MCGRAW-HILL COMPANIES MHP
February 09, 2013 - 7:51pm EST by
jcoviedo
2013 2014
Price: 42.67 EPS $3.45 $3.25
Shares Out. (in M): 285 P/E 12.4x 13.1x
Market Cap (in $M): 12,144 P/FCF 15.2x 13.3x
Net Debt (in $M): -984 EBIT 1,441 1,555
TEV ($): 11,239 TEV/EBIT 7.8x 7.2x

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  • Regulatory action
  • Duopoly
  • Sum Of The Parts (SOTP)

Description

 

Thesis

Down 27% last week (loss of $4.5 billion in market cap) on the announcement of the DOJ’s lawsuit against the company and trading at around 7x EBITDA, MHP shares are already discounting a worst case scenario with respect to the company’s potential legal liabilities. Outside of a settlement, any cash payments related to litigation would be many years from now and could be absorbed by MHP’s under-levered balance sheet. As the noise relating to the DOJ’s February 4th lawsuit subsides, MHP should trade back towards fair value around $60/share. Dividend increases, share repurchases, additional asset sales, or a settlement of the DOJ lawsuit could all provide catalysts for upside revaluation.

 

Overview

McGraw-Hill is a collection of high margin, low capital intensity information services businesses including the S&P Ratings Agency, a 73% ownership position in S&P/Dow Jones Indices, S&P Capital IQ, Platts, J.D. Power and Associates, McGraw-Hill Construction and Aviation Week. On November 26th 2012, MHP announced the sale of its education business to Apollo for $1.9 billion in net proceeds including a $250MM 8.5% bond which is expected to close sometime in Q1 2013.

 

MHP reports earnings before the market opens on February 12th.

 

DOJ Lawsuit

On February 4th, the U.S. Department of Justice filed a civil lawsuit against McGraw-Hill and its S&P Ratings subsidiary alleging fraud under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) for the company’s ratings on RMBS and CDO transactions in the 2004-2007 time period. The DOJ is seeking $5 billion in damages on the part of federally insured financial institutions that suffered losses when these structured products collapsed. The DOJ did not file lawsuits against either Moody’s or Fitch. A copy of the DOJ’s complaint can be found here: http://www.justice.gov/iso/opa/resources/849201325104924250796.PDF

 

The DOJ lawsuit has numerous flaws:

  1. The DOJ argues that S&P dumbed down its ratings in order to win business from the banks underwriting the structured products. However, the DOJ provides no evidence in its complaint that anyone at the banks was shopping around for the ratings agency with the lowest ratings standards. No underwriting bank would admit to intentionally making its structured finance products worse since it would open the bank up to significant liability. Without evidence that S&P knew that the banks were basing their decisions of which ratings agency to use by virtue of their looser standards and evidence that the banks were intentionally watering down their structured products, the government has no case.
  2. The DOJ argues that S&P was motivated to change its models because it was losing business to other ratings agencies. This argument therefore implies that S&P’s ratings methodology was more conservative than its competitors.
  3. Most of the transactions cited by the government were also rated by one of S&P’s competitors and the ratings were almost always similar. Unless the government can prove that the competitors were also part of a fraudulent scheme to keep high ratings then S&P can always point to their opinions and methodology being no different than accepted wisdom at the time. Also its very hard to prove that S&P’s opinion alone caused an investor to purchase the security when its opinion was no different than everyone elses.
  4. The crux of the government’s argument is that S&P knew that RMBS going into CDOs issued in March-June 2007 were about to be downgraded and that was not reflected in the ratings of the CDOs when they were issued. In reality only one of the CDOs identified by the government was negatively impacted by RMBS ratings actions taken in July 2007 as S&P had required additional collateral for CDOs containing any of the 500 subprime RMBS securities that the agency had taken actions against in March through July 2007.
  5. 9 of the rated securities identified by the government claim Citigroup was duped into purchasing a structured product underwritten by Citigroup and rated by S&P. 2 of the rated securities identified by the government claim Bank of America was duped into purchasing a structured product underwritten by Bank of America.  Try proving that S&P was the cause of Citigroup’s or Bank of America’s losses on these transactions in court.
  6. The DOJ filed the lawsuit in the Central District of California and not the Southern District of New York. While S&P has an office in Los Angeles, the company’s headquarters is in New York and its structured products teams are based predominately in New York and London. S&P can likely spend a year arguing for a change of venue to drag out the time line of the case.
  7. While the DOJ claims $5 billion in damages, it provides no methodology to calculate that number. To put it in perspective, total revenues for S&P from the transactions cited by the government was only $13 million. S&P’s total revenues for underwriting CDOs between 2005 and 2007 was $481MM.
  8. The government has to prove that investors in these RMBS and CDO securities relied on the S&P rating in order to make their investment decision (ie not their own internal due diligence, work done by the underwriters, or the ratings of other ratings agencies.) Most of the offering documents for these securities specifically told investors not to rely on the ratings in making investment decisions.  
  9. To prove fraud, the government has to prove that S&P’s ratings were faulty (i.e. in circumvention of the company’s published ratings methodology at the time) and published intentionally to deceive the investors in the securities. Nothing in the government’s complaint shows any evidence that S&P intentionally circumvented its established ratings policies. The government also has no evidence of intentional deceit of investors.    
  10. After 4 years of discovery in this case and after numerous Congressional and other investigations, the government still hasn’t come up with a smoking gun or other highly damaging piece of evidence. Several of the emails the government cites in its complaint are taking out of context or not relevant to securities purchased by U.S. federally insured financial institutions and therefore not relevant to a FIRREA case.
  11. If the government thought it had a solid case and that the emails it cited were so damning then why didn’t the government file a criminal complaint. The government has a pretty lousy track record in winning fraud lawsuits related to financial institutions including losing the Arthur Andersen Enron case, and losing the recent Brian Stoker CDO fraud case (http://dealbook.nytimes.com/2012/07/31/former-citigroup-manager-cleared-in-mortgage-securities-case/ )

 

S&P is frequently sued when bonds default and has a very good track record of defending itself. Of 71 cases relating to S&P ratings on structured products issued in the 2004-2007 time period, S&P has had 31 dismissed and 10 voluntarily withdrawn. If the DOJ decides to take this trial, the lawsuit (including any appeals) would likely take 5 to 10 years before the final resolution and any payments.

 

A good corollary to the structured finance litigation matters is S&P’s experience in litigation surrounding its role in the 2003 Parmalat bankruptcy. In the main Parmalat case, while S&P was sued in 2005 claiming 4 billion euros in damages they ended up paying just $1.1 million when final judgment was rendered in 2011.  Several other Parmalat related trials remain outstanding. 

 

Press reports indicate that S&P and the DOJ were in settlement talks within the range of $100 million to $1 billion but those settlement talks broke down over demands by the DOJ for S&P to admit to wrongdoing. An S&P admission of wrongdoing would likely impair its defense in the 30 other trials currently ongoing including the Abu Dhabi and Calpers trials slated to begin this year.

 

Given the pretty obvious flaws in the government’s case, and S&P’s elevated legal costs required to defend itself, the most likely resolution of litigation related to the financial crisis (including the DOJ lawsuit) is a settlement (without an admission of wrongdoing) in the $100 million to $1 billion range.

 

Capital Structure

 

Share Price

42.67

Shares Out

285

Mkt Cap

12,144

   

Pro Forma Cash

1,783

MHEP Notes

250

 

 

Debt

799

Underfunded Pension

329

   

EV

11,239

 

With $1 billion of net cash after the McGraw-Hill Education sale is completed, MHP has more than ample balance sheet capability to withstand a $5 billion litigation loss. Even if MHP had to pay $5 billion in cash tomorrow the company would still only be levered around 2x EBITDA. MHP generates roughly $900 million to $1 billion annually.

 

2013 EBITDA

1,667

Capex

-112

Interest

-19

Taxes

-538

Minority Interest in S&P/Dow Jones JV

-83

2013 FCF

916

 

Value

I value MHP on a sum of the parts basis.

 

Sum of the Parts

     
 

2013 EBITDA

Multiple

EV

S&P Ratings

795

8x

6,360

S&P Dow Jones

307

15x

4,605

S&P Capital IQ

281

13x

3,657

       

Platts

211

11x

2,326

Commercial Info

72

6x

432

       

Minority Interest in S&P Dow Jones

-1,243

Target EV

   

16,136

       

Target Equity Value

   

17,041

Target Share Price

   

59.88

 

 

For the Ratings business, I use Moody’s current EV/2013 EBITDA multiple of 8x. Since Moody’s is subject to similar litigation risk as MHP’s S&P Ratings division (and saw a similar 22% drop in its share price last week), Moody’s multiple already reflects the market’s assumption for potential litigation liability which is why I don’t include an additional assumption for litigation losses in my sum of the parts valuation for MHP as the litigation risk is already reflected in the lower multiple for the ratings business. Historically Moody’s has traded between 9-10x EBITDA. If you adjusted this SOTP analysis by placing a 9x multiple on the ratings business and then deducting $1 billion for litigation losses, the implied SOTP equity value would be $59/share.

 

For the Index business, I use LSE’s recent purchase of the FTSE Index business for 15x to reflect the multiple for this business. Given the massive strategic value of this business to CME (exclusivity of high margin S&P and Dow Jones contracts), other Exchanges (CBOE in particular), and asset managers (all the index funds and ETFs that pay license fees for use of the indexes) I believe there would be a robust bidding process if this asset were ever put up for sale.

 

For Capital IQ, I use a premium to FDS’s 12.2x EV/2013 EBITDA multiple to reflect the faster growth in the user base for Capital IQ over Factset.

 

For Platts, I use a 2 turn discount to IHS’s EV/2013 EBITDA 13.4x multiple to reflect that some of Platts EBITDA is still coming from publishing assets and not just the information services. Platt’s multiple is likely to rise over time as the company receives more licensing revenue for financial contracts related to its commodities data.

 

Risks

Government changes regulations mandating ratings for debt instruments held by pension funds, banks, insurance companies and other financial institutions. If regulations like Basel 3 did not set different capital requirements for assets based on their ratings from recognized ratings agencies, it is likely that demand for bond ratings would decline significantly. Likewise if pension funds and insurance companies were no longer mandated to keep specified percentages of their fixed income books in bonds with certain ratings, the demand for ratings would decline.

 

The government could also make it easier for new ratings firms to emerge. Even with the ratings agencies massive failures with regards to subprime RMBS, CDOs and synthetic CDOs, new ratings agencies like Egan-Jones, Kroll and Morningstar have failed to gain any meaningful market share. The big 3 ratings agencies garnered over 95% market share in 2012.

 

 

Interest Rates and Credit spreads could spike which would reduce the demand for debt refinancings and result in reduced estimates for the 2013 and 2014 EBITDA of the S&P ratings business. That said, at present debt issuance trends remain very strong as evidence by MCO’s recent Q4 2012 earnings beat and increased earnings guidance for 2013.

I do not hold a position of employment, directorship, or consultancy with the issuer.
Neither I nor others I advise hold a material investment in the issuer's securities.

Catalyst

Settlement or other resolution of the company's lawsuit with the DOJ.
 
Closing of the sale of the McGraw-Hill Education business.
 
Continued share repurchases and announcement of new buyback plans.
 
Sale of Platts or the S&P/Dow Jones Index business
 
Earnings results and upbeat 2013 earnings guidance
 
 
    sort by    

    Description

     

    Thesis

    Down 27% last week (loss of $4.5 billion in market cap) on the announcement of the DOJ’s lawsuit against the company and trading at around 7x EBITDA, MHP shares are already discounting a worst case scenario with respect to the company’s potential legal liabilities. Outside of a settlement, any cash payments related to litigation would be many years from now and could be absorbed by MHP’s under-levered balance sheet. As the noise relating to the DOJ’s February 4th lawsuit subsides, MHP should trade back towards fair value around $60/share. Dividend increases, share repurchases, additional asset sales, or a settlement of the DOJ lawsuit could all provide catalysts for upside revaluation.

     

    Overview

    McGraw-Hill is a collection of high margin, low capital intensity information services businesses including the S&P Ratings Agency, a 73% ownership position in S&P/Dow Jones Indices, S&P Capital IQ, Platts, J.D. Power and Associates, McGraw-Hill Construction and Aviation Week. On November 26th 2012, MHP announced the sale of its education business to Apollo for $1.9 billion in net proceeds including a $250MM 8.5% bond which is expected to close sometime in Q1 2013.

     

    MHP reports earnings before the market opens on February 12th.

     

    DOJ Lawsuit

    On February 4th, the U.S. Department of Justice filed a civil lawsuit against McGraw-Hill and its S&P Ratings subsidiary alleging fraud under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) for the company’s ratings on RMBS and CDO transactions in the 2004-2007 time period. The DOJ is seeking $5 billion in damages on the part of federally insured financial institutions that suffered losses when these structured products collapsed. The DOJ did not file lawsuits against either Moody’s or Fitch. A copy of the DOJ’s complaint can be found here: http://www.justice.gov/iso/opa/resources/849201325104924250796.PDF

     

    The DOJ lawsuit has numerous flaws:

    1. The DOJ argues that S&P dumbed down its ratings in order to win business from the banks underwriting the structured products. However, the DOJ provides no evidence in its complaint that anyone at the banks was shopping around for the ratings agency with the lowest ratings standards. No underwriting bank would admit to intentionally making its structured finance products worse since it would open the bank up to significant liability. Without evidence that S&P knew that the banks were basing their decisions of which ratings agency to use by virtue of their looser standards and evidence that the banks were intentionally watering down their structured products, the government has no case.
    2. The DOJ argues that S&P was motivated to change its models because it was losing business to other ratings agencies. This argument therefore implies that S&P’s ratings methodology was more conservative than its competitors.
    3. Most of the transactions cited by the government were also rated by one of S&P’s competitors and the ratings were almost always similar. Unless the government can prove that the competitors were also part of a fraudulent scheme to keep high ratings then S&P can always point to their opinions and methodology being no different than accepted wisdom at the time. Also its very hard to prove that S&P’s opinion alone caused an investor to purchase the security when its opinion was no different than everyone elses.
    4. The crux of the government’s argument is that S&P knew that RMBS going into CDOs issued in March-June 2007 were about to be downgraded and that was not reflected in the ratings of the CDOs when they were issued. In reality only one of the CDOs identified by the government was negatively impacted by RMBS ratings actions taken in July 2007 as S&P had required additional collateral for CDOs containing any of the 500 subprime RMBS securities that the agency had taken actions against in March through July 2007.
    5. 9 of the rated securities identified by the government claim Citigroup was duped into purchasing a structured product underwritten by Citigroup and rated by S&P. 2 of the rated securities identified by the government claim Bank of America was duped into purchasing a structured product underwritten by Bank of America.  Try proving that S&P was the cause of Citigroup’s or Bank of America’s losses on these transactions in court.
    6. The DOJ filed the lawsuit in the Central District of California and not the Southern District of New York. While S&P has an office in Los Angeles, the company’s headquarters is in New York and its structured products teams are based predominately in New York and London. S&P can likely spend a year arguing for a change of venue to drag out the time line of the case.
    7. While the DOJ claims $5 billion in damages, it provides no methodology to calculate that number. To put it in perspective, total revenues for S&P from the transactions cited by the government was only $13 million. S&P’s total revenues for underwriting CDOs between 2005 and 2007 was $481MM.
    8. The government has to prove that investors in these RMBS and CDO securities relied on the S&P rating in order to make their investment decision (ie not their own internal due diligence, work done by the underwriters, or the ratings of other ratings agencies.) Most of the offering documents for these securities specifically told investors not to rely on the ratings in making investment decisions.  
    9. To prove fraud, the government has to prove that S&P’s ratings were faulty (i.e. in circumvention of the company’s published ratings methodology at the time) and published intentionally to deceive the investors in the securities. Nothing in the government’s complaint shows any evidence that S&P intentionally circumvented its established ratings policies. The government also has no evidence of intentional deceit of investors.    
    10. After 4 years of discovery in this case and after numerous Congressional and other investigations, the government still hasn’t come up with a smoking gun or other highly damaging piece of evidence. Several of the emails the government cites in its complaint are taking out of context or not relevant to securities purchased by U.S. federally insured financial institutions and therefore not relevant to a FIRREA case.
    11. If the government thought it had a solid case and that the emails it cited were so damning then why didn’t the government file a criminal complaint. The government has a pretty lousy track record in winning fraud lawsuits related to financial institutions including losing the Arthur Andersen Enron case, and losing the recent Brian Stoker CDO fraud case (http://dealbook.nytimes.com/2012/07/31/former-citigroup-manager-cleared-in-mortgage-securities-case/ )

     

    S&P is frequently sued when bonds default and has a very good track record of defending itself. Of 71 cases relating to S&P ratings on structured products issued in the 2004-2007 time period, S&P has had 31 dismissed and 10 voluntarily withdrawn. If the DOJ decides to take this trial, the lawsuit (including any appeals) would likely take 5 to 10 years before the final resolution and any payments.

     

    A good corollary to the structured finance litigation matters is S&P’s experience in litigation surrounding its role in the 2003 Parmalat bankruptcy. In the main Parmalat case, while S&P was sued in 2005 claiming 4 billion euros in damages they ended up paying just $1.1 million when final judgment was rendered in 2011.  Several other Parmalat related trials remain outstanding. 

     

    Press reports indicate that S&P and the DOJ were in settlement talks within the range of $100 million to $1 billion but those settlement talks broke down over demands by the DOJ for S&P to admit to wrongdoing. An S&P admission of wrongdoing would likely impair its defense in the 30 other trials currently ongoing including the Abu Dhabi and Calpers trials slated to begin this year.

     

    Given the pretty obvious flaws in the government’s case, and S&P’s elevated legal costs required to defend itself, the most likely resolution of litigation related to the financial crisis (including the DOJ lawsuit) is a settlement (without an admission of wrongdoing) in the $100 million to $1 billion range.

     

    Capital Structure

     

    Share Price

    42.67

    Shares Out

    285

    Mkt Cap

    12,144

       

    Pro Forma Cash

    1,783

    MHEP Notes

    250

     

     

    Debt

    799

    Underfunded Pension

    329

       

    EV

    11,239

     

    With $1 billion of net cash after the McGraw-Hill Education sale is completed, MHP has more than ample balance sheet capability to withstand a $5 billion litigation loss. Even if MHP had to pay $5 billion in cash tomorrow the company would still only be levered around 2x EBITDA. MHP generates roughly $900 million to $1 billion annually.

     

    2013 EBITDA

    1,667

    Capex

    -112

    Interest

    -19

    Taxes

    -538

    Minority Interest in S&P/Dow Jones JV

    -83

    2013 FCF

    916

     

    Value

    I value MHP on a sum of the parts basis.

     

    Sum of the Parts

         
     

    2013 EBITDA

    Multiple

    EV

    S&P Ratings

    795

    8x

    6,360

    S&P Dow Jones

    307

    15x

    4,605

    S&P Capital IQ

    281

    13x

    3,657

           

    Platts

    211

    11x

    2,326

    Commercial Info

    72

    6x

    432

           

    Minority Interest in S&P Dow Jones

    -1,243

    Target EV

       

    16,136

           

    Target Equity Value

       

    17,041

    Target Share Price

       

    59.88

     

     

    For the Ratings business, I use Moody’s current EV/2013 EBITDA multiple of 8x. Since Moody’s is subject to similar litigation risk as MHP’s S&P Ratings division (and saw a similar 22% drop in its share price last week), Moody’s multiple already reflects the market’s assumption for potential litigation liability which is why I don’t include an additional assumption for litigation losses in my sum of the parts valuation for MHP as the litigation risk is already reflected in the lower multiple for the ratings business. Historically Moody’s has traded between 9-10x EBITDA. If you adjusted this SOTP analysis by placing a 9x multiple on the ratings business and then deducting $1 billion for litigation losses, the implied SOTP equity value would be $59/share.

     

    For the Index business, I use LSE’s recent purchase of the FTSE Index business for 15x to reflect the multiple for this business. Given the massive strategic value of this business to CME (exclusivity of high margin S&P and Dow Jones contracts), other Exchanges (CBOE in particular), and asset managers (all the index funds and ETFs that pay license fees for use of the indexes) I believe there would be a robust bidding process if this asset were ever put up for sale.

     

    For Capital IQ, I use a premium to FDS’s 12.2x EV/2013 EBITDA multiple to reflect the faster growth in the user base for Capital IQ over Factset.

     

    For Platts, I use a 2 turn discount to IHS’s EV/2013 EBITDA 13.4x multiple to reflect that some of Platts EBITDA is still coming from publishing assets and not just the information services. Platt’s multiple is likely to rise over time as the company receives more licensing revenue for financial contracts related to its commodities data.

     

    Risks

    Government changes regulations mandating ratings for debt instruments held by pension funds, banks, insurance companies and other financial institutions. If regulations like Basel 3 did not set different capital requirements for assets based on their ratings from recognized ratings agencies, it is likely that demand for bond ratings would decline significantly. Likewise if pension funds and insurance companies were no longer mandated to keep specified percentages of their fixed income books in bonds with certain ratings, the demand for ratings would decline.

     

    The government could also make it easier for new ratings firms to emerge. Even with the ratings agencies massive failures with regards to subprime RMBS, CDOs and synthetic CDOs, new ratings agencies like Egan-Jones, Kroll and Morningstar have failed to gain any meaningful market share. The big 3 ratings agencies garnered over 95% market share in 2012.

     

     

    Interest Rates and Credit spreads could spike which would reduce the demand for debt refinancings and result in reduced estimates for the 2013 and 2014 EBITDA of the S&P ratings business. That said, at present debt issuance trends remain very strong as evidence by MCO’s recent Q4 2012 earnings beat and increased earnings guidance for 2013.

    I do not hold a position of employment, directorship, or consultancy with the issuer.
    Neither I nor others I advise hold a material investment in the issuer's securities.

    Catalyst

    Settlement or other resolution of the company's lawsuit with the DOJ.
     
    Closing of the sale of the McGraw-Hill Education business.
     
    Continued share repurchases and announcement of new buyback plans.
     
    Sale of Platts or the S&P/Dow Jones Index business
     
    Earnings results and upbeat 2013 earnings guidance
     
     
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