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 (in $M): | 11,239 | TEV/EBIT | 7.8x | 7.2x |
Sign up for free guest access to view investment idea with a 45 days delay.
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:
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.
show sort by |
Are you sure you want to close this position MCGRAW-HILL COMPANIES?
By closing position, I’m notifying VIC Members that at today’s market price, I no longer am recommending this position.
Are you sure you want to Flag this idea MCGRAW-HILL COMPANIES for removal?
Flagging an idea indicates that the idea does not meet the standards of the club and you believe it should be removed from the site. Once a threshold has been reached the idea will be removed.
You currently do not have message posting privilages, there are 1 way you can get the privilage.
Apply for or reactivate your full membership
You can apply for full membership by submitting an investment idea of your own. Or if you are in reactivation status, you need to reactivate your full membership.
What is wrong with message, "".