Description

McGraw-Hill Ryerson, a 70.1% owned, publicly traded (on the Toronto exchange), small/micro-cap Canadian subsidiary of McGraw-Hill Inc. (MHP), is a leading publisher and distributor of educational and professional text and reference books, interactive educational resources and teaching assessment and support solutions. McGraw-Hill Ryerson is trading significantly below its intrinsic value--you can own the business for free. Note: throughout this write-up, any $ represent Canadian dollars ($1 Canadian = $0.62 U.S.). The company's history is as follows: in 1944, McGraw-Hill bought the Embassy Book Company of Toronto, incorporating it as a wholly-owned franchised distributor for McGraw-Hill. In 1970, McGraw-Hill bought The Ryerson Press, which was the first publishing company in Canada. In 1972, McGraw-Hill Ryerson became the only publisher of educational and trade books in Canada to go public.

McGraw-Hill Ryerson serves three primary markets: (i) higher education division: Canadian universities, community colleges, and career vocational schools, (ii) school division: Canadian secondary and elementary schools (K-12th grade), and (iii) trade division: Canadian trade, professional and medical (continuing learning). The company has the exclusive right to distribute McGraw-Hill’s textbooks, professional trade publications and educational content in Canada, which accounts for approximately 55% of the company’s sales. The company also publishes and sells its own Canadian textbooks and Canadian adaptations of other textbooks (comprises most of the remaining sales). Management believes that it is difficult to gauge the company’s exact market share in the educational markets given that the other competitors are private, but mgmt. believes that the company’s market share in the secondary and higher-education markets is greater than 20% (and growing). While I do not have a figure for the trade division, one would expect the company’s market share to be lower due to greater competition.

Through the quarter ended 9/30/01, McGraw-Hill Ryerson had recorded LTM revenue of $86.6 million (Canadian) dollars and LTM EBITDA of $14.6 million. The company has a market cap of $38 million, no debt and cash of $8.3 million. The company is trading at 2.0x LTM EV/EBITDA, 3.3x LTM EV/EBIT, and 3.8x LTM EV/(EBITDA-Capex & Capitalized Expenses—some pre-publishing costs are capitalized). In addition, the Company has net working capital equal to 75% of its enterprise value and the net book value of buildings on the company’s balance sheet is equal to 44% of enterprise value. In addition, the company owns a variety of titles which are staples in the Canadian school system. You are essentially buying a business that will produce significant, stable cash flow for free.

While the company’s micro-cap status, small float, and controlling shareholder necessarily translate into a deflated valuation, I believe that the market is paying no attention to the fundamentals of the company. McGraw-Hill Ryerson is one of the market leaders in the Canadian text book industry, has demonstrated steady growth and cash flow generation since the early 1990s, will post very attractive year over year results in 2001, and has steadily increased dividends per share since 1996. Moreover, the company is poised to capitalize (risk-free and without incremental investment) on the investments in education made by McGraw-Hill.

The trade division accounted for 13.2%, 17.1%, 24.9%, and 21.7% of the company's total revenue for the 9 mos. ended 2001, and the full years 2000, 1999, and 1998, respectively. The higher education division accounted for 47.7%, 50.2%, 46.7%, and 50.3% of the company's revenue for the 9 mos. ended 2001, and the full years 2000, 1999, and 1998, respectively. The school division accounted for 39.1%, 32.7%, 28.4%, and 28.0% of the company's total revenue for the 9 mos. ended 2001, and the full years 2000, 1999, and 1998, respectively.

Most of the trade division content is imported from the parent company and subsequently sold in Canada (without adaptation). Leading products in the trade, professional and medical division include the Appleton & Lange medical list (acquired by the parent in 1999—comprised 48% of the company’s medical sales in 2000), various computing books and a number of business bestsellers. While the trade, professional and medical division performed well through 1999, a number of factors have caused this division to exhibit relative weakness in 2000 and 2001 (discussed below). The company also generates significant sales from imports of the parent’s higher-education and school content. McGraw-Hill is the number one pre-K-12th grade publisher in the U.S. and is committed to expanding the business. For example, McGraw-Hill’s (parent) acquisition of the Tribune Company in September of 2000 for $672 million in cash significantly increased the number of titles and subjects available to the company, including an expanded math, world languages and social studies offering.

The products developed and published or adapted by the company (as opposed to those products that are imported from the parent without adaptation) primarily target the Canadian secondary and higher education markets, as some U.S. textbooks are not appropriate for Canadian educational markets. In the last two years, investment in local publishing and adaptation has increased substantially, as is evidenced by the amount of capitalized pre-publication expenses relative to revenue ($1.5 million, $2.5 million, $5.6 million and $3.8 million of capitalized pre-publication expenses for 1998, 1999, 2000 and the first 9 mos. of 2001, respectively). The combination of increased investment in local publishing and adaptation and expanded offerings from the company’s parent has resulted in increasing market share in the Canadian higher-education and secondary markets. In 2000, sales in the higher education markets grew 6.1%, while sales in the secondary and elementary school division grew 13.5%. This growth was despite very low growth in student enrollment and flat government spending on education in the elementary and secondary markets. One should not expect this macro situation to change very much, but there is reason to believe that the company will continue to grow the secondary and elementary division through market share gains in the near future. The demographics for the higher education market are more promising, as the number of students enrolling in post-secondary education in Canada is expected to grow by approximately 5% over the next few years.

While the Company’s operating results have been steady and growing since the early 1990s, in 2000 the Company’s results slipped, as revenue declined year over year by 1% and net income fell year over year by 21%. The relatively weak performance in 2000 was due to softness in the trade, professional and medical division. The weakness in this division was the result of a challenging retail environment in Canada, as one of the largest bookstore chains (Chapters) in Canada altered their inventory mix and merchandising strategy, which resulted in a reduced overall space allocated to books and significant product returns to the company. Moreover, more Canadian are purchasing books through online retailers (i.e., Canadian Amazon), a market that the company is working to penetrate further. The trade division has not shown significant improvement in 2001 so far, but the company expects that the division will show slight annual growth over 2000. In its quarterly filing, the company stated that any weakness for the remainder of the year in the trade division would be more than offset by strength in the other divisions. I believe that the trade division poses mostly upside potential, as the company has fared relatively well despite a decline in this division, and has a number of trade titles that provide steady revenue. When the consolidation in the Canadian book retailing industry ends, the Canadian economy improves (this division is the most economically sensitive) and the company further penetrates the online retailing market, the company will likely grow trade revenue, which when combined with increased market share in the other divisions will result in a company firing on all cylinders.

For the first nine months of 2001, the Company reported revenue of $67.3 million, an increase of 17.5% over 2000. EPS was $2.68 for the first nine months of 2001 (compared to $2.21 during the same period in 2000). Higher education revenue increased by 19% during this period and the school division’s revenue increased by 25%. Trade division revenue has declined by 8% year to date, but as noted above the company expects trade division revenue to increase for the full year due to significant bookings in October (implying stronger trade division performance in the fourth quarter)—although it has fairly easy year over year comparisons in this division. The higher-education and school division is highly seasonal with most sales coming in the fall and winter quarters. Historically, the company has earned approximately 25% of its revenue and net income in the fourth quarter (other than 2000, which is somewhat of an outlier due to the significant returns from Chapters). Given the company’s upbeat guidance in its September quarterly filing and the historical seasonal trend, one could expect the company to easily exceed EPS of $3.00 in 2001 (most likely in the $3.30 range), implying a trailing P/E multiple of 6.3x or lower.

The company’s stock price has historically hovered between $20.00 and $25.00 per share, but on lower earnings. A return to a normalized (but intrinsically undervalued) P/E multiple would suggest a conservative valuation of greater than $24.00 with little risk of capital loss. The company’s increasing market share in the educational market, the parent’s strong commitment to the market (and the company’s ability to leverage that commitment) and steady earnings are strong arguments for multiple expansion (as is the fact that less than 2.0x EBITDA is not a reasonable valuation for any steadily profitable public corporation). The stock is not followed by any Wall Street analysts and attracts very little institutional interest. A buyout is highly unlikely given the ties to the parent and the fact that management owns very little of the stock, but an acquisition by McGraw-Hill of the remaining 30% interest not held by it is possible (management only stated that such a move is currently not in process). This would be a highly accretive transaction, but relatively unimportant in terms of actual $ given the size of the parent. The company’s cash balances will likely increase substantially in the coming months and years. Historically, the company has not bought back stock, but I would be surprised if the dividend was not increased (current yield of 2.8%). Given the lack of near-term catalysts, one has to take comfort in the fact that a company that grows profitably will eventually get noticed and valued properly.

Risks

· Significant decreases in spending on education by local governments in Canada. The Ontario government recently announced a significant investment in textbooks for the 10th and 11th grade (which the company has competed for successfully)--$30 million for the 10th grade and $15 million for the 11th grade. While educational funding in most Canadian provinces has been stable since 1988, it is uncertain whether Ontario will maintain the levels of funding of recent years
· Stock price is never valued properly given size and lack of following/no catalysts
· The trade division’s performance continues to deteriorate due to increasing purchasing power of national accounts, migration to online purchasing, etc.
· The company’s growth slows because it can not continue to gain market share and the overall markets are growing slowly

Below are some key valuation and operating statistics—all figures are in millions of Canadian Dollars (approximately $0.62 U.S. dollars per Canadian Dollar):

Market Value
Shares Outstanding 1.996638
Current Price per Share $19.00
Market Capitalization $37.9

ST & LT debt 0.0
Cash on balance sheet 8.3

Enterprise Value $29.6

Balance Sheet
Net Working Capital
A/R 30.7
Due from affiliated companies 4.0
Inventories 18.4
Prepaid Expenses 0.3
A/P (8.2)
Due to affiliated companies (23.2)
Total NWC 22.1

Other Significant Tangible Assets:
Building Cost: 17.7
Less: Depreciation (4.6)
Net Book Value of other Tangible Assets 13.1

Net Book Value of McGraw Hill Ryerson $53.4


Revenue:
LTM $86.6M
1st 9 mos. 2001 $67.3
1st 9 mos. 2000 $57.2
2000 $76.5
1999 $77.4
1998 $68.4

EBIT:
LTM $9.0M
1st 9 mos. 2001 $8.5
1st 9 mos. 2000 $6.6
2000 $7.1
1999 $10.3
1998 $9.2

EBITDA:
LTM $14.6M
1st 9 mos. 2001 $13.1
1st 9 mos. 2000 $10.0
2000 $11.5
1999 $13.8
1998 $12.7

EBITDA-capex-capitalized pre-publishing expenses:
LTM $7.8M
1st 9 mos. 2001 $8.8
1st 9 mos. 2000 $5.7
2000 $4.7
1999 $10.3
1998 $10.7

Catalyst