Description
We suggest going long McGraw Hill (MHP) with at TEV of $13.1 billion (equity cap of $12.3 billion and net debt of $800 million) and short Moody's (MCO) with a TEV of $10.0 billion (market cap of $9.3 billion and net debt of $700mm); this creates the non-ratings business of MHP for $3.1 billion, which in 2007 produced approximately $500mm of EBIT (6.2x).
MHP has three segments and four businesses:
(i.) Education - sells text books - 12/07 year revenue $2.7 billion; segment EBIT ~ $400mm
(ii.) Info/Media - Business Week, TV stations, other - 12/07 year revenue $1.0 billion; segment EBIT ~ $75mm
(iii.) Financial Services - two businesses - 12/07 year total revenue $3.05 billion; segment EBIT $1.36 billion
(a.) rating agency - similar to Moody's - $2.26 billion revenue
(b.) investment services - including S&P Index business - $790mm revenue
In addition, there is corporate expense of about $150mm.
Our thesis is simple:
- Moody's (MCO) and the ratings agency business of McGraw Hill are basically the same business; clearly there are some differences (% of business that is transaction based, brand name, etc) with lots of positives and negatives for both Moody's and S&P, but, at the end of the day, they are basically the same. In fact, Moody's revenue last year was $2.26 billion (same as the ratings agency segment of financial services) and EBIT was $1.18 billion (versus segment EBIT of $1.36 billion in the financial services segment of MHP, which includes the index business).
- If you short out the ratings agency portion of McGraw Hill, you are left with some pretty good businesses that are trading at about 6x EBIT (with private market values north of 11x).
- Under almost any circumstances, McGraw Hill generates more cash per year than Moody's - - the difference is probably about $400mm - - so this $3.1 billion that you are paying for the rest of McGraw Hill gets cheaper by about $400mm per year.
Clearly, there are many more "issues" with this idea (both companies are buying back a lot of stock, MCO has a higher short interest ratio, there may be different legal issues with Moody's and McGraw Hill, "conglomerate" discount, etc), but I think there is a huge margin of safety in this idea and a lot could go wrong before you lose money (over time) in this trade. On a dollar-value basis, if you want to short out the entire ratings business, one would probably want to short $0.70 of MCO for every $1.00 long MHP; if you want to short out just the transaction-based part of MHP, we think you should short $0.30 for every $1.00 long.
Disclaimer: Our firm is long MHP and short MCO and may decide to unwind the trade at any time without notice.
Catalyst
Hopefully, Carl Ichan (or some other activist) goes after MHP and breaks it up into two or three companies. Carl?
Time/cash-flow arbitrige.