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January 26th, 2009 Newsletter: McGraw Hill – Ticker: MHP – BUY

|Includes:S&P Global Inc. (SPGI)

Is McGraw Hill a Good Company?

The McGraw-Hill Companies, Inc. (“McGraw Hill” or “MHP”) provides information services and products to the education, financial services, and business information markets worldwide. The Company operates in three major segments: Education, Financial Services and Information and Media.
McGraw-Hill Education (41% of 2008E revenues / 40% market share) sells educational and professional development materials (primarily books) into the elementary, high school, and post-secondary education markets. The elementary and high school markets represent 52% of education segment’s 2008E revenues and the post-secondary market represents 48% of 2008E revenues. Elementary and high school materials are sold at the state and local level to school boards and education regulators.  Post-secondary education market sales are made to professors who then list the materials as required reading for the class, which can then be purchased by students at book stores on or near campus or online through sites like The primary cost of developing educational materials is author royalties and printing costs. The Company’s capital expenditures are primarily related to improving this segment’s technology, as more materials are transitioning online or at least becoming digitally based.
The company’s Financial Services segment (42% of 2008E revenues / 40% market share), operates under the Standard & Poor’s brand, which provides debt issuers independent credit ratings for a fee paid by the issuer and investment services, which develops securities indices (i.e. S&P 500 index funds must pay a royalty to McGraw Hill). Credit ratings represent 66% of financial services 2008E revenues (27% transaction based and 73% from ongoing monitoring), while the other 34% of 2008E revenues comes from investment services. The primary cost of providing these services is the employment of the Company’s financial professionals.
McGraw Hill’s Information & Media segment (17% of 2008E revenues) operates in two segments (i) Business-to-Business and (ii) Broadcasting. Its Business-to-Business Group includes BusinessWeek, a business magazine; J.D. Power and Associates, a global marketing information firm that conducts surveys of customer satisfaction, product quality, and buyer behavior; Platts, a source for energy-industry information and services; McGraw-Hill Construction, which connects people, projects, and products in the design and construction industry; and Aviation Week, which provides multimedia information to the aviation and aerospace industry. Its Broadcasting Group operates nine TV stations, including four ABC affiliates and five Azteca America affiliates. This segment generates ~7% of cash flow, and thus will not be discussed thoroughly in this report.
Over the past 5 years, the Company has earned excellent returns on capital, exceeding 65% every year and over 100% over the past 3 years. Below I will discuss the factors that drive such high returns on invested capital and why I believe those returns can be preserved over long periods of time.

Education Segment

The education materials/textbook market is characterized by limited competition from four major companies, (i) Pearson, (ii) Reed Elsevier, (iii) McGraw Hill and (iv) Houghton Mifflin. The market has high barriers to entry with no material new entrants into the market in over 50 years. Once a book is developed, the bulk of the content is normally usable for 30 years, with relatively minor revisions made each year. Once faculty members get used to a certain book, it is difficult to get them to switch books and they will likely continue to use the same book with new editions every year. Further, brand is important to authors who are publishing books, as they want the largest possible audience for their book, as it increases their potential royalty stream. The four major publishers have spent the last century developing such prominent brands. While many investors have worried that the shift from paper books to online books would hurt publishers, just the opposite is happening. As books transition online, not only does it reduce paper and labor costs for publishers, but it also eliminates the used book market for that particular book, which represents ~30% of the books sold in the post-secondary education. Publishers usually make higher profits with online books by taking market share from the used book market and reducing paper and labor cost, which more than offsets the impact of the lower prices. This demonstrates the value of the content regardless of the delivery mechanism. The largest risk to the cash flow generated from this segment is that during recessions, state and local budgets are constrained and they do not purchase new educational materials. That reduction in spending will occur next year with the Company projecting that industry sales to the elementary and high school markets will decline 10 – 15% YOY (post-secondary market will still likely grow at 3 – 4%, as it has historically been recession resistant or even countercyclical). While next year the elementary and high school markets will be challenging, the long term trend towards increasingly educated societies and the standardization of learning materials will likely continue for the foreseeable future, making it near certain that demand for the Company’s education products will be higher in 5, 10, and 20 years than they are today.

Financial Services
The rating agency market is characterized by limited competition from two major companies, (i) Standard and Poor’s and (ii) Moody’s who represent over 80% of the market. The market has high barriers to entry with no material new entrants in nearly 100 years. State and federal regulatory capital requirements for banks, broker/dealers, and insurance companies are often based on S&P and Moody’s ratings. Loan documents often utilize ratings when determining the rate the borrower will pay (e.g. if S&P rates Alice’s Bakery bellow BBB, the interest rate she pays will increase by 2%). Also, investment and pension fund documents often restrict investments in securities below certain credit rating thresholds. Further, S&P and Moody’s receive private information from companies when determining their credit ratings. S&P’s and Moody’s reputation of not disclosing that information, and the fact that the debt issuer pays them for their rating, provides assurance that valuable or sensitive information will not leak to the public. Additionally, serial issuers are unlikely to switch ratings providers, as they understand the ratings process with S&P and Moody’s and would not want to take the time to educate another ratings provider about their business. Lastly, most companies obtain credit ratings from both prominent rating agencies, as it provides a net benefit to the debt issuer by lowering its borrowing cost. The borrowing cost is lowered, because investors gain more comfort with the debt, as it has been through the ratings process at more than one agency.  This dynamic decreases the competition between S&P and Moody’s for market share. All of these factors result in defensible cash flow generation capabilities for S&P with relatively price insensitive customers (especially given that the cost of a rating is so small in comparison to the savings resulting from the lower interest rate obtained by receiving a rating). Further, the Company’s index business has the strongest brand in the industry with nearly $200Bn of assets under management using S&P indices, such as the S&P 500, as their investment portfolios. The largest risk to the Company’s moat, and what is currently depressing the stock, is concern over increased regulation as a result of the sub-prime mortgage crisis, where some investors believe that the rating agencies issued credit ratings that were too favorable given the risk of the securities. Congress held hearings in October of 2008 on this topic and the SEC passed increased disclosure rules in December 2008, which also sought to curb issue abuses like “ratings shopping”, where an issuer takes information to both S&P and Moody’s and chooses the rating agency that will provide them with the best rating. Ratings shoppers must now pay each agency a fee for going through the ratings process, even if they ask that agency not to publish the rating. This new regulation may even positively impact S&P’s revenues. Otherwise, these regulations will have a minimal impact on the Company’s revenue and cost structure, as they primarily increase disclosure. The EU is also near adopting similar regulatory changes that are expected to mirror the SEC’s. ~15% of McGraw Hill 2007 revenues were generated in the EU. There are also several pending lawsuits from investors in sub-prime mortgages against S&P and Moody’s. No rating agency has ever been found liable to investors for having too high of a rating on an issue, as ratings are opinions regarding creditworthiness, not guarantees. Given that the world will continue to demand more capital, as its economies expand over the long term, it is nearly certain that demand for S&P’s credit rating service will increase over time. Further, as investors continue to shift towards index funds with lower fees, especially given the underperformance of active money managers, demand for the Company’s index products will increase over time.
Does McGraw Hill have a Good Management Team?
The McGraw Hill management team is lead by Harold McGraw, III. He has been President, Chief Executive Officer, and Chairman of the Board of The McGraw-Hill Companies, Inc. since 1993, 1998 and 1999 respectively. Harold served as Executive Vice President of Operations from 1989 to 1993. Prior to that, he served as President of McGraw-Hill Financial Services Company, President of the McGraw-Hill Publications Company, Publisher of Aviation Week & Space Technology magazine and Vice President of Corporate Planning. Before joining McGraw-Hill Companies Inc., in 1980, he held various financial positions at the GTE Corporation. Harold earned an MBA from the Wharton School of the University of Pennsylvania in 1976 and a BA from Tufts University in 1972.  
Since Harold became CEO in 1998, he has increased return on invested capital from 15.5% to over 100%, while reducing the Company’s capital base by ~15%. Not only has Harold obviously made some wise capital allocation decisions, he has also returned ~90% of the cash flows generated by the business over the last 10 years back to shareholders, as the Company does not require large amounts of capital to grow.  Further, Harold has steered the Company well through the current regulatory issues, with only a benign increase in regulations resulting from congressional hearings and SEC investigations. Harold owns over $100MM of stock outright (not including his out of the money stock options). His stock ownership is ~33x his base salary and bonus, ensuring that he will continue to keep a long-term shareholder value mind set.
Can McGraw Hill be Bought at a Cheap Price?
After examining the past 10 years and recession level free cash flow, I believe that normalized pre-tax equity free cash flow is ~$900MM. At Friday’s closing per share price of $20.31, McGraw Hill’s market capitalization is ~$6,400MM, which means the stock has a 14% pre-tax equity free cash flow yield (Warren Buffett’s hurdle rate for a high quality business like McGraw Hill). If McGraw Hill trades at a 7% pre-tax equity free cash flow yield, which would be appropriate for this high quality business, the stock will rise to ~$41 without any earnings growth, making it a compelling buy at $20.31. Further, the Company has a 4.3% dividend yield at $20.31 per share, which I find attractive in this low interest rate environment. 
Again, please feel free to contact with any questions or if you would like to discuss my research further.
Thank you,
Matt Darrah
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© Matthew Darrah, 2009.
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