Digging Deeper into McGraw-Hill (MHP)

Hedgefund manager David Einhorn has been very critical of the credit ratings agencies. He accuses them of having massive conflicts of interest. Firms seeking a rating for their debt can shop around and choose the rating agency most likely to give them the best score. Einhorn also says the agencies use too short a time horizon when evaluating credit worthiness. And finally he says that he does not know anyone who uses the ratings that agencies provide because they believe they are well researched. He knows only people who use them because they are legally required to do so. Thus, Einhorn decided to short Moody’s and Standard & Poor’s parent company, McGraw-Hill. As of May 26th according to an article by Reuters (http://www.reuters.com/article/idUSN2623288920100526), he is still short the rating agencies.

I agree in principle with everything Mr. Einhorn says; yet, I am long McGraw-Hill. Why? Did I forget to take my meds this morning? No. The reason is one word – price. The market has currently priced McGraw-Hill as if the credit market services part of the business is worth exactly $0.

Before we delve into the specifics, let’s look at how McGraw-Hill’s business breaks down and what risks it faces. In 2008, 41.8% of revenue came from its Standard and Poor’s division. This included 27.6% of revenues from Credit Market Services, the credit ratings portion of the business, and 14.2% of revenues from its information services division. Education accounted for 41.5% of revenue and Information and Media accounted for 6.7%.

The credit ratings portion of the company is currently facing two major risks: financial reform and increased competition. While we discuss the risks, keep in mind we are talking about risks that affect a little less than 30% of the company’s revenue.

Financial Reform
Judging by the reforms that have been mostly finalized for banks, the reforms for credit raters are unlikely to be onerous. The financial system has a huge ingrained need for credit ratings. Restrictions on investments based on credit ratings are found in the investment policy statements of tens of thousands of mutual funds, pension plans, endowments, and other institutions. While the credit ratings agencies may not be perfect, getting rid of them would create larger problems. The intelligent way to go about reform is to reduce the conflicts of interest that plague the agencies and to add financial incentives for sound (well researched) ratings.

Competition
Previously, the credit ratings business was an oligopoly of Standard & Poor’s and Moody’s, with Fitch playing a minor role. Since those three agencies now serve as poster children for bad behavior, it’s highly likely that whatever reforms Congress enacts will help facilitate new entrants to the field. Institutions are likely to welcome a newcomer untainted by the scandal as well. Indeed, Bloomberg L.P. has added in-house credit ratings to their services. Increased competition will mean lower profit margins and less revenue, but there are still high barriers to entry and one or two more major competitors should not have a large adverse affect.

Valuation
Let’s look at a worst case scenario for MHP. Let’s assume that financial reform takes its most draconian form and S&P is no longer in the business of providing ratings for debt. To understand what effect this would have on the valuation of MHP, look at the source of their revenue. MHP does not break out what portion of revenue or income comes from the ratings business in SEC filings, but the 2010 Investor Fact Book (http://investor.mcgraw-hill.com/phoenix.zhtml?c=96562&p=irol-investorfactbook) does give us a revenue breakdown for 2008 for the ratings business, called Credit Market Services.

2008 Revenue Percent of Total Revenue
Credit Market Services $1755 28%
…Transactions …$ 538 …09%
…Non Transactions …$1217 …19%

All Other Business Units $4600 72%

Total Revenue $6355 100%

In 2008, MHP earned $6,355M in revenue. Of this Credit Market Services as a whole made up 28% of sales or $1755M. The new securities ratings business, called Transactions, accounted for $538M or 9% of MHP’s total 2008 revenue. The remainder of business in Credit Market Services, called Non Transactions, includes annual fees for frequent issuer programs, surveillance, and subscriptions. While the fees for frequent issuers would disappear, it is unknown how the surveillance and subscription services would be affected. For our worst case scenario, let’s err on the conservative side and assume they go to zero as well. So we are left with a McGraw-Hill that would earn only 72% of what it is earning now.

For 2010, analysts’ consensus estimate is that MHP will earn revenue of $6,244M. In our armageddon scenario for MHP, 28% of that disappears. So MHP would earn only $4,495M for 2010. The price/sales ratio for the sector is 2.02. That would give us a valuation of a little over $9B. It is possible to break out McGraw-Hill’s revenue by business segment and compare it to similar pure play businesses. No matter how you slice it, you end up with a figure close to $9B. So, for simplicity’s sake, I used the average price-to-sales ratio for the sector. McGraw-Hill currently has a market cap of approximately $8.7B. Right now the market seems to have assessed the value of the ratings business at zero.

Essentially the market is giving you an education publishing and services, investment and analytic services, and magazine and media company at a fair price and throwing in a disgraced credit ratings agency for free. While I have no idea what will ultimately happen to the ratings agencies, I am confident they will be worth more than $0. How much more I don’t know. At a price that implies they are free, I think it’s a great bet. Even in a worst case scenario you’ve bought a company that has phenomenal business characteristics. The business is a cash generating machine with low capital expenditure requirements. Over the last decade McGraw Hill has turned an average of 20% of sales into free cash flow (cash available to expand the business or return to shareholders.)

Disclosure: My clients are long MHP