Stock Analysis: McGraw-Hill Companies (MHP)

Company Description:

The McGraw-Hill Companies, Inc., incorporated in December 1925, is a global information services provider serving the financial services, education and business information markets. Other markets include energy, construction, aerospace and defense, and marketing information services. The Company serves its customers through a range of distribution channels, including printed books, magazines and newsletters, online via Internet Websites and digital platforms, through wireless and traditional on-air broadcasting, and through a variety of conferences and trade shows. Its operations consist of three business segments: McGraw-Hill Education, Financial Services and Information & Media. On September 12, 2006, J.D. Power and Associates (JDPA) acquired Automotive Resources Asia, a market strategy and information firm specializing in Asia's car markets. In March 2007, Standard & Poor's, a division of The McGraw-Hill Companies, completed the sale of its mutual fund data business to Morningstar, Inc. As part of the transaction, Standard & Poor's will license fund data from Morningstar.

Click here for a full description of the company’s operations (provided by Reuters).

Annual Report Highlights (latest report is for the period ending 12/30/06):

Business

The McGraw-Hill Companies, Inc., incorporated in December 1925, is a leading global information services provider serving the financial services, education and business information markets with a wide range of information products and services

The Company’s 20,214 employees are located worldwide. They perform the vital functions of analyzing the nature of changing demands for information and of channeling the resources necessary to fill those demands. By virtue of the numerous copyrights and licensing, trademark, and other agreements, which are essential to such a business, the Company is able to collect, compile, and disseminate this information. All book and magazine manufacturing is handled through a number of independent contractors. The Company’s principal raw material is paper, and the Company has assured sources of supply, at competitive prices, adequate for its business needs.

Risk Factors

• Historical Growth Rates
• Changes in the Volume of Debt Securities Issued in Domestic and/or Global Capital Markets and Changes in Interest Rates and Other Volatility in the Financial Markets
• Changes in Educational Funding
• Cyclical Nature of Customers’ Businesses
• Changes in the Global Advertising Markets / Affiliation Agreements
• Possible Loss of Market Share or Revenue Through Competition or Regulation
• Broadcasting Regulations
• Introduction of New Products or Technologies
• Operating Costs and Expenses
• Protection of Intellectual Property Rights
• Exposure to Litigation
• Risk of Doing Business Abroad

Management’s Discussion and Analysis

Overview

The McGraw-Hill Companies is a leading global information services provider serving the financial services, education and business information markets with information products and services. Other markets include energy, construction, aerospace and defense, broadcasting and marketing information services. The operations consist of three business segments: McGraw-Hill Education, Financial Services and Information & Media.

The McGraw-Hill Education segment is one of the premier global educational publishers. This segment comprises two operating groups: the School Education Group (SEG), serving the elementary and high school (el-hi) markets and the Higher Education, Professional and International (HPI) Group, serving the college, professional, international and adult education markets. The School Education Group and the industry it serves are influenced strongly by the size and timing of state adoption opportunities and the availability of funds. In 2006 the state new adoption market declined by about 30% from the prior year, and the volume of open territory business was not sufficient to offset the reduction in the state new adoption market. In 2006, a number of open territory states and districts reported decreased educational funding due to increased healthcare, fuel and pension costs.

Revenue at the HPI Group is affected by enrollments, higher education funding and the number of courses available to students. The current U.S. college enrollment is projected to rise at 1%–2% per year through 2013. For-profit colleges and distance-learning institutions continue to report stronger enrollment growth, with annual gains of 7.5% expected through 2010. There is increased federal funding for distance learning institutions due to the U.S. government’s removal of the “50% rule,” whereby colleges will no longer be required to deliver at least half of their courses on campus instead of online to qualify for federal student aid. According to Eduventures, it was estimated that 1.4 million U.S. students attended fully online higher education programs in 2006. State appropriations for higher education increased again in 2006, 6.9% nationwide to $67.4 billion in 2006, according to the Center for Higher Education at Illinois State University. Internationally, enrollments in secondary schools are also increasing significantly, particularly in India and China. The State Department issued a record 591,000 student and exchange visas in the 12 months ending September 2006, a 14% increase over the prior year.

The Financial Services segment operates under the Standard & Poor’s brand as one reporting unit and provides independent global credit ratings, indices, risk evaluation, investment research and data to investors, corporations, governments, financial institutions, investment managers and advisors globally. The segment and the markets it serves are impacted by interest rates, the state of global economies, credit quality and investor confidence. The Financial Services segment continues to be favorably impacted by the current trend of the disintermediation of banks and the increased use of securitization as a source of funding. In 2006, the Financial Services segment was favorably impacted by the continued low interest rate environment and an improved merger and acquisition market. The mortgage-backed securities market for commercial and residential mortgages remained strong for 2006, as mortgage rates were within historical norms and at levels that kept refinancing and debt consolidation robust in the early part of the year. Corporate issuance in 2006 also was robust, especially high yield issuance.

The Information & Media segment includes business, professional and broadcast media, offering information, insight and analysis and consists of two operating groups: the Business-to-Business Group (including such brands as BusinessWeek , J.D. Power and Associates, McGraw-Hill Construction, Platts and Aviation Week ) and the Broadcasting Group, which operates nine television stations (four ABC affiliates and five Azteca America affiliated stations). The segment’s growth is driven by the need for information and transparency in a variety of industries and to a lesser extent, advertising growth, which is dependent on continued economic recovery in the U.S.

Management analyzes the performance of the segments by using operating profit as a key measure, which is defined as income from continuing operations before taxes on income, interest expense and corporate expense.

The following is a summary of significant financial items during 2006:

• Revenue and income from operations increased 4.2% and 4.5%, respectively, in 2006. Results from operations improved on the strength of the Financial Services segment, primarily due to the performance of structured finance and corporate (corporate finance and financial services) and government ratings, and the impact of the April 1, 2005 acquisition of J.D. Power and Associates. Foreign exchange rates had a $12.7 million favorable impact on revenue and did not materially impact operating profit.
  

• Diluted earnings per share from operations increased 9.0% to $2.40. Diluted earnings per share from operations include dilution from restructuring charges and stock-based compensation expense, as well as the impact of the Sweets transformation. During 2006, the Sweets building products database was integrated into the McGraw-Hill Construction Network, providing architects, engineers and contractors a powerful new search function for finding, comparing, selecting and purchasing products. Although it was anticipated that Sweets would move from a primarily print catalog distribution offering to an integrated online service, customers have contracted to purchase a bundled print and online product. Historically, Sweets file sales were recognized in the fourth quarter of each year, when catalogs were delivered to its customers. Online service revenue is recognized as service is provided. Sales of the bundled product will be recognized ratably over the service period, primarily 2007. This negatively impacted 2006 revenue by $23.8 million and operating profit by $21.1 million.
  

• As a result of the Financial Accounting Standards Board’s (FASB) Statement No. 123(R), Share Based Payment , in 2006, the Company incurred stock-based compensation expense of $136.2 million ($85.5 million after tax, or $0.23 per diluted share) including a one-time charge of $23.8 million ($14.9 million after tax, or $0.04 per share) from the elimination of the Company’s restoration stock option program. The Company’s Board of Directors voted to terminate the restoration feature of its stock option program effective March 30, 2006. Also included in year-to-date stock-based compensation expense is restricted performance stock expense of $66.0 million ($41.5 million after tax, or $0.11 per share) compared with $51.1 million ($32.1 million after tax, or $0.08 per share) in the same period of 2005. Additionally, the Company has reshaped its long term incentive compensation program to emphasize the use of restricted performance stock over employee stock options. Stock-based compensation is discussed in further detail in Notes 3 and 4 to the Consolidated Financial Statements.
  

• During 2006, the Company restructured a limited number of business operations to enhance the Company’s long-term growth prospects and incurred a restructuring charge of $31.5 million pre-tax ($19.8 million after-tax) which diluted earnings per share by $0.06.
  

• The Company acquired 8.4 million shares for a total purchase amount of $468.8 million of the Corporation’s stock from the holdings of the recently deceased William H. McGraw. The transaction was funded through a combination of cash on hand and temporary borrowings in the commercial paper market.
  

• Cash flow provided from operations was $1.5 billion for 2006. Cash levels decreased 52.8% from the prior period but remained strong at $353.5 million. During 2006, the Company repurchased 28.4 million shares of common stock for $1.5 billion under its share repurchase program, paid dividends of $260.3 million and made capital expenditures of $426.4 million. Capital expenditures include prepublication costs, property and equipment and additions to technology projects.

Revenue and Operating Profit: 2006 Compared with 2005

In 2006, the Company achieved growth in revenue and income from operations. The results are primarily attributable to growth in the Financial Services segment and the impact of the April 1, 2005 acquisition of J.D. Power and Associates which contributed $43.8 million in revenue in the first quarter of 2006 and had no material impact on operating profit. In 2006, foreign exchange rates contributed $12.7 million to revenue and had no material impact on operating profit. In 2005, foreign exchange rates contributed $6.0 million to revenue and had no material impact on operating profit.

In the third and fourth quarters of 2006, the Company restructured a limited number of business operations to enhance the Company’s long-term growth prospects. The restructuring will strengthen key capabilities, lower costs and allow the Company to direct resources to areas with the greatest potential for continued growth in the years ahead. The Company incurred a 2006 restructuring charge of $31.5 million pre-tax ($19.8 million after tax, or $0.06 per diluted share), which consisted primarily of vacant facilities and employee severance costs related to the reduction of approximately 700 positions in the McGraw-Hill Education segment, Information & Media segment and Corporate.

During 2006, the Sweets building products database was integrated into the McGraw-Hill Construction Network, providing architects, engineers and contractors a powerful new search function for finding, comparing, selecting and purchasing products. Although it was anticipated that Sweets would move from a primarily print catalog distribution offering to an integrated online service, customers contracted to purchase a bundled print and online product. Historically, Sweets file sales were recognized in the fourth quarter of each year, when catalogs were delivered to its customers. Online service revenue is recognized as service is provided. The impact of recognizing sales of the bundled product ratably over the service period negatively impacted 2006 revenue by $23.8 million and operating profit by $21.1 million and will correspondingly benefit 2007.

During 2006 no significant acquisitions or divestitures were made.

During 2005, the Company made several acquisitions as follows:

• CRISIL Limited: The Company acquired majority ownership of CRISIL Limited (CRISIL), a leading provider of credit ratings, financial news and risk and policy advisory services in India on June 1, 2005. CRISIL is now part of the Financial Services segment.
  

• Vista Research, Inc: The Company acquired Vista Research, Inc., a leading provider of primary research on April 1, 2005. Vista Research, Inc. is now part of the Financial Services segment.
  

• J.D. Power and Associates (JDPA): The Company acquired JDPA, a leading provider of marketing information services for the global automotive industry that has established a strong and growing presence in several other important industries, including finance and insurance, healthcare, home building, telecommunications and energy on April 1, 2005. JDPA is now part of the Information & Media segment.

In 2005, the Company sold its Healthcare Information Group, a unit of the Information & Media segment. The Healthcare Information Group was comprised of several magazines including: The Physician and Sportsmedicine, Postgraduate Medicine and Healthcare Informatics, as well as a variety of healthcare information programs that serve the medical market. The Company recognized a pre-tax loss of $5.5 million ($3.3 million after tax, or less than 1 cent per diluted share).

In 2005, the Company sold its Corporate Value Consulting (CVC) business, the valuation services unit of the Financial Services segment. This business was selected for divestiture as it no longer fit with the Company’s strategic plans. The divestiture of CVC enabled the Financial Services segment to focus on its core business of providing independent research, ratings, data indices and portfolio services. The Company recognized a pre-tax gain of $6.8 million ($4.2 million after tax, or $0.01 per diluted share).

Revenue from McGraw-Hill Education’s service contracts for assessments of $214.4 million and $246.1 million in 2006 and 2005, respectively, have been reclassified from product to service as a result of the service component becoming more significant and inseparable from the deliverable.

Product revenue decreased 3.7% in 2006, due to a weaker adoption year for the McGraw-Hill Education segment. Product revenue comprises the revenue from McGraw-Hill Education and Information & Media segments and represents educational products, primarily books, magazine circulation revenue and syndicated study product revenue.

Service revenue increased 10.0% primarily due to increased revenue in the Financial Services segment, which increased 14.4% or $345.6 million. Financial Services revenue increased due to the strong performance of structured finance and corporate (industrial and financial services) and government ratings. The full year impact of the 2005 CRISIL Limited and Vista Research, Inc. acquisitions represented approximately 14.0% of the growth in the service revenue. Also contributing to growth was the acquisition of JDPA, which represented 10.6% of the growth in service revenue. Service revenue comprises revenue of the Financial Services segment and the remaining revenue in Information & Media and McGraw-Hill Education’s service contracts for assessments. The revenue represents information-related services, advertising and service contracts for assessments.

Outlook

Comparisons in 2007 will be less challenging as Standard & Poor’s continues to grow, McGraw-Hill Education enters a stronger state new adoption market and Information & Media receives the benefits of the Sweets transformation.

In the McGraw-Hill Education segment, the state new adoption schedule will fuel growth. 2007 will mark the beginning of a three-year period of stronger state new adoption opportunities. State new adoptions are projected to increase to between $750 million and $800 million in 2007. In the testing market, focus will remain on state-specific custom assessments as mandated by the No Child Left Behind Act. In the 2007-2008 school year, science will join reading and math as a tested subject. In addition, the Company expects continued growth in higher education both in the U.S. and abroad. The higher education space will continue to be influenced by the growth in online course programs. The McGraw-Hill Education segment will experience increased expense as additional investments are made in order to take advantage of the increased opportunities in the el-hi marketplace in 2007 and beyond, and to take advantage of the increased digital opportunities in the higher education space. In 2007, prepublication spending is expected to increase as the Company takes advantage of the significant adoption and open territory opportunities in key states for 2007 and beyond. The McGraw-Hill Education segment will also realize efficiencies from restructuring initiatives taken during 2006.

In Financial Services, continued global expansion and product diversification as well as a favorable interest rate environment, increased capital spending, and robust merger and acquisition activity by companies will mitigate the anticipated decline in U.S. residential mortgage-backed securities. The U.S. residential mortgage-backed securities market is projected to decline 10–15% in 2007.

In 2007, the Information & Media segment will continue to transform, placing greater emphasis on digital asset management and Web-based delivery which offers new opportunities to deliver premium services. With the infrastructure support already in place, J.D. Power and Associates will continue to expand its global automotive business into the rapidly growing Asia-Pacific markets. In the construction market, the transformation of Sweets to an Internet-based sales and marketing solution resulted in a shift that positively impacts revenue in 2007. The Sweets transformation will benefit the 2006 to 2007 comparison as the loss of recognized revenue of $23.8 million and operating profit of $21.1 million in 2006 will flow into 2007. The ongoing volatility of the oil and natural gas markets continues to increase customer demand for news and pricing products. The segment will continue to invest in BusinessWeek.com during 2007. The Information & Media segment will also realize efficiencies from restructuring initiatives taken during 2006.

In addition, the Company plans to continue its focus on the following strategies:

• Leveraging existing capabilities into new services.
  

• Continuing to make selective acquisitions that complement the Company’s existing business capabilities.
  

• Expanding and refining the use of technology in all segments to improve performance, market penetration and productivity.

There can be no assurance that the Company will achieve success in implementing any one or more of these strategies. The following factors could unfavorably impact operating results in 2007:

• A lack of educational funding as a result of budget concerns.
  

• A sudden and significant spike in interest rates.
  

• A sudden deterioration of credit quality due to corporate scandals or other economic events.
  

• A change in the regulatory environment affecting the Company’s businesses, including educational spending or the ratings process.

Dividends

On January 31, 2007, the Board of Directors approved an increase of 12.9% in the quarterly common stock dividend from $0.1815 to $0.2050 per share. On January 24, 2006, the Board of Directors approved an increase of 10% in the quarterly common stock dividend from $0.165 to $0.1815 per share.

Share Repurchase Program

At December 31, 2006, authorization for the repurchase of 20 million shares remained under the 2006 program. On January 31, 2007, the Board of Directors approved a new stock repurchase program authorizing the repurchase of up to 45 million additional shares. In 2007 the Corporation expects to repurchase up to 15 million shares from the 2006 program, subject to market conditions.

During 2006, the Board of Directors approved the repurchase of 28.4 million shares, which included the remaining 3.4 million shares under the 2003 program. In 2006, a total of 28.4 million shares were purchased under these programs, for $1,540.1 million at an average price of $54.23.

Financial Highlights:

Revenue Growth (1-yr): 4.2%
Revenue Growth (9-yr average): 6.6%

Net Income Growth (1-yr): 4.5%
Net Income Growth (9-yr average): 14.6%

Earnings-Per-Share Growth (1-yr): 8.6%
Earnings-Per-Share (9-yr average): 24.1%

Free Cash Flow Growth (1-yr): (4.0%)
Free Cash Flow Growth (9-yr average): 23.8%

Net Profit Margin (current): 14.1%
Net Profit Margin (10-yr average): 11.6%

Return On Equity (current): 30.6%
Return On Equity (10-yr average): 31.5%

Debt Ratio (current): 0.56
Current Ratio (current): 0.91

Financial analysis:

• Company’s debt ratio has stayed fairly consistent throughout the past decade and currently stands at 0.56.
  

• ROA has also been consistent throughout the past ten years, hovering around the low teens. Currently it stands at 14.3% and 10-yr average is 12.5%.
  

• ROE has also shown consistently outstanding results. Currently it’s at 30.5% and 10-yr average is 31.6%.
  

• All margins (gross margin, operating margin, and net profit margin) have steadily improved over the past ten years. Profit margin is currently at 14.1% and company posted an 11.6% 10-yr average.
  

• Revenue growth has not been very impressive in the past nine years. Company posted growth of 4.2% in 2006 and averaged 6.6% over the past nine years.
  

• Net income growth has been more exciting than revenue growth, but unlike revenue growth, it has been in the negative territory (in 2001). Most recently, net income grew 4.5% and 9-yr average is 14.6%.
  

• Free Cash Flow margin has improved from mid-teens in the past decade to the current margin of 22.1%. FCF growth, on the other hand, has been anything but consistent. It was negative in three years: 1999, 2004, and 2006. The company also has had stellar years when growth was 96%, 57%, and 56% (that was in 1998, 2001, and 2005, respectively). Average growth for the past nine years stands at 23.8%.
  

Discounted Cash Flow (DCF) Analysis:

I used discounted cash flow analysis to arrive at the intrinsic value of the company. I estimated that free cash flow would grow at an average rate of 5% per year for the next 10 years and at 3% (trailing GDP growth) perpetually after that. The company’s free cash flow grew at an average rate of 24% during the past nine years, which makes my conservative estimate very plausible. I used to 5% rate to trail its revenue growth for the past nine years (6.6%) and company’s revenue growth is expected to slow down somewhat. FCF growth has averaged 23.8% for the past nine years, but it has been very inconsistent so it would be crazy to estimate that the company would grow free cash flow at an average of 24% per year for another nine years.

I used a discount rate of 10% because McGraw-Hill is a mature company with an established franchise such as S7P and therefore it commands a slightly below-average discount rate.

Using the assumptions listed above, my intrinsic value of the stock came out to $71.63. My intrinsic value of McGraw-Hill is somewhat higher than what Morningstar has as a “fair value” for this company. I believe our difference in opinion lies in the fact that Morningstar underestimates this company’s growth potential.

Pros:

• S&P has enormous potential for growth overseas and its margins are likely to expand further as well.

• The company has educational publishing segment is forecasted to perform better in 2008 and this growth may offset the stale financial services division during the next year.

• McGraw-Hill continues to buy back its common stock year after year, which boost earnings-per-share and subsequently share values.

Cons:

• S&P is likely to face more competition in the future and a more strict regulation environment following its inability to provide meaningful ratings in light of the subprime mortgage mess.

• The company is likely to stumble through 2008 in the wake of the S&P troubles and stock may only move sideways until 2009.

Final Decision:

McGraw-Hill owns S&P, which provides over 70% of the total operating profit, and this franchise has a very dominant position in the market, which is unlikely to change in the foreseeable future. This company also has an established educational publishing business that is doing well and being invested into. Currently, MHP’s stock trades at $48 vs. $.72 that I have for intrinsic value of the company. Given my safety margin of 30-50%, it is within my buying price range $36-$50. I definitely like this company and this share price, all I’m wondering about is how low the stock can go because of the market’s concerns over S&P’s potential problems arising from possible regulation related to its credit-rating business. But since timing the market isn’t exactly the easiest of tasks, I will most likely add this company to my portfolio once the push will come to shove.