. In our testing and assessment business, we're seeing a shift to lower margin, state specific customized tests from our more profitable norm reference tests as states work to meet the requirements of No Child Left Behind. We are making significant investments in technology and in process improvements to strengthen margins in this business. We're also continuing to invest in key electronic products at the Higher Education, Professional and International Group. We're using technology to go beyond print and improve the learning experience.

Homework Manager is getting traction because college and university instructors typically have to spend up to five hours a week grading papers. But, if the class uses our product, students can take end of chapter tests online, get them automatically graded and the results entered into the instructor's digital book guide. We will add Homework Manager to more courses in 2006. We are leveraging proven content to provide online instruction for higher education. We have over 40 online courses in the pipeline for 2006. They represent the next generation of E solutions with animation, streaming video and personalized assessment. We also provide digital subscription based services for professionals, with AccessMedicine, McGraw-Hill has transformed the trusted content of Harrison's Principles of Internal Medicine and more than 30 other leading McGraw-Hill medical titles into a cross searchable database of clinical and educational material to medical content that provides instant answers. AccessMedicine can be accessed by physicians and students anywhere 24/7.

The markets for these electronic products are still embryonic, but as they mature we expect margins to improve. Amortization of prepublication costs will also increase in 2006 as a result of new El-High programs we are publishing this year. These include initiatives in reading, literature and language arts and a customized program called Vista where the key California social studies adoption this year. We expect $250 million for 2006. This is a $16 million increase compared to $234 million for 2005. There will also be additional expenses for 75 new editorial design and production employees we need to get ready for the expanded adoption schedule.

We are stepping up our capital expenditures. Purchase of property and equipment was $47.5 million for the fourth quarter and $120 million for 2005. For 2006 we expect $200 million. The increase is primarily driven by investments in our data centers, where we are adding capacity to support increasing digitization in education and realtime capabilities to further the direction of all of our businesses, a new facility for McGraw-Hill Education in Iowa. Technology initiatives at Financial Services and at streamlining the ratings process and leasehold improvements in India. Additions to technology were $5 million in the fourth quarter and $16.5 million for 2005. For 2006 we expect $40 million due to digital initiatives at McGraw-Hill Education. In Information and Media Services we will start the transformation of suites from our print catalog service to a fully integrated internet sales and marketing solution. We will still deliver print catalogs, but the move to an online service also means a shift in revenue recognition. Online revenue is recognized as services provided.

Historically, most of the suite's revenue was recognized in the fourth quarter of each year when the catalogs were delivered to our customers. As a result we expect lower revenue in operating profit in 2006 due to the change in when we recognize revenue from the new product stream in the range of $15 million and reduced earnings per share by $0.02 to $0.03. It's important to note, however, that our business in effect, that is our existing and new customer signing up for this new online service, will be approximately the same as we had in 2005 and is expected to show significant growth in the future.

To sum up, what it factored into the guidance for 2006, $0.03 to $0.04 dilution from acquisitions, $0.02 dilution from the pension plan, $0.03 benefit from the 2006 share repurchase program, $0.02 to $0.03 dilution from the transformation of suites. Higher cost associated with the release of significant new El-High programs in 2006 coupled with increase prepublication investments and editorial, design and production staff additions for the development of new programs for 2007 and 2008, and increases in capital expenditures for the purchase of property and equipment and additions to technology. Our cash position at the end of 2005 was $749 million and we're essentially debt free. Net interest expense declined in the fourth quarter as expected due to the early payment of the commercial paper debt. We ended the year at $5 million which is about $3 million lower than we projected. For 2006 we expect approximately $14 million in interest expense and the interest is from the expanded share repurchase program in 2006 and rising interest rates.

Let's now look at our corporate expenses. Corporate expenses increased in the fourth quarter by $4 million to $37 million this is due in part to increased compensation related expenses for the full year it was $125 million virtually flat as compared to 2004. Excluding the impact of the incremental stock based compensation, corporate expenses are expected to increase only modestly in 2006. The new 2006 stock based compensation program matches the value of the restricted shares and stock options granted in 2005. Under the new design we took the 2005 stock option value as if it had been expensed and adjusted the mix of stock options and restrictive performance shares to achieve the same total value for 2006. The effective tax rate in the fourth quarter was 40.4%. This includes $10 million of tax on the repatriation of $209 million of earnings from foreign subsidiaries. The blended effect of tax rate for 2005 was 37.9%. In 2006 we expect it to return to the annualized rate of approximately 37.2%.

Now for the non-cash items, I've already reviewed the amortization of prepub costs. Depreciation was $107 million in 2005. We expect it to be $130 million in 2006 reflecting the higher level of capital expenditures in 2006 and the full year depreciation from the capital expenditures made in 2005. Amortization of intangibles was $44 million in 2005, this is expected to grow to $50 million, the increase largely driven by the 2005 acquisitions. That brings me to free cash flow. In defining free cash flow we start with operating cash flow and reduce that amount by certain cash out flows for investing and financing activities that we deem are recurring by nature. As you see from the table, cash provided by operations per GAAP was $1.6 billion for 2005. We then subtract the following which we already described. Investments and prepublication costs, purchases of property and equipment, additions to technology projects and dividends paid to shareholders. We have also made other adjustment principally for foreign exchange totaling about $23 million. Under this definition of free cash flow for 2005 was $896 million versus $630 million in 2004. That's 42% increase which is primarily due to growth in income as well as working capital benefits.

For 2006 we anticipate free cash flow in the range of $650 million reflecting higher investment spending and the dividend increase. The decrease also shows a return to a more normalized level of working capital. We have ample cash for dividends, share repurchases, strategic acquisition, and to meet our requirements for internal investments. You've heard a lot about the cost this morning so I'd like to make one final point about our cost structure in the future. An important strategic program is now under way across the corporation and we're encouraged by the potential for realizing substantial savings in the next few years. This major new initiative is really about global resource management.

As never before we are focused on new ways to leverage our buying power, aggregate initiatives to maximize the benefits of scale, standardize processes for increased operating leverage, improve project management and build global supplier relationships with our suppliers. In short as we grow globally we're working to increase operational efficiency and create solutions that can be leveraged worldwide. We are creating unified platforms that enable the McGraw-Hill Companies to expand its supply chain, improve back office and servicing operations and speed up product development while improving quality. The digital age, time and geography are no longer barriers to effective global partnerships.

The McGraw-Hill Education Global Transformation Platform is one such example. Platforms are being built for the Financial Services and Information and Media Services segments so we can create, tag, store and reuse digital content in a digital asset library. Common work load tools will access this centralized repository and facilitate work flow management across all our segments. Efforts are you also underway at the corporate level to drive global process standardization by providing technology enabled services to all McGraw-Hill businesses. There are many benefits. Our customers will benefit from innovative products and solutions, our employees will benefit from systems that enable effective collaboration and digital content management, and McGraw-Hill investors will benefit from an improved cost structure and increased business opportunities. Thank you and now back to Terry.

Harold (Terry) McGraw, Chairman, President and Chief Executive Officer

Okay, a very strong 2005. A little bit more challenging 2006, and albeit double digit top and bottom line growth of Financial Services. A declining K-12 market year-over-year coupled with increased investments for a very robust 2007, 2008, and 2009 marketplace improvement in the advertising and our business information areas gives us guidance for 2006 of $2.36 to $2.41 excluding the options so I think with that, Don, we can go to you and then to any questions we have.

Questions & Answers

Donald Rubin, SVP Investor Relations

Thank you, Terry. Operator Instructions Let's start if there are any questions in the room.

Q - Doug Arthur, Morgan Stanley

Doug Arthur, Morgan Stanley. Terry, in terms of the residential mortgage backed market, you've talked about a 10% or so decline for '06. What is the immediate pipeline look like for the first quarter and then a second question is, is it too early to get revved up about the bond market outlook in India and China?

A - Harold (Terry) McGraw

Well, good morning, Doug, first of all, the residential mortgage backed market looks pretty good right now. The pipeline still is very active and that's why we were saying we anticipate a 10% to 15% decline and that's our guess. Just because of the year-over-year comparisons and gradually over the course of the year. The pickup that we're seeing in the commercial mortgage backed market and is also very strong right now, and seems to be accelerating. So, at this point the residential mortgage backed market remains healthy, but we do see over the course of the year that the comparisons are obviously going to get tougher. Great question on China and India. I think that both of these represent significant opportunities albeit future opportunities. India probably more immediate in that, the acquisition of majority interest in CRISIL, the leading player in India, has given us a wonderful platform not only for the ratings activities for further expansion into financial information services as transparency become a more important issue. Also in terms of some of their add on capabilities. They have a very strong capability in the energy sector as well with an entity called Gas Strategies that is working with Platts now and that's quite strong. Also Arrebna which produces equity research out of Sha Nai in the south. So it's a very strong base and we plan to expend a lot of time in the continuing to develop that one, and I think the opportunities there are going to be a little bit more immediate. On the China side we're well represented there as well. Both mainland China as well as Hong Kong, and we have a nice relationship with the government but it's a small relationship. One that we expect to build as more companies there either want to be listed in Hong Kong or listed outside of China and an opportunity to bring credit quality to them. But, those are two very important opportunities, but I would say India will be probably the more immediate contributor to that.

Q - Clawrence Seniors, Carson Investments

Clawrence Seniors (ph), Carson Investments I was trying to come down in terms of the objectives used, the 5% to 8% increase in total earnings and I was just trying to determine just what are we looking for in terms of percentage growth and revenues and maybe an idea of just what we're looking at in terms of operating margins. The other question I have in terms of the overall outlook going forward, is are they in a divestitures in terms of maybe underperformers being considered right now, and are they any acquisitions of any significance in the works?

A - Harold (Terry) McGraw

Okay, Clarence, the guidance that we give is there. If you take a look at the three operating segments, as we stated we expect double digit top and bottom at S&P, and at this point it is a little early in the year, but given the strength that we're seeing across the board, we're saying that the margin improvement that we saw this year in '05 upped to 42.5%, will hold at that level at this point, and we'll see and we'll amend that as we go as we see certain activity. But we think that it will be very similar to '05 on that one. In the education segment because of the weakness in the K-12 market, you are going to see some margin decline there, and modest revenue growth because of the fact that at this point we think the K-12 market will be flat, to down 4%, and in the information immediate we expect modest revenue growth there. And we're going to see some profit increase as well, even with the transformation of suites to an online product from a product. So, overall really what we're dealing with is the K-12 market and the influence on that. And hopefully we'll see the upside out of information immediate, the global higher education platform as well as Financial Services.

On the divestiture, we don't comment on what could be on that one. I can promise you that every asset is looked at, and if we believe that the path to growth or accelerated growth is not there, then we're looking at all alternatives in that and the implications of that for 2006 are good. On the acquisition front at this point there are no large acquisitions being contemplated. We're constantly looking at lots of opportunities to obviously as we've always talked about them, either as platform or component acquisitions that either strengthen an existing platform or we have components that will strengthen an acquiring platform. There is nothing at this point that's imminent. But we continue to be very active in terms of looking at ways to strengthen existing properties.

Donald Rubin, SVP Investor Relations

That's it for questions in the room, we will go to our phone participants.

Operator

Thank you. Our first question comes from Peter Appert with Goldman Sachs.

Q - Peter Appert

Good morning, Terry, question for either you or Bob. The higher capital spending and prepublication cost numbers you spoke about for '06, should we assume on a go forward basis, '07 and beyond these are permanent increases in terms of the levels of spending requirements?

A - Harold (Terry) McGraw

Probably not on a capital expenditure side. That will waiver depending upon technology and obsolescents kinds of issues and replacement on that one. On the program side of prepublication, at this point for the next couple years, yes because of the fact that, and you know the good news on that is that the out going calendar is so strong, 2007, 2008, 2009, actually 2010. At this point we're looking very hard and from a program standpoint at 2007, 2008 and 2009. '09 even looks like it could be, this is just take new adoption out in excess of a billion, but that's out there and we're working on those programs. So yes, the prepub costs are going to be stand out level. Now, the flip side of that is our participation rates and capture rates, and we feel very good about these opportunities, but, we also have to execute here and we fully expect to achieve good capture rates, but that's what we're going to have to see. Bob, do you want to add anything to that.

A - Robert Bahash

I think the only thing I'd add is with regard to the capital expenditure side we'll probably see a level similar in 2007 because the big item there is the plans to construct a major new data center because of the increasing digitization of our, of basically all our businesses. So, that's a two-year project that will probably be carrying over into 2007 at similar levels.

Q - Peter Appert

Okay, great. And then somewhat related question in terms of the cash flow dynamic, you're taking on debt it looks like or your anticipating taking on debt in '06 to fund the share repurchase which I think is a change from the way you've approached your stock buy backs in the past. Is there a message we should read into this in terms of a expectation of again a permanent increase in terms of a more aggressive approach to buying back stock, willingness to take on some more meaningful amounts of debt to fund it?

A - Harold (Terry) McGraw

Peter, this is simply a timing issue. We are, in term of our cash needs are seasonal we tend to have very strong cash inflow's in the latter part of the third quarter and then into the fourth quarter. The first quarter and second quarter are more significant outflow's just by the nature of our investment spend as well as the general revenue cycle of the corporation, so any debt that we would be taking on would be short term commercial paper swing that would be simply liquidated by the end of September/October. So, we're not taking o debt, there's only a swing factor in there. And when we quoted the $0.03 improvement in share repurchase we're factoring in an assumption that there's a loss either interest income element to it or there's an interest expense because obviously your capital's not free. So, that's why we're at $0.03.

Q - Peter Appert

Maybe I miss heard you then. Buying 15 million shares under the new authorization, 3.4 under the old, correct, 18 million total?

A - Harold (Terry) McGraw

18.4 million total. We're going to obviously move into the marketplace relatively soon. So, as we go through the year, especially the first and second quarters with higher levels of expenditures there, higher levels of expenditures for prepublication investments as well as our capital, there could be a period of time of a few months where we may actually be in the commercial paper market place, which will evaporate toward the latter part of the year.

Q - Peter Appert

I'll drop it after this, but you said $650 million in free cash flow, roughly $900 million for stock buyback, right, wouldn't that imply that you'd be in a net debt position by the end of the year?

A - Robert Bahash

Well, we're starting with an excess cash…..

Q - Peter Appert

With the cash. Got it. Okay. Thank you.

A - Robert Bahash

Let me be very clear with that, Peter. There is no change, to the policy that we've implicated with our dividend program or with the share repurchase and given the strength of cash flow we would not be in a position of going into a finance program for those programs.

Q - Peter Appert

Right. So not willing to take on debt to fund stock repurchases?

A - Robert Bahash

That is correct.

Q - Peter Appert

Thank you.

Operator

Thank you. Our next question comes from Brian Shipman with UBS. Please go ahead.

Q - Brian Shipman

Thanks. Good morning. Terry early in the year you'd mentioned you thought the open territory state sales could total just over $2 billion in '05. Wondering now that you've got the year in the bag how that ended up and then could you give us a take on total sales of open territory states in '06? Thank you.

A - Harold (Terry) McGraw

Thanks, Brian. Again we don't have hard numbers yet from the AAP in terms of the compilation on that. But I think a safe number for growth of open territories in 2005 is roughly 3%, and given the strength of some of the schedules in '05, usually what we see is a stronger open territory market that comes after a very strong market year that way. So, we would expect open territories to be up over 2005, really hard to tell at this point what that could be. But I think that we are going to see nice growth in open territories in 2006, and just as soon as we get some indication on that, we will be going there. Of course we are going after that market aggressively. We talked about some of the programs there, Treasures, one of our early reading programs, brand new reading program and we're very excited about and is going after that market in the open territories up front. So we'll get a good look at it. But I expect to see nice growth in open territories in '06 on top of 3% growth in 2005.

Q - Brian Shipman

Thanks, Terry.

A - Harold (Terry) McGraw

Thanks.

Operator

Thank you our next question comes from Dave Lewis with J.P. Morgan.

Q - Fred Searby

Hi, it's actually Fred Searby of J.P. Morgan. Good morning. A couple questions, Terry, one is on the margins we saw some nice margin expansion and S&P in '05 and I'm wondering why we wouldn't,given the double digit growth, if you could just help us understand why I think you're looking for flat margins, why that would suddenly shift into a down gear, and then if you can help us, you made a couple acquisitions that had a lot of conceptual appeal, but there's still question marks about how they're doing. It sounds like they're doing great. Can you give us some sense of how fast capital IQ grew in '05 and how fast CRISIL is growing in the fourth quarter? Thanks.

A - Harold (Terry) McGraw

Okay. First of all on the margins, again, as we came into 2005 and 2004, in 2004 we did a 40.8% margin. And the guidance that we use coming in was similar to 2004, and then we will see where the strength is and whatever. We are very confident on the double digit top and bottom for S&P in '06 and I think that again given some of the investments that we're making and will continue to make there, I think that as guidance coming into this year holding to the 42.5% is a good position and we'll monitor as we go, Fred, and we'll give you that indication. I think one of the, some of the swing factors are associated with some of the things that Doug Arthur was talking about is where is the pipeline now for example for residential mortgage backed and commercial mortgage backed and where do you see some of that participation? We have to see on that one. I have to believe that there's going to be some decline in the residential market, but we're still seeing some strong activity. So, we have to see.

I think going into the year at 42.5% is a good mark on that part. On the acquisitions, Bob gave you the cash positions and the accretive methods for 2007, but we are really, really pleased. J.D. Power and Associates is ahead of plan. They are doing really well and we're very excited about some of the non-automotive initiatives they've made, but also their progress in the Asia Pacific market. Here where you've got expanding economies and growing consumer participation, J.D. Power is finding terrific receptivity on that part and we're going to continue to be pushing very aggressively on that, and it's going to help in some of our other businesses, especially in the energy markets and the construction market in terms of supporting some of their initiatives.

CRISIL is a little early without breaking things out specifically on that, but our relationship with CRISIL goes back to 1996. I'm correct on that, Don was it '96, '97? '96 on that where we had a small position and continued to build on it. So we know this management team very well. It's a very strong team, and we have been participating in their growth as they've acquired things and are developing in that market. But, for the Indian market the last 15 or 16 months have been a very exciting time period in terms of a lot of initiatives that have improved business environment conditions, improved foreign direct investment and we're working very hard on those trends and our part in bringing the higher transparency to this. CRISIL is in great shape. Capital IQ is on plan. We have integrated Compustat into that operation on that one. This is going to be a very good year for that combination, and we want to see some heightened progress on that one. We're excited about it. But we will continue to be working to integrate more of S&P's information products onto that platform and the like, but there's going to be a very aggressive, as there has been, sales and marketing effort as well as we plan to expand it. So those are all on target on that one and we're pleased with where they are.

Q - Fred Searby

Terry, not to beat a dead horse to death, but on the share buyback, academics keep telling us that given the tax yield and that it makes sense for you probably to have some ,leverage if your stock dropped materially it looks very, very accretive here. Would you consider really getting aggressive and taking on some leverage, putting some debt on the balance sheet on buy back some shares?

A - Harold (Terry) McGraw

I would put it this way, Fred. I would say that we have looked at a lot of alternatives and we are, I'm disappointed that the El-High market is soft in '06, but we've known that and but given the strength of '07, '08, '09 coupled with the fact we need to invest this year for that, I'm not disappointed in any way about our prospects here, and we'll see how the year unfolds on this one and we're going to be doing everything we can to make sure that we improve upon all of our forecasts and budgets aren't ceilings, budgets are what they are at that point. So I don't see those kind of concerns. However, everything is open and all alternatives are looked at and we feel very good about the share repurchase program and how we're using the free cash flow that way and the dividend program and we will continue to look at things as we go.

Q - Fred Searby

Okay. Thank you, sir.

Operator

Thank you. Our next question comes from Steven Barlow with Prudential Equity Group. Please go ahead.

Q - Steven Barlow

Thank you. Bob, is it possible to break down the $0.13 option expense by division and corporate and secondly, Terry, you talked about Financial Services margins obviously improved. Is all of that due to CVC and if so, if CVC is going away, really for three quarters that you had it in '05, why wouldn't again margins go up in '06?

A - Harold (Terry) McGraw

Okay, I'll give you Bob on the option expense. CVC was relatively small, Steve, so it wouldn't have had that kind of impact and of course as we are investing in a lot of the non-rating areas as well, you're seeing some very strong opportunities that way. But again, I think going into this year at 42.5 it is a good position to be in at that point and again we'll just see as we go along. I need to see what some of the, just how robust some of the transaction activity is going to be before I would change that guidance, but we feel very good about in a position we're in going into this year.

A - Robert Bahash

Terry, on the option expense, and these are right now ballpark estimates, but to try to give you some color as to how it would break down between the three segments and the corporate areas, let me shoot these numbers off. For McGraw-Hill Education 10.8 million, for Financial Services, 22.4 million; for Information and Media, 10.3; and for the corporate area, 35.6; totaling approximately 79 million out there roughly $0.13. Those are rounded numbers, but it should give you enough color to reflect these in your models and make your appropriate adjustments with regard to margins.

Q - Steven Barlow

Great, thank you. And lastly, Terry, is there a way to size the percent of revenue in the education business that you get from testing since that says more important these days?

A - Harold (Terry) McGraw

From what, Steve?

Q - Steven Barlow

Testing in terms of percent of revenue in the education business?

A - Harold (Terry) McGraw

Yeah, again we don't break that out. On that one. But it is an essential business given the mandatory testing of No Child Left Behind. It has been a very good contributor for us, and it is going to grow at very strong rates, so I think it's going to be a number that will be a big part of K-12 going forward on that one. But, again we don't break that out specifically. Bob, do you want to add anything to that?

A - Robert Bahash

No, I think that really says it. This is part of the El-High group and that we just simply don't break it out.

A - Harold (Terry) McGraw

Yea, and again, the areas that we're looking at for significant growth is the shift to formative testing rather than some of the summit of our high stakes testing, and that's where the investment and the development costs have gone into making sure that our strong capability is going to be on the formative side. That's coupled with our already very strong position on the high stakes side. States are requiring a lot more customization and therefore we've been working hard on the technology platform to be able to do that. The other one that's a little different and why you saw some of the restructuring charge on CTB McGraw-Hill had to do with the fact that states as they put out very large contracts are also asking for state scoring capabilities that way and so therefore what we've been doing is building out infrastructure in some of those states.

Q - Steven Barlow

Thanks.

Operator

Thank you. Our next question comes from Michael Meltz with Bear Stearns. Please go ahead.

Q - Michael Meltz

Great, thank you. Bob, just to follow up on that CapEx question, can you just clarify that a bit? You're saying just so I'm clear, 200 in '06 plus another 40 for tech, and does all of that stay for '07? And then what do you view as sort of a run rate or I don't want to say maintenance but a run rate for the McGraw as a whole and then I have a follow up on S&P.

A - Robert Bahash

Yes, that's a fair question. What we've stated in the past in terms of our normal run rate for McGraw-Hill is in the range of 120 to 130. That's a normalized run rate. It will take into account the mainly technology investments that we're making for, and I'm really referring more to the equipment side. Generally that runs at about a little bit better than 60% of the normal run rate is technology related equipment. 2006 is going to be influenced by two big factors, actually three. One is the construction of a new facility in Dubuque, Iowa for our education group. Some significant expansion and resale improvement activities with regard to our very broad India facilities where we now have well over 2,000 employees. But most importantly the beginning of the construction of a new data center because of the significant growth that we have been experiencing from a standpoint of digitization of all our content and assets as many companies have gone through this issue, most of the data centers that folks had were more, were really created more to support the infrastructure side of the house, and of course as you know, with a company like us and where we are, all aspects of the Company really rely on the capabilities of a data center, so the construction of a data center is a pretty sizable investment. We're beginning that process in 2006 with the completion expected for 2007, so that's why I'm looking at the $200 million number as the run rate for 2007 with the completion of the data center as that's a major expenditure.

Q - Michael Meltz

And that 40 million.

A - Robert Bahash

The 40 million, that's investment and technology projects as they come forward to the corporation as long as they, one, meet the hurdle rates and meet the particular needs of the markets and the customers and such. But, I would expect that to stay at that kind of level, because these are opportunities to create new products, new services, new delivery systems to really provide to the customer that information that really is relevant to them. We would expect that to stay at that level and perhaps pick up another 10 million possibly.

Q - Michael Meltz

Okay.

A - Harold (Terry) McGraw

I would also add on that, Michael, to your point of a run rate, that and it's hard to start looking at CapEx projects in 2008 and beyond but the 200 million would be declining by 2008 and we would be getting back to a more normalized run rate.

Q - Michael Meltz

And two questions on S&P. Is there any update on regulatory issues, Terry? Anything you think is going to happen in the first half this year and secondly, can you just talk about sort of the melded price hikes you pushed through at S&P ratings early this year?

A - Harold (Terry) McGraw

Okay. In a price hike, our normal rate and at this point, at this time of year is where you will see them. On this one, but they are all different dependent upon asset class and on the ratings side. The structured finance area would be more aggressive because of the complexity of the instrumentation especially on CDOs and more modest on the corporate side. As far as regulatory, Michael, this is an ongoing one and in fact we have a session with the SEC in Washington this afternoon, and it's the ongoing dialog about everything from voluntary over site to other kinds of issues associated with the code of conduct that we have put out, the code of conduct that we've agreed to with the IOSCO, the security commissioners in Europe as well as the regulators there, and I would hope that at some point in the first half that we could get agreement on that, but it seems very slow and not a high priority and so we're continuing to work with the SEC and again we have good relations, have to, with all the government agencies that of the countries that we deal in and certainly here on that one. But, nothing imminent on that one and just continue to dialog on that and we're very hopeful that we'll be able to achieve some agreement similar to that which we have done in Europe.

Q - Michael Meltz

What about house legislation?

A - Harold (Terry) McGraw

Well, again, that's in terms of a volume level, we've seen that and we saw the hearing in Pennsylvania in December, and we watched that and their relationship with the SEC is one of essentially where is this all coming out? And our relationship is not with the house committee but with the SEC and we're working very hard with them. Again, I don't want to be prescriptive here on this one. I think that I don't expect any adverse conditions here and we're going to continue to work to get an agreement on a code of conduct and I expect hopefully, I was hoping that it was going to happen in 2005. But, that didn't, so I would hope in the first half of 2006 that we could get some agreement on that.

Q - Michael Meltz

Okay. Thank you very much.

Operator

Thank you. Our next question comes from Brandon Dobell with Credit Suisse.

Q - Brandon Dobell

Thank, I'll try and make it quick. Over at the S&P a couple questions. One maybe you could try to quantify or at least qualitatively talk about the impacts of some of the issuance caps and what that did to revenues and then as the mix shifts potentially more towards international from domestic especially emerging markets from domestic, how would that same issue about caps play out? Would we see a change in potential impact there and related as the business shifts toward more emerging markets, more international, do you anticipate any kind of change in how you view transaction versus retention revenues, your philosophy there? Thanks.

A - Harold (Terry) McGraw

Sure. Again, in terms of the volatility associated with transactions versus creating more substantive relationships and being able to create surveillance streams and so forth, there has been some change in that when you talk about international only because of the size of the relationships. As the relationships get bigger so too do the value proposition that we can propose to those clients and therefore a surveillance fee relationship. I see maybe a little increase on the international only side of transaction impact, but as we gain size, that will dissipate and I expect a relationship very similar to the 60/40 relationship that we talk about domestically. So I don't see that longer term because it's again, it's a very similar relationship to client development here in the United States. But, you're right. The growth is going to go up by the end of the decade we will be approaching probably 50% of our revenue generation coming from outside the United States and things are growing very rapidly and not only in Europe but in Japan but also the Asia Pacific market more broadly. That's why we entered into the relationship in 2005 in Malaysia, that's why we bought a majority position in the Taiwan ratings corporation and that will continue. The Asia Pacific market is a very strong market and one that we're focused on. Now, I would also say to you that Latin America is continuing to show nice growth opportunities, Mexico, Brazil, a little bit Argentina on that one in particular, so we're focused there, but as again, you build the base, the infrastructure gets leveraged and we can develop into surveillance fees.

Q - Brandon Dobell

Okay. One final one if I could over in the college market. You talked about growth in the market and then taking share in that market. Maybe if you'd give us more visibility and to how to think about the relative sizes, the relative growth rates and you could separate the college market from the other assets you have in that category. Just trying to get a sense for what kind of share you might be taking, what the relative growth rates might be in that segment.

A - Harold (Terry) McGraw

Okay. Again, when we talk about the college and university market, you're talking about your gross revenue capability and then you want to net out returns on that one. And those numbers aren't complete at this point, from the AAP. We saw a little bit higher returns in the fourth quarter given some of the, the acceleration of the new programs that we have, that we've listed. But the college and university market overall we expect to grow again in 2006 in the 5% to 6% range and we fully expect to out perform it. This is a fabulous business. The attention that it's getting, if you just want to put it into context, the higher education market, the global spend for the higher education market is about $300 billion a year. Depending upon how you classify certain students and whatever, there's probably about 85+ million students in higher education in the world, about 3.5 million professors to teach them. That number, that 85 million is probably going to go the next 20 years to somewhere in the 300 million range and on that one, and so the opportunity in terms of knowledge development skill set, work force capabilities is going to be huge, and it's getting an awful lot of attention, but it's not just on the higher ed side. The continuous learning notion is very powerful and therefore adult education and professional development are going to be very strong components this way. Also as you're developing out more college and university capabilities as we've talked about before in the U.K., Germany, Taiwan, Australia, New Zealand, Singapore, and it gives our international operations more opportunity and more leverage off of those capabilities. It is a very strong market.

Q - Brandon Dobell

Thanks a lot.

Operator

Thank you. Our next question comes from Karl Choi with Merrill Lynch.

Q - Karl Choi

Hi, good morning. Couple of questions in the education segment. First of all, I wonder if you can talk a little bit about the Texas adoption $100 million adoption that was delayed last year. Ultimately how much was spent in '05 and how much do you think could come again in the first quarter of 2006? And second question is I wonder if you can talk a little bit, give us a little bit of a sense of the margin differential between the off the shelf tests and the customized tests that the states are now asking, what kind of margin differential are we talking about here? Thanks.

A - Harold (Terry) McGraw

Did you get the last one? I didn't hear that. You grab that one and I will grab the first. Texas? Proclamation 2001, proclamation 2002, as we came into 2005 we fully expected the parts that were delayed which were about 140 million a proclamation 2001 to be completed in 2005. That has been achieved. The proclamation 2002 was delayed from the end of the second quarter and that pushed that into the third quarter and as funding issues became clear we were able to pick up additional dollars there in the fourth quarter. We think that there could be a spill over effect in the first quarter and that's some additional dollars. All we know is the programs that they've been purchasing and our capture rate, and we talked about the health and the music and all of that. I would expect that we will be complete with proclamation 2002 by some time early this year and as we get those dollars, as we see those dollars and can account for them, we will get them to you. I think for the most part 2002 is well on its way to completion.

Q - Karl Choi

Okay.

A - Harold (Terry) McGraw

I'm sorry, the other part was Bob's.

A - Robert Bahash

Just to finish up on that one item, there is about 60 million, we estimate about $60 million remaining in proclamation 2002 but it is unclear because of a number of restrictions that the state legislature has put in place whether those monies will be spent. We're just not certain. We are thinking of something closer to about a third of that that we anticipate that will be spent but time will tell.

A - Harold (Terry) McGraw

But the other issue there, to your question, Karl, is that somewhere around 40% of last year's opportunity was Texas.

Q - Karl Choi

Right.

A - Robert Bahash

The second part that question related to the testing side and the margins, the margin differential between customized testing and off the shelf testing. The industry has shifted rather dramatically over the past few years. We used to produce products like CTBS, the California achievement test, Terra Nova and products like that that were used by a number of whether it be state districts, local districts and such, so you were able to leverage the capabilities of what you developed across a number of your customer sets. With No Child Left Behind there is a plus and there is a minus associated with that. The plus is that there is a significant push to an increased testing environment. The minus side is that each state is looking at a customized version of the test to meet their particular teaching needs, their particular syllabus, where they're going so everything needs to be customized, so as you customize by your products, there is an additional cost element to that. As Terry mentioned earlier, we're, working on a number of issues, a number of technology based initiatives to help us in that effort. In addition, we're developing products and services as well for the formative testing side that we see our bigger opportunities. Without getting into the specifics in terms of what the margins are clearly there is a big enough differential between a customized test that's highly competitively bid state by state versus an off the shelf product.

Q - Karl Choi

Thanks. If I could just ask one last question, can you give a little bit more color on why the acquisition dilution is coming in a little bit higher than you thought would be the case in 2006?

A - Harold (Terry) McGraw

The question earlier and I would like to elaborate which hopefully will answer your question related to capital IQ in CRISIL as an example, capital IQ is currently running in terms of the new customer ads at rates in excess of where our business plan was and where they were. So we, in CRISIL is also running at rates that are significantly ahead of their business plan just using those two as examples. We are, as a result of that, we are making additional investments outside of where we thought we were going to be for new data sets, et cetera, to help to fuel that growth. This is a good situation, a good example of where acquisitions are actually performing from our perspective better than where we thought and as a result we're fueling a little bit more in the way of investments, so our original forecast last year was to have $0.01 to $0.02 dilution in 2006. As I mentioned in my remarks, it is $0.03 to $0.04 because of the additional investments as a result of the very positive environment.

Q - Karl Choi

Great. Thank you.

Operator

Thank you our final question comes from William Baird I am sorry, William Bird with Citigroup.

Q - William Bird

Thanks. Terry, I was wondering if you could talk just a little bit on S&P and just in general, what your thoughts are in bridging the margin gap to Moody's. Thanks.

A - Harold (Terry) McGraw

Thanks, Bill. Again, you have to compare those carefully because of the fact that Standard & Poor's is a much bigger organization in that it takes on a lot of financial information product and capability and therefore some of those products are at lower margin levels than what we would be achieving in some of the rating categories. Having said that, I think we're probably pretty comparable in some areas and in some there may be initiatives that we need to do to strengthen that. Those would come probably more on the technology work flow issues and on risk and quantitative tool sets. And so those are the areas that we're working on to pick up margin improvement where we perceive there to be some issues, but for the most part I would have to say that it has to do with the fact that we had different businesses than the ratings business in that group, and some of those are at different margin levels and it influences it.

Q - William Bird

Thank you.

A - Harold (Terry) McGraw

That's it.

Donald Rubin, SVP Investor Relations

Okay. Well, thank you very much for our interest and support. Off into 2006 and we hope to build from the base that we started. Thanks very much.

Operator

Thank you. That concludes this morning's call on behalf of McGraw-Hill Companies we thank you for your participation and have a good day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: McGraw Hill Companies Q4 2005 Earnings Conference Call Transcript (MHP)
This Transcript
All Transcripts