Donald Rubin - Senior Vice President Investor Relations
Harold McGraw III - Chairman, President and CEO
Robert Bahash - Executive Vice President and Chief Financial Officer
Peter Appert – Goldman Sachs
Craig Huber – Lehman Brothers
Michael Meltz – JP Morgan
Edward Atorino - The Benchmark Co.
Catriona Fallon – Citigroup
The McGraw-Hill Companies, Inc. (MHP) Q2 2008 Earnings Call July 29, 2008 8:30 AM ET
Welcome to McGraw-Hill Companies second quarter 2008 earnings call. (Operator Instructions) I will now turn the call over to Donald Rubin, Senior Vice President of Investor Relations for the McGraw-Hill Companies.
I’m Donald Rubin, Senior Vice President of Investor Relations at the McGraw-Hill Companies. With me today are Harold McGraw III, Chairman, President and CEO, Robert Bahash, Executive Vice President and Chief Financial Officer.
This morning the company issued a news release with second quarter results for 2008. We trust you've all had a chance to review the release. If you need a copy of the release and financial schedules, they can be downloaded at www.McGraw-Hill.com/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 Form 10-Ks, 10-Qs, and other periodic reports filed with the US Securities and Exchange Commission. We are aware that we do have some media representatives with us on the call, however this call is for investors and we would ask that questions from the media be directed to Mr. Steve Weiss in our New York office subsequent to this call.
Today's update will last approximately an hour. After our presentations we will open the meeting to questions and answers. It's now my pleasure to introduce the Chairman, President and CEO of the McGraw-Hill Companies, Terry McGraw.
Good morning everybody and welcome to our review of the McGraw-Hill Companies second quarter earnings and the outlook for the rest of 2008. Bob Bahash our Executive Vice President and Chief Financial Officer is joining me today on this call. I’ll begin by reviewing the second quarter results and our prospects then Bob will review our financial performance and obviously we’ll be pleased to take any comments or questions that you might have.
Earlier this morning as Don said we announced second quarter results. Earnings per share were $0.66 that included a pre-tax restructuring charge of $23.7 million or $0.05 per diluted share primarily for the severance costs relating to a work force reduction of 395 positions. Revenue for the second quarter declined by 2.6%.
The biggest national housing recession since the great depression and the credit crunch in the financial markets obviously continue to have an effect on our results. David Wyss who is our S&P Chief Economist doesn’t expect the housing prices to bottom out until the first half of 2009. The large supply of unsold existing homes continues to weigh on the market. David expects housing sales and starts to bottom out some time in the third quarter of 2008 but prices will probably have about another 10% to go. Again, we’re looking for somewhere in the later part of the second quarter 2009.
The Federal Reserve is not expected to take any action on interest rates at its August 5th meeting. In fact, the next move expected from the Fed will be rate hike probably in the second quarter of next year. David Wyss estimates gross domestic product, GDP growth of 1.7% in the second quarter and 1.8% in the third quarter as consumers spend the rebate checks so a lot of activity moving forward into the second and third quarter and therefore he expects negative growth in the fourth quarter of this year and in the first quarter of 2009 followed by 3% growth in the second quarter next year.
In this environment states are dealing with falling tax receipts and challenging budgets but that has raised questions about the outlook for education budgets and of course in the new fiscal year that started July 1, and we have 46 states that start their new budgets July 1. The states are working very hard to protect educational funding.
A new survey of state education budgets by McGraw-Hill Education has pinpointed information on K-12 education budgets in 38 states and we’ve learned that most of these states education budgets are increasing in the new fiscal year although at a slower rate than last year. The increase is averaging about 3.5% for the new fiscal year versus about 10% last year. We have seen at this point reductions in K-12 education budgets in only three states, two of them are flat.
There’s another factor to consider in evaluating state budgets and its bond issuance. In the face of declining tax revenues states are now more likely to step up bond issuance in the new fiscal year and that’s a plus for Standard & Poor’s. With that as background let’s turn to the review of the operations.
Let’s begin with McGraw-Hill Education, a very good start in what is expected to be a robust state new adoption market this year was a key factor in McGraw-Hill Education second quarter performance. For the second quarter revenue increased 3.6%, operating profit including a pre-tax restructuring charge of $8.5 million declined by $10.9 million or 13.5%. The operating margin was 10.4% versus 12.4% last year. The restructuring charge reduced the operating margin by 126 basis points.
The McGraw-Hill School Education Group increased revenue by 6.9% to $438.2 million and the McGraw-Hill Higher Education Profession and International Group saw revenue decline of 2.1%. With the decision making largely completed in the adoption state we have a pretty good idea at this point of our prospects there. As you know in 2007 we captured 32% of the state new adoption market and that was worth about $820 million.
In 2008 we expect to capture about a third of an even larger state new adoption market. We estimate this year’s market will come in between $900 and $950 million. The biggest opportunities this year are in reading and math. The key adoption states are Florida, Texas and California. We expect to produce solid results in both key disciplines in all of our key adoption states.
In the second quarter we saw the first signs of our successful campaigns as orders came in for reading from Florida and math from Texas, an exceptional year is taking shape in Florida, we’re very pleased here where Treasures our balance basal program which has been widely adopted but that’s not the whole story.
We compete obviously with a spectrum of products because US education is not a one size fits all market so we will take additional market share in Florida with our alternative basals and those are Imagine It! and Reading Mastery Plus. As a result, our products will account for more than half of this years Florida K-5 reading market.
We also did very well in Texas with our new state specific balance basal math program and in California we expect to build on last year’s success in science with an excellent performance in the sizeable second year K-8 adoption. We also anticipate good results there in the K-8 math with our new state specific balance basal and with Everyday Mathematics.
In the overall K-12 reading and literature state new adoption markets we expect solid results in Alabama, Indiana, Louisiana, and Oklahoma. Spotlight on Music is leading the elementary market and our fine arts, health, business and vocational lines are performing well in states adopting these categories.
The supplemental market remains sluggish. Although we’re enjoying some success with intervention products our prospects in this market got an unexpected boost last week when the Texas Education Agency announced a new $15 million opportunity for reading intervention programs. That new funding will be spent during the 2008-2009 school year on the Texas intensive reading initiative for grades four through grade eight.
Three of our intervention programs have been adopted, that’s Reading Triumphs, Corrective Reading, and Jamestown Reading Navigator. They represent comprehensive print and digital solutions for students reading below grade level.
Summing up the outlook for the elementary high school market in 2008 a solid year is taking shape in the state new adoption market. The bulk of open territory orders traditionally come in the third quarter and we’re still looking for some increase in these states. This market should grow 1% to 2%. Obviously we’re hoping for more. We still expect to gain share in the overall K-12 market which will grow probably 4% to 5% this year.
In the Testing market we compete with a spectrum of assessment products, Acuity, which is our new formative product, continues to win new customers. We are winning new business for our TABE series which offers diagnostic assessments and instructor support for adult students. With our LAS Links series for English language learners, last week Nevada, for example, extended its contract for LAS Links for three years to serve nearly 80,000 English language learners in the state.
Our system helps states ensure compliance with no child left behind Title Three requirements and we’re seeing some changes in no child left behind requirements that play to our strength in testing. The US Department of Education has been permitting states to add a growth component to their school accountability programs. The growth model looks at the academic performance at individual students to determine if they’re on track to become proficient.
If students score below the proficient stand in reading or math but are still making progress and appear likely to achieve proficiency they may be counted among the schools proficient students. Eleven states have not been permitted to add a growth component to their state accountability plan. Growth components require the development of a vertical scale. We have strong industry recognized expertise in vertical scaling which links one grade to another so schools can see how students are progressing from grade to grade.
Our TerraNova testing series has vertical scales and the same it true for our Acuity predictive test which enables us to show a growth through formative assessments a significant competitive advantage for schools and teachers.
In the Higher Education international and professional markets we saw some softness in the second quarter as book stores cut orders and reduced inventory. Some college textbook distributors also shifted the timing of their orders for the fall semester from late June into July. We expect softness in professional markets for the balance of the year. It’s a combination of tough comparisons. Last year we had the benefit of a new edition of the Encyclopedia of Science and Technology. This year we’re facing the impact of the economy on book store sales.
We now expect our US College and University business to grow about 4% to 6% this year. However, sales of our digital, custom and career product lines are showing stronger growth. The outlook is mixed in international markets. Summing up for McGraw Hill Education overall, slower growth in our Higher Education professional and international market may reduce the rate of increase in revenue this year for McGraw-Hill Education.
Our original forecast called for revenue growth of 6% to 8%. We now estimate revenue growth of 4% to 6% in 2008 and we’ll have to see as orders come in in August and again July/August for them we call it the 60 day month. We’re not changing our estimate however on the operating margin. Our estimate of 50 to 100 basis point decline in the segments operating margin holds.
Let’s move now to Financial Services, for our Financial Services segment the second quarter will probably be the most challenging of the year. S&P peaked last year in the second quarter achieving its highest levels of revenue and operating profit as a structured finance market continued to surge. In face of tough comparisons this year, diversification and cost containment where critical factors in our performance.
For the second quarter revenue declined 10.4%, operating profit including a $15.2 million pre-tax restructuring charge was down 25.4% and operating margin was 40.7% down from 48.9% last year. Restructuring charges reduced the operating margin in the second quarter by just over 200 basis points. In a typical first half Financial Services produced an operating margin of 40.5% and that includes the second quarter restructuring charge. The restructuring charge reduced the operating margin by 110 basis points.
The performance underscores some very key components about the outlook for Financial Services. First, diversification contributed importantly to our results. Secondly, our strategy buffers Standard & Poor’s against the decline in new issuance. Three, the cost containment will continue to be a priority and fourth, while there have been more headlines and new rule and regulatory proposals in recent weeks there is no change in our assessment of legal or regulatory risks. In my opinion, both remain low. Fifth, our guidance for the segment in 2008 remains unchanged.
If the decline we experience in the first half in structured finance continues for the remainder of the year then we believe that revenue for Financial Services could be off 7% to 9% in 2008. Under these circumstances we would also expect a 500 to 600 basis point pull back in the segments operating profit but that’s if we experience the decline in structured finance that we saw in the first half.
Now let’s examine these points in more detail and let’s start with the impact of diversification. A key aspect of diversification is illustrated by this table which compares results of Financial Services with new issue dollar volume in the bond market. Revenue for the Financial Services decline 10.4% and S&P Credit Market Services was off 20.1%. Global new issues dollar volume fell 32.5% in the second quarter. Domestic revenue for the credit market services was off 30.6% while total US new issue dollar volume fell by 44.4%.
In the second quarter international revenue for credit market services was down 3.3% while international new issue dollar volume declined by 20%. As we had forecasted Standard & Poor’s Investment Services produced double digit revenue growth up 22.8% for the second quarter and 20.4% for the first half. We still expect double digit revenue growth from these non-rating businesses for the full year.
We continue to expand in data and analytics both here an abroad. The Capital IQ products are attracting new customers in both domestic and international markets. Capital IQ now has more than 2,400 customers worldwide and that is a 23% increase compared to last year. Our index services are still rolling ahead adding new products and more customers. Assets under management in exchange traded funds based on S&P indices grew by 15.5% to $206.3 billion versus the same period last year.
Sales of our custom indices and data also increased. Trading in exchanged traded derivatives based on S&P indexes has been robust. The average daily volume of contracts for the major exchange traded derivatives was 2,820,000 in the second quarter and that’s up 25% from the comparable quarter last year. Trading of over the counter derivatives also increased substantially due in part to our products and that includes the S&P GSCI Index, the S&P Diversified Trend Indicator and the S&P Commodities Trend Indicator and the S&P Select Plus Custom Series.
Investment banks licensed these products from S&P to create structured vehicles that are linked to their performance. For example, to pick one of them the S&P Diversified Trend Indicator is a composite of 24 highly liquid future contracts and they’re grouped in 14 different sectors evenly weighted between financials and physical commodities.
The S&P DTI positions each sector except energy either long or short based on its price behavior relative to its moving average. It’s just another example of all the things that I think are possible with these kinds of instruments. It’s all about innovation and creativity, there’s an endless permeation of the number that you can come up with. We continue to expand.
Let me quickly recap this year’s activity for S&P indices. Eighteen new exchange traded funds were launched in the second quarter, 31 new exchange traded funds were launched in the first half compared to 46 for all of 2007 and there are now a total of 175 exchange traded funds based on S&P indices and we have more new indices on the launch pad of the second half.
Our effort to diversify is not limited to S&P investments services. Diversification is also an important strategic activity at S&P Credit Market Services reducing S&P’s dependence on the new issue market and expanding internationally our key initiatives the 13.7% increase in non-transaction revenue for the second quarter and 12.5% for the first half are tangible measures of our success clearly growth in this area helped partially offset the decline in new issue markets.
Non-transaction revenue includes surveillance fees, annual contracts and subscriptions, all three categories grew in the second quarter as did deferred revenue for the financial services segment. Incidentally deferred revenue for this segment increased 12% in the second quarter to just over $840 million. We expect deferred revenue in this segment to continue growing.
In this environment obviously cost containment is vitally important. We are closely managing costs while making investments to assure that S&P is prepared for the turn around in credit markets and growth in our non-ratings businesses. We have taken a measured approach to restructuring by eliminating approximately 170 positions at the end of 2007 and another 246 positions in the second quarter.
We have also reduced incentive compensation in our effort to streamline the organization we will continue to examine the management structure and make process improvements. We’re watching the hiring and that means a very selective. Reduction of discretionary expenses is a priority and Bob Bahash will provide more information on costs and expenses in just a moment.
The US structured finance market continues to show major declines in the second quarter. New issue dollar volume was obviously down and you can see the numbers on the chart in front of you 75.4% in April, 81.8% in May, 84% in June 79% for the first half. Only the issuance of asset backed securities is up after six months but not by much 0.2%.
With these bar charts we have been illustrating the monthly comparison in US new issue volume since the beginning of 2008. There is a sequential improvement in US Corporate new issuance in the second quarter. June was the best month of the second quarter for public finance. Even a sequential pick up in structured finance is hard to spot. Based on early indications in July we don’t expect to see much change in these patterns this month. Year over year comparisons don’t start to get easier until September.
There are signs that the market is healing but has not yet healed. Despite the turmoil in credit markets, investment grade issuers show strength in the second quarter as better known issuers attracted receptive investors. Nearly all of the recent deals have been substantially oversubscribed and indication that there’s plenty of cash available. We think the corporate outlook for the second half is promising although speculative grade issuance will remain weak.
We expect more growth in public finance. The state and local government pipeline continues to look strong. We expect growth in international markets in the second half. We will benefit from our geographic expansion into the Gulf and Central and Eastern Europe. Refinancing requirements of industrials in Europe should also be a source of growth and activity remains very slow in the structured market.
We are seeing some interesting developments in the US residential mortgage backed securities market. The focus will probably continue to be on the secondary market trades and all of the repackaging. As a result S&P may have some opportunities to rate some of the re-securitizations or Re-REMICs.
There’s also growing US interest in covered bonds which have been issued in Europe since the 1700’s. Some market participants believe covered bonds could stimulate the US mortgage market but since the US does not have an explicit legal framework for covered bonds there’s not an effort to resolve that issue and Secretary Treasurer Hank Paulson was referring to that just the other day. If that effort succeeds large capitalized banks could be important issuers.
The structure of covered bonds makes them attractive in today’s environment because the investor has essentially two levels of protection. Covered bonds are senior debt obligations of the issuing institution secured directly on a portfolio of specific assets. The issuer is obligated to pay interest and principle on the bonds but for example, if the issuer defaults the assets in the covered asset pool also are available to repay the covered bond.
Another opportunity for S&P is also emerging in structured finance. In the last eight years an estimated $25 trillion of securitized assets have been issued. The majority of these assets is still in the market and need to monitored, revalued, and priced for the trading in the secondary market. To tap this market potential S&P recently created Fixed Income Risk Management Services or the acronym using FIRMS under the direction of Lou Eccleston.
It will provide market intelligence and analytic insight for risk-driven investment analysis including debt, structured finance and the derivatives market.
As this slide shows we have specific strategic initiatives for our target markets. The acquisition of IMAKE last year is the key to offering a new integrated credit risk modeling, surveillance and evaluation platform. We have already established the partnership with Super Derivatives to create the largest coverage of assets in a single offering and redesign and re-launching of RatingsDirect is on track for next January.
Let me shift now and let’s talk about the legal situation and a little bit of the regulatory situation as we see it right now. We recently won our first court decision related to subprime litigation. Last week the court dismissed the Blomquist action. This was suit was filed in California last August and it was alleging various state and federal claims against numerous financial institutions, government agencies, McGraw-Hill and individuals, including myself.
Last May we filed a motion to dismiss all claims which was granted by the court on July 23rd. Significantly the court dismissed the case against us without giving the plaintiff the opportunity to amend the complaint.
A new suit was filed in July so there are now five that we’re dealing with. The latest was filed in New York Supreme Court by Oddo Asset Management against essentially Barclays Bank but lots of others as well including ourselves. The suite alleges losses in two structured investment vehicles and the confirmation of allegedly false ratings by S&P.
In May and early June the New Jersey Carpenter Health and Vacation Fund filed three separate lawsuits against issuers, underwriters and a whole host of people including ourselves. These actions concern losses on mortgage backed securities and allegedly inappropriate credit ratings.
The class action suite filed last August in the District of Columbia is being moved to the US District Court for the Southern District of New York. The plaintiffs here seek damages relating to the decline in the value of McGraw Hill stock price. These are traditional stock drop type suits and it alleges because senior management allegedly failed to warn investors about problems in the structured market or in some of the products like S&P’s, Residential Mortgage Backed Securities or CDO ratings.
To wrap this up we believe all of the remaining suits are without merit and in our view the legal risk from these actions also remains low.
S&P remains very actively engaged with all regulatory issues and is making progress on our intense commitment to a part of the solution. That’s why we’re working very closely with policymakers and market participants around the world to enable greater transparency and that is the most important thing in terms of helping to restore confidence in our markets.
Separating the facts from the headlines is not easy in this environment. The level of activity increased substantially in June and July so let’s review some of the recent developments. On June 5th S&P and two other ratings agencies announced agreements with New York Attorney General Andrew Cuomo; the focus was on the US residential mortgage backed securities.
As part of that undertaking there were no findings of wrongdoing. There were no payments and the New York Attorney General closed his investigation of the rating agencies. The agreement underscores our commitment and our strong, strong commitment to transparency, openness and the strengthening of the governance process.
The SEC held two public meetings in June to discuss proposed new rules and regulations for NRSROs. On June 11 the SEC discussed a comprehensive set of rules that have the potential to bring more transparency to the structured market and this was including the additional disclosure, there was increased record keeping and strength in management of potential conflicts.
The SEC put out these proposals for new rules and asked all market participants for public comment and they’d like them back by July 25th. I’ll summarize the comments that we submitted to the SEC in just a moment. The other one was on June 25 the SEC met to discuss the use of NRSRO ratings in its rules mainly the broker-dealer net capital rule and the money market fund investment rule. Comments to the SEC regarding these proposals are requested by September 5 and I’ll also review these potential changes in just a moment.
First I want to comment on the report issued by the SEC on July 8 after its comprehensive 10 month examination of the three ratings agencies. Amid all the news stories on the SEC report some critical conclusions got very scant attention. According to the SEC report no evidence was found by the SEC staff that decisions about ratings methodologies or models were based on attracting or losing market share.
There was no indication that the rating agencies compensated analysts in a manner contrary to their policy. The SEC recognized the rating agencies enhanced their procedures in connection with their registration as NRSROs in 2007. The SEC report did note that further improvements can be made in the management of conflicts of interest.
At the conclusion of the examination the SEC called for more documentation of the ratings process and recommended that S&P conduct reviews in certain areas. The S&P is committed to doing just that. S&P will be implementing these recommendations and taking steps to strengthen its ratings process accordingly. As you all know in the first half of this year we introduced 27 leadership actions in four categories. Those categories were governance, analytics, information and investor education.
As I noted earlier S&P on July 24 responded to the SECs request for comments on its proposed rules. First I want to point out that S&P overall support the SEC proposals. We are committed to cooperating with the regulators and policymakers both here and abroad and we believe that the dialogue is extremely important. Also the policymakers and regulators think it’s extremely important.
They recognize that the issues are complex and merit this discussion and that’s why the SEC asked for comments on the proposed rule. This is not a game of gotcha. It is all about transparency, openness and helping to restore confidence in our capital markets. That’s the context for S&Ps response to the SEC on July 24. S&P responded to the SEC on two levels, commentary on the proposals itself and then observations on specific legal and related questions raised by the SEC staff.
S&Ps goal was to be constructive and see clarifications where the proposals were not necessarily clear. We share the SECs desire to enhance investor understanding and address potential conflicts of interest in the current rating industry. At the same time we believe that any new SEC rules must be narrowly tailored as required by the law and should not regulate the substance of credit ratings or otherwise impair the value of rating agencies independent opinions.
For example S&P fully supports the principle underlying the proposed rules that public rating decisions should be made broadly and publicly available. However, S&P also believes that is should be able to control how it disseminates its proprietary historical data and intellectual property. S&P agrees with the SEC that it should have policies and procedures that prevent it from structuring the products it rates. We already do that.
We are concerned about the interference with the free flow of information between the rating agencies and their issuers. This is not a black box business and communications between rating agencies and issuers should be encouraged not inhibited. S&P also believes the costs of the proposed rules both for rating agencies and the market have been underestimated by the SEC and that’s why S&P offered to share a detailed breakdown of its research on these matters with the SEC.
These are some of the highlights from a 33 page letter S&P sent the SEC last week and if you have time and you’re so inclined I hope you’ll have a chance to read and it and you can access this letter at www.StandardandPoors.com. We look forward to working closely with the SEC and market participants so that any new regulations lend themselves to openness, transparency, market competition while remaining compatible with the existing law and regulation.
The SEC is also seeking comment on rule changes affecting the use of ratings to meet capital requirements and I would observe that we didn’t make the rules and believe we can continue to operate successfully if they’re changed. We already do this outside the United States. We would be concerned if the proposed changes led to unintended disruption in financial markets.
Soon we expect to see a draft of proposed regulations from the European Commission. In so far as European regulators may consider additional oversight of rating agencies we believe such steps would best be addressed through a globally coordinated approach recognizing the benefits of consistency for investors and issuers operating in international businesses. On this basis we will continue to communicate regularly with regulators around the world and we do that.
That’s a lot of information on legal and regulatory but I wanted to make sure that you had a complete look at the current situation. To sum up we continue to believe that any new or currently proposed legislation, regulations or judicial determinations would not have a material adverse effect on our financial conditions or results of operation.
Summing up for Financial Service, legal and regulatory risk remains low, double digit revenue growth for S&P Investment Services. Revenue for the segment could be off 7% to 9% of the year if the first half decline in structured finance continues for the remainder of the year. That would result in a 500 to 600 basis point drop in the operating margin again if the first half decline in structured finance continues for the remainder of the year.
Moving over to Information and Media, growth in Business to Business products were key to the second quarter results at Information and Media. In the second quarter revenues increased 6.8%, operating profit improved by 68.2% and the operating margin was 9.3% compared to 5.9% for the same period last year.
Revenue for the Business to Business Group grew by 7.8% even as advertising pages declined 11% at BusinessWeek in the second quarter. Strong global growth in Platt’s news and pricing services and international and auto consulting growth at JD Power and Associates were the key factors in this segments second quarter performance.
Platts is simply the company’s most global product proportionately it does more business overseas than any other McGraw-Hill product or service. The demand for petroleum and natural gas products which shows now sign of diminishing in today’s volatile energy markets is clearly benefiting Platts. Platts is expanding into new areas too. Steel is the world’s third largest commodity. Platts just launched Steels Market Daily in 2006 and is working with market participants to bring price transparency to this market.
We continue to make progress in construction. The electronic delivery of our information is a critical part of the transition and is continuing to produce an increasing share of McGraw-Hill Constructions revenue.
The advertising outlook at BusinessWeek is challenging. Ad pages through the issue of July 28 are off 17.3% and that’s according to Publishers Information Bureau, PIB. At the same time BusinessWeek circulation is growing and new syndicated studies indicate that our audience is younger and more affluent than in years past.
Revenue for McGraw-Hill Broadcasting Group was off by 1% in the second quarter. Declines in the base business primarily national offset our gains that we were able to record in political advertising. We expect overall political advertising to be a strong component in the second half. In August our Colorado stations will benefit from a state primary which includes contests for the US Senate and two House Representative Seats.
This fall in California we expect the ballot to include at least 11 propositions, including a controversial same-sex marriage proposition. Of course all of our TV markets will benefit from the general election on November 4. Summing up for Information and Media obviously more progress this year, revenue growth of 6% to 8% and operating margin improvement.
That wraps up our review of operations and looking ahead for the corporation it is clear that year over year comparisons get easier in the second half. Excluding second quarter restructuring charges and related benefits we still expect earnings per share in the $2.65 to $2.75 range for the full year.
Let me hold it there and let me turn it over to Bob Bahash and he will go through the specific financials for you.
I’ll begin with an update on our share repurchase program. We are approximately half was through our 15 million share repurchase target for 2008. In the second quarter we repurchased four million shares for a total cost of $170.8 million at an average price of $42.69 per share. That brings the first half repurchases to 7.4 million shares for total cost of $304.8 million at an average price of $41.19 per share. Twenty point six million shares remain in the 2007 program that was authorized by the Board of Directors.
Net debt as of June 30 was $1.4 billion. This is up approximately $170 million from the end of the first quarter and is driven primarily by seasonal cash requirements as well as funding for share repurchases. As of June 30 on a gross basis total debt was $1.7 billion and is comprised of $1.2 billion of unsecured senior notes and $526 million in commercial paper outstanding. This is offset by $355 million in cash, primarily foreign holdings.
Due to the seasonality of the business debt levels tend to be higher in the first half of the year and for the later part of the year we are focused on maintaining debt levels comparable to year end 2007.
Let’s review the outlook for free cash flow. As I indicated in our first quarter earnings call we expect free cash flow this year to be approximately $600 million, prior to any acquisitions or share repurchases versus approximately $900 million in 2007. To calculate free cash flow we start with after tax cash from operations and deduct investments and dividends. What’s left is free cash flow, funds we can use to repurchase stock, make acquisitions or pay down debt.
Free cash flow for the first half of this year reflects a $319 million decline compared to the same period last year. The decline is due to reduced profits at Financial Services and the corresponding impact on working capital, an increase in working capital usage at McGraw-Hill Education as they prepare for the strong adoption opportunities, cash outflows for construction costs for the new data center that were accrued in 2007 and a one time shift in the timing of our employee profit sharing contribution from 2007 to 2008.
Additionally, the payment of the 2007 incentive compensation awards in the first quarter of 2008 negatively impacted 2008 cash flow. The cash savings from reduced 2008 compensation will not be realized until the awards are paid out in 2009. We had anticipated first half comparisons would be particularly challenging due to the factors I just mentioned. We generate the majority of our free cash flow in the second half of the year, primarily due to the seasonality of the education business.
In the second half of 2008 we’ll benefit from easier profit comparisons at Financial Services, reduced investments for purchases of property and equipment as the second half of 2007 reflected significant investments in our data center building, anticipated lower cash tax payments and normal seasonal working capital improvements. As a result we expect fee cash flow in the second half of this year to approximate free cash flow for the second half of 2007, resulting in $600 million for the full year as we had forecasted.
Regarding net interest expense in the second quarter we had $20 million compared to $12 million in the same period last year an $8 million increase. We continue to expect it to be in the range of $75 to $85 million for 2008. Our diluted weighted average shares outstanding for the second quarter was 321.1 million shares a 29.2 million share decrease compared to the second quarter of 2007 and a 2.3 million share decrease compared to the first quarter of 2008.
Corporate expenses were $33.5 million in the second quarter a $7.5 million or 18% decrease versus the same period last year. This is primarily driven by reduced incentive compensation accruals as well as stringent expense controls. For 2008 we still expect the mid single digit decrease in corporate expenses.
I’d like to take a few moments to discuss expense growth at Financial Services and McGraw-Hill Education in the second quarter. At Financial Services expenses in the second quarter increased $17 million or 4%. Excluding the $15 million second quarter restructuring charge expenses were essentially flat compared to the same period a year ago with growth of just 0.4% or $1.5 million.
This year over year expense comparison benefits from a $30 million reduction in incentive compensation and savings from the fourth quarter 2007 restructuring actions. These expense savings were partially offset by the impact of acquisitions made in 2007 and 2008 the impact of weakening US dollar on non-US dollar expense and investments in fast growing areas such as CRISIL, Capital IQ and Index Services.
Financial Services sequential second quarter expenses increased $52 million or 13.5% versus the first quarter. The primarily contributors to this expense increase are the previously announced restructuring charges of $15 million, a $20 million increase in incentive compensation provision versus the very depressed first quarter levels and a $17 million increase in broad expense categories for our strong growth businesses for example, Capital IQ, Index Services and CRISIL.
Expenses at McGraw-Hill Education increased 6.1% in the second quarter. Adjusted for the second quarter restructuring charge expenses grew $26 million or 4.6%. The increase is driven by $9 million in higher pre-publication costs, increased marketing costs related to the strong state new adoption market opportunities as well as investments in technology, including $3 million in data center migration costs.
These increases were partially mitigated by benefits from the fourth quarter 2007 restructuring and reduced stock based compensation. Benefits from the second quarter restructuring will be largely realized in the second half of the year.
I’d like to provide an update on the migration of our digital products and services to the new data center, a key effort as we increasingly deliver products and services electronically. The migration is going very well. In the second quarter the migration cost was $9 million. For the first half it was $13 million. We continue to expect that overall costs will be about $40 million for 2008. McGraw-Hill Education represents $18 million or almost half of those costs as this segment continues to deliver more digital content and services.
I’ll now review unearned revenue which was $1.1 billion at the end of the second quarter that reflects a 7.5% year over year increase. Financial Services represents approximately three quarters of unearned revenue and experienced growth of 12%. This growth was partially offset by a reduction at McGraw-Hill Education due to accelerated fulfillment of orders for basal tests and related components including increased use of electronic delivery.
For 2008 we continue to expect unearned revenue growth will be in the mid single digit range compared to last year given the forecast for slower revenue growth at Financial Services. In terms of our effective tax rate we expect the rate to be 37.5% in 2008 approximately the same as 2007 on a full year basis.
Let’s now look at capital expenditures which include pre-publication investment and purchases of property and equipment. In the second quarter our pre-publication investments were $65 million compared to $75 million in the same period last year. We firmed up our estimates and now expect $270 million for 2008 versus the previous projection of $290 million that we provided during the first quarter earnings call.
Purchases of property and equipment were $25 million in the second quarter compared to $61 million in the same period last year. This was higher last year while we were building the data center but we’ve returned to a more normalized rate this quarter. For 2008 we continue to project $160 million for CapEx. This includes normal replacement expenditures, additional purchases of software and technology equipment for the new data center and continued investments in technology.
Finally, now non-cash items, amortization of pre-publication costs was $66 million compared to $57 million last year. For 2008 we’re lowering our guidance to $275 million. This represents a $35 million increase versus 2007 and is driven by significant pre-publication investments to take advantage of opportunities in the el-hi market.
Deprecation was $30 million compared to $29 million in the same period last year. We still expect it to be about $125 million for the year, reflecting completion of the data center, the purchase of new technology equipment for the data center and other general increases in capital expenditures. Amortization of intangibles was $13 million compared to $11.5 million in the same period last year. For 2008 we continue to expect approximately $52 million.
As we came into this year we knew this was going to be a first half second half kind of year. We’re pleased with the performance given some of the difficulty in the market, obviously with continued uncertainty in financial markets and some of the economic conditions still existing. Year over year comparisons obviously get easier for us in the second half. We’re pleased that there’s no change in our full year earnings forecast.
There are a number of focuses here, obviously with the assessment of legal and regulatory risks being lower but our commitment to our share repurchase program and our commitment to cost containment are imperative in this. With that let me turn it back to Don Rubin and let’s go to any question or comments that you may have.
We will now take the first question.
(Operator Instructions) Your first question comes from Peter Appert – Goldman Sachs.
Peter Appert – Goldman Sachs
A couple questions on the S&P business. First the SEC is very proactive in terms of trying to bring more players in to the ratings industry. Can you give you thoughts on how the competitive dynamics in the market are changing and whether specifically seeing any implication in terms of price?
Really no, what we’re seeing in the marketplace, we’re seeing some nice growth in the corporate and government side of ratings. Also in the public finance side but obviously the extreme weakness on the structured finance new issuance is the issue there. In terms of the activities that we have its pretty much market as usual, it’s the same players in that part. Again, we’re really fairly early on in some of the uncertain conditions. Therefore I wouldn’t expect to see that kind of new participation at this point.
What we’re working on is ourselves and making sure that we’re doing everything we possibly can. I mentioned the 27 leadership actions get higher transparency in all of those kinds of things. No impact from increased competition.
Peter Appert – Goldman Sachs
Have you done anything on pricing this year at S&P?
Nothing differently, in terms of pricing mechanisms it’s pretty straight forward in terms of whether it’s a very complex instrument or less complex instrument. We have not changed any of our pricing policies.
Peter Appert – Goldman Sachs
Year to year have you made price increases?
In areas where there is activity normal increases obviously with the weakness in structured finance that’s a very different issue.
On average price increases have been in the range of 2% to 3% in areas that we’ve increased price.
Peter Appert – Goldman Sachs
What should we look for in terms of year to year expense trends in the second half within the Financial Services business typically I’m thinking you get the benefit of the productions but is that fully offset by incentive comp comparisons getting tougher in the fourth quarter?
The incentive comp comparisons will be a bit more difficult because as you may recall last year we were adjusting incentive comp accruals in the third quarter and more dramatically in the fourth quarter so that will certainly have an impact. The Financial Services team is very focused on maintaining costs contingencies very strict containment of the overall cost side on the credit market services side.
I do want to emphasize that we continue to invest in those investment services business that has been growing at 20% we expect the growth rate we’re not really projecting growth rates for the second half of the year but we’ll be very, very strong and robust. We’re going to continue to make those investments in those areas. We are benefiting and will be benefiting from those restructuring actions.
I think you’re going to look for continuing trend from what we saw on a sequential basis first quarter to second quarter going out for the next couple quarters this year.
It really is a tale of two cities, in those areas that there’s activity, there’s growth, we are not cutting back there obviously. In fact we’re pushing very aggressively to make sure that market penetration and share are factors there. Corporate governments and public finance are doing well and we’re seeing some strength in the asset backed market as we were talking. The mortgage loan market is obviously impacted and you’ll see continued cost containment. The investment services side is doing very well. It will be dependent upon activity levels.
Peter Appert – Goldman Sachs
You mentioned similar sequential patterns [inaudible] for the first to second you saw fairly significant increase in costs do we look for costs to be up fairly meaningfully then in the second half?
The increase in the second quarter on a sequential basis there were really three items. One was the restructuring amount roughly $15 million, the other was an increase on a quarter to quarter basis of about $20 million for incentive compensation. When we completed the first quarter we were really taking that run rate going out for the balance of the year and to maintain a very low level for incentive compensation.
Not that we’ve seen a big increase but we see a little bit of light especially the continuation of benefits from investment services side. As a result the accrual rate for the incentive compensation increased by $20 million on a quarter to quarter basis. Then there was basically about $17 million of investments added for those growth businesses. That’s why I say we’ve got the costs controlled for those areas that we want to control and we’re making investments for those areas that we need to.
Your next question comes from Craig Huber – Lehman Brothers.
Craig Huber – Lehman Brothers
In light of your second quarter performance can you discuss maintaining your $2.65 to $2.75 EPS guidance for the full year excluding restructuring charges? Are you just trying to be conservative here to see how things play out the remaining six months why you haven’t raised that?
The first half had a lot of uncertainty to it we’re seeing a different second half comparisons should definitely be easier we’ve got an education quarter in the third quarter and so forth. There’s a fair bit of uncertainty in the market about how things are going to come back, what will come back, when it will come back and all those kind of things. The guidance that we’ve given is very appropriate for the conditions. If that changes so will we. At this point the $2.65 to $2.75 is a good range to adhere to.
Craig Huber – Lehman Brothers
Can you talk a little bit about what you’re seeing in July in Financial Services across the various categories, any significant change there versus what you saw in the second quarter?
Obviously the second quarter was still impacted significantly. What we have seen is some pick up in the structured finance area in the asset backed area. We’ve also seen some increases on the corporate and governments side in terms of investment grade issuance on that one. We are in the middle of a credit crunch and we have to see that on the mind and the uncertainty on timing is certainly there.
Hopefully things start to relax a little bit and we start getting back to a growth mode. I do think that notwithstanding the comments that David Wyss made as our Chief Economist that I think we benefited from the stimulus package and we still have a fourth and first quarter of next year that will probably be negative and then we’ll start to see some low slow growth. The capital markets will reflect some of those conditions.
Craig Huber – Lehman Brothers
Asia, was that about roughly 10% of your ratings revenues in the quarter? The other part of the question is how do Asia new issuances do for your company in the second quarter?
Breaking out issuance and the like, these are cross border securities and we don’t break out exactly what issue pertains to, which region. The Asia region obviously is a very important region to us and we’ll only get more so going forward. It’s still the United States and Europe are the largest components of that but increasingly the Middle East and Central, Eastern Europe are going to become as important as some of the Asian markets. The lions share is in the developed countries.
Craig Huber – Lehman Brothers
Is that to say that Asia held up much better than you US and Europe in the second quarter?
The Asia markets are feeling less of the capital market retraction than the developed countries.
Especially when you included Asia which we of course naturally do CRISIL which continues to show very strong growth. Asia in terms of the regions, one its third as Terry pointed out, and it’s US, UK Europe then Asia. Asia did hold up better because they were not plagued with the level of some of the structured products that the other to markets were.
Increasingly going forward longer term the Asian markets are going to be critical to our growth patterns.
Your next question comes from Michael Meltz – JP Morgan.
Michael Meltz – JP Morgan
Two clarifications please on S&P, I think Craig had asked is there any change in business tone in July relative to Q2, I’m wondering on the transaction side. Terry is that where your comments were saying when you talked about investment grade picking up and asset backed picking up in July?
Exactly, we saw some in the early part of the second quarter. As I think some corporate treasurer taking advantage of the fact that they had the ability to get into the market. Yes, we’re starting to see some pick up on the corporate and government side. We are pleased by the pick up on the public finance side which we hadn’t expected a little bit. The asset backed I think is signs that parts of the structured market are starting to come back but again its going to be bias against speculative and to a flight to quality.
Michael Meltz – JP Morgan
On the non-transaction relationship revenue that was up big sequentially, it was up $30 million. Can you talk about that’s a lot of extra relationship there what was driving that, was that mostly research or what’s in that number the big jump in the quarter.
It’s a lot of thing but most important its surveillance fees. There are a lot of relationship fees here and surveillance fees. People forget that there’s been a pull back in the new issuance of structured finance but you’ve got about $35 trillion rated structured finance product in the market that’s doing well. It needs to be monitored and surveyed and we have relationship fees on that. That relates to the deferred revenue.
In addition to relationship fees there are very significant credit information products such as RatingsDirect and products like that which have experienced rather dramatic growth. They account for a good portion of that increase as well.
Michael Meltz – JP Morgan
Peter had asked a question about the expense trend and I still don’t understand the answer. Expenses excluding the charge were up $35 million versus Q1 are you expecting that type of increase to persist in Q3 and Q4, can you clarify your comments?
Yes, of the $35 million, $20 million was incentive compensation so depending upon how the year progresses both for the ratings side and the information side that will dictate the level of incentive compensation accruals going forward. If you separate out incentive compensation, what I’m trying to say here is incentive compensation is going to be driven by the overall performance of the business.
Separating out incentive compensation the core expenses for people, physical locations, etc is maintained in very, very tight control pretty much a very modest increase for credit market services. The only areas where you’re seeing some increases and appreciable increases would be on the investment services side. That was the clarification. Trying to separate out the incentive compensation which is going to be affected by the overall performance of the business and keep the response to the core expenses that we’re managing on a day to day basis.
Your next question comes from Edward Atorino - The Benchmark Co.
Edward Atorino - The Benchmark Co.
On migration costs do they disappear mostly in ’09 or is there some kind of carry over on the migration numbers?
The migration costs the plan right now is that we will go into the first quarter of 2009 and hopefully by that time we’ll have completed almost the entire migration. There’s a possibility we might step that up and have some of the applications that were planned for the first quarter move in the fourth quarter of this year. The specific answer to the question, at most we will have one quarters worth of migration costs in 2009 that being the first quarter then it’s gone.
Edward Atorino - The Benchmark Co.
What are the actual shares at the end of the second quarter? Not the average, the actual.
Do you want basic or diluted?
Edward Atorino - The Benchmark Co.
Basic is 317.6 million shares, and fully diluted 319 million.
Your next question comes from Catriona Fallon – Citigroup.
Catriona Fallon – Citigroup
Just a clarification on your regulatory comments you indicated that you think the SEC doesn’t quite realize the extent of the costs involved with some of what they’re asking for. Does that differ from your comments about not seeing regulatory or legal issues actually impacting your financials or would that actually be an increased cost and a crunch on margins?
All costs and all estimates of regulatory and compliance are in the numbers that we have here. We’re talking about new rule changes that the SEC is posing for US issued securities. This is a comment letter, this is a letter that they sent out to all market participants and asked for comments. We’re saying that we work very, very well with the SEC and we both have the same objective of bringing more transparency and confidence restoration back into the markets. We talked about a lot of the leadership changes that we’re taking and with them on this.
There’s a point where you’ve got to be careful and one of the comments that we are making between open market behaviors and market regulation. You want to construct a balance here you don’t want to get unintended consequences and costs. We just want to make sure that in terms of our reflection on the new rules that we’re trying to strike that balance in the market and that’s what we’re saying.
Catriona Fallon – Citigroup
A follow up on the indices it looks like there was a slight sequential increase in revenue from indexes. Was this primarily due to new ETS that are being formed and could you also speak a little bit to how those fees are charged and collected is it on a monthly basis and is this calculated on a monthly basis so none of these fees are in deferred.
Obviously on a monthly basis we record all that again it depends on when the various new indices are launched. As I was saying in my remarks that the activity in the first half has been extraordinary and the receptivity for these products worldwide are really good. We have been very aggressive in pushing these out and we’ll continue. Last year was a very strong year for indices and we’re at a pace at the end of the first half that is pushing the full year 2007. We’re very pleased with this kind of product and the receptivity of the product and we’ll continue to be aggressive in pursuing it.
Catriona Fallon – Citigroup
Can you comment on the margins for that business?
High. We don’t break it out but those are terrific businesses. The most important thing is making sure that you’re being very responsive to various investor constituents and that you’re coming out with product that they want to be able to utilize and develop on. If you’re doing so those are very, very nice businesses.
A clarification on the question you asked are they deferred revenue. There are various different relationships that we have only a very small amount is in deferred revenue. Less than 5% of the Financial Services deferred revenue would relate to index services so a relatively modest amount.
Catriona Fallon – Citigroup
My last question is regarding the non-transaction revenue. Have you been finding new corporate relationships? You mentioned that most of the increase in deferred is surveillance fees coming on but are there any new corporate relationships at this time or not really?
For new investment grade issuers there would be but it’s not significant at this point in time.
Your last question comes from Craig Huber – Lehman Brothers.
Craig Huber – Lehman Brothers
I did have a question about Education. Can you talk a little bit further about why you lowered your guidance slightly for this year and then also for the adoption market for 2009 the past you’ve thought it would be $850 to $900 million market for 2009 is that still the case from your vantage point?
The guidance for 2009 in terms of the new adoption market is unchanged. In terms of the revenue projections the K-12 market is obviously off to really good start. We’re very pleased in the projection of 33% market capture would be a very good number. We’re very, very pleased with reading in Florida and California with science. That’s doing very well.
We want to watch that open territory and we still have that at 1% to 2% and what we’re seeing is strength in some of the Southern states and in come of the Southwestern states and we’re seeing some conservatism in the Northeast and Central states. There’s a mix here that’s going on. We’re going to hold the 1% to 2% but we’re hoping to see that better. We’ll know more towards the end of August and into September on that part.
On Higher Education July/August as you know from a timing standpoint is a 60 day month, where you see the increases. We’re seeing it as a little bit softer than what we had expected but we have to see what August does and so we’re monitoring that carefully. I think it’s just prudent to say 4% to 6% is a better number right now. We hope to be at the upper end. Given where we are right now 4% to 6% are good numbers.
That does conclude this morning’s call. On behalf of McGraw-Hill Companies we thank you for participating and wish you a good day.