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WIKI ANALYSIS
McGraw-Hill Companies, Inc. is a global information services provider doing business in the education, financial services, and business information markets. Operating in three distinct segments – Education, Financial Services, and Information & Media – the company enjoys several strong brand names in McGraw Hill Publishers, Standard & Poor’s, BusinessWeek (which has officially been sold to Bloomberg L.P. on Dec1 2009 [1] and J.D. Power & Associates, and sports dominant market shares in several segments, notably the Financial Services segment through Standard & Poor’s credit rating service (41% market share) and the Education segment through McGraw-Hill’s educational publishing of textbooks (35% market share).
McGraw-Hill’s most profitable segment, Financial Services, enjoys several tailwinds and competitive advantages through its operations as Standard & Poor’s, including increasingly large and complex worldwide capital markets in which market participants demand trusted, reliable, distilled information and ratings on trillions of dollars worth of securities and financial obligations.
The company’s Education segment, while not as profitable as S&P, enjoys the bulk of a moderately lucrative $800 million textbook publishing industry. With high school and college enrollment rates increasing, McGraw-Hill stands to benefit from long-term societal trends toward higher education, though it is subject to short-term changes in state-wide book adoption rates.
Finally, the Information & Media segment operates business-to-business publications like JP Power & Associates as well as television broadcasting of several ABC affiliate stations. The segment suffers from the lowest operating margins of MHP’s divisions, and like many consumer cyclical and advertising reliant mediums, has seen eroding margins and stiff competition from the Internet as circulation decreases and advertisers leave.
Company Overview
Financial Services
Operating as Standard & Poor’s, McGraw-Hill’s Financial Services segment offers fee-based standardized credit ratings, research, and analysis of fixed income securities and debt instruments. Firms often depend on such ratings to lower their cost of capital and provide liquidity, since investors associate with the trusted S&P ratings system. Along with Moody’s Corporation, S&P is the largest player in its market with a 41% worldwide market share and is deeply entrenched in the worldwide capital markets. This division is the largest revenue unit of the company and generates a disproportionately high operating profit as well.
Education
The Education segment consists of McGraw-Hill Publishers, which publishes educational textbooks and sells them to public and private universities, secondary schools, and elementary schools systems. The segment generates the second most in revenue, but it is much less profitable than Financial Services. Nonetheless, McGraw-Hill maintains the largest market share in this niche market, and stands to benefit from increased state book adoption and/or higher enrollment rates.
Information & Media
In 2005, this division of McGraw-Hill purchased JD Power & Associates (JDPA), which is a leading provider of industry data, customer satisfaction surveys, rankings, and marketing information in the automobile industry, which comprises 70% of JDPA’s revenue. Recently JDPA has been building a portfolio to cover additional industries, including finance, insurance, and homebuilding; collectively, these generate the remaining 30% of JDPA revenue.
Business Growth
Q4 2009 (ended December 31, 2009)[2]
- MHP's net income increased 44.3% year-over-year, from $116 million in Q4 2008 to $167 million in Q4 2009. The increase in net income was pushed by the higher operating margins in all of the company's business segments.This was the first time since Q3 2007 that the company had an increase in diluted earnings per share.
- Net sales was $1.46 billion in Q4 2009, up 3.3% from net sales of the prior-year quarter. The McGraw-Hill Education segment revenue rose 2.6% due to stronger sales in the elementary-high school market, which showed some recovery in the last months of 2009. Revenue from the Financial Services segment increased 10.6% due to a 14.9% increase in revenue of the Standard & Poor's Credit Market Services. Lastly the Information & Media segment revenue fell 11.4% due to declines in revenue for the Business-to-Business Group and Broadcasting Group.
- Operating profit for Q4 2009 was $293 million, and operating margin was 20.0% of net sales. This is a 540 bps increase from Q4 2008, during which operating profit was $206 million, or 14.6% of net sales.
| Metric | 3Mon ended Q4 FY2009 | % Change (or % Point Change) | 3Mon ended Q4 FY2008 |
|---|---|---|---|
| Total Revenue | $1,462 | 3.3% | $1,415 |
| Gross Profit | n/a | n/a | n/a |
| Operating Margin | 20.0% | 5.4% | 14.6% |
| Net Income | $167.3 | 44.3% | $115.9 |
Business Drivers
McGraw-Hill is in essence a provider of information through a variety of mediums and in a number of fields. Positive trends such as continued strong demand for information, population growth, college enrollment, globalization, financial sector expansion, and technology all provide tailwinds for the company.
Evolution of Global Capital Markets
Capital markets have also become more complex and rapidly changing, providing both a challenge and an opportunity for the company. While increasing complexity and change makes it more difficult for S&P to provide reliable and consistent ratings, it also boosts the demand for ratings from investors, who face the same daunting task of analyzing more complex securities and obligations.
Complex structured finance products have grown 27% since 2002. These credit instruments typically involve an entity (corporation or government) using "safer" and more reliably creditworthy assets such as accounts receivable as collateral for debt. Such a transaction enables the company to obtain a lower interest rate on issued debt by isolating the "safe" collateral asset from the company itself (the less safe alternative). For instance, a company rated B by S&P may be able to use its accounts receivable to obtain an A investment grade rating on debt. The number of assets used in such transactions has increased in the past two decades. Whereas only around 20 asset classes were “packaged” for securitization in 1990, over 200 are currently available. Structured obligations are typically highly complex than standard issuances of corporations and governments, and as a result, investors enjoy the benefit of a trusted, easily understood rating from S&P.
The trends of general growth and increasing complexity in the global capital markets will likely continue worldwide. Markets continue to emerge, global economic expansion continues to fuel demand for capital and, as a result, firms and investors seek more sophisticated means of securitizing asset classes, which in turn bring in more ratings fees for S&P. S&P continues to expand internationally to capitalize on these trends, though the majority of its revenue still comes from the United States, the world’s largest and most advanced capital market.
The Internet's Effect on Print Media
Over the past decade, print publications have suffered a vicious cycle of decline. New, cheaper, easier-to-access mediums, most notably the Internet, have led to lower generally lower circulation and readership of traditional publications like magazines, newspapers, and other periodicals. As this happened, advertisers simultaneously began leaving or paying less for exposure. These compounding factors have produced eroding margins and declining profits for many companied depending on revenue from traditional media advertising.
McGraw-Hill’s Information & Media segment has suffered much the same fate, though it has seen top-line growth through acquisition (such as JDPA in 2005). The industry-wide decline partly explains the significantly lower operating margins of this segment (5%) compared to the company’s two others versus (43% for Financial Services and 13% for Education).
However, the company has also been able to capitalize on technological innovation by introducing new products itself. In the Fall of 2009, McGraw-Hill Education introduced the Connect Teaching and Learning platform. The tool would allow students to actively engage with course content from wherever they were as long as they have an internet connection. The tool allows students to improve learning and retention as they have 24/7 access to Connect. In January 2010, more than 1.2 million students and professors were using the tool. [3]
The company's Information & Media division, along with competitors, has moved towards building out their own Internet properties and expand its online presence. The low barriers to entry and extreme competition for viewership on the Internet may likely lead to permanently lower margins.
The broader impact of the Internet on McGraw-Hill's business may have a generally positive net effect. These advances have facilitated the flow and accessibility of information about investments available throughout the world. The globalization of the financial world boosts demand for S&P’s services as it practically necessitates a credible rating system to compare different geographic regions on a standard scale. S&P provides a convenient and trustworthy way for sizing up all opportunities and making sense of the vast amount of information flowing among market participants.
Government Policies
Monetary & Fiscal Policies
Governmental monetary policies affecting interest rates have substantial effects on the demand for debt. When interest rates are high, the cost of debt hampers the demand for it; as a result S&P generates less demands for its ratings. Fiscal policies and government spending can also affect such demand by impacting budget surpluses or deficits and, hence, general economic growth or recession. For instance, in periods of general recession, businesses have less demand for capital. Nonetheless, S&P has demonstrated a consistent growth trajectory and is surprisingly less affected in the long-run by changes in interest rates, government spending, and monetary policy than one might initially suspect.
Credit Rating Regulation
In many countries, rating agencies have been or may become subject to numerous guidelines, restrictions, and standardized practices. Various nations may themselves also provide government-backed ratings. The advent of such systems present a potential threat, although few major governments have taken these steps to date. Also, it is less likely that governments of countries with large capital markets would institute such changes.
In September 2006, President Bush signed the Credit Rating Agency Reform Act of 2006, to promote competition within the credit rating industry. The act is partly the result of the failure of the major rating agencies to pick up on Enron’s and Worldcom’s deceiving credit standings prior to their infamous falls. Previously, credit rating agencies were bestowed competitive advantages by virtue of SEC designation as Nationally Recognized Statistical Rating Organizations. While over 130 credit rating agencies existed last year, only S&P and its four major competitors had earned such a distinction. The 2006 Act, however, eliminated this title, and made it much easier for ratings companies to simply register as a “statistical rating organization” by the SEC. This new designation requires some standards and a minimum of three years of experience in the field.
Rating agencies typically compete on quality, geographic reach, and product scope to a much greater degree than price, and often rely on the trustworthiness of their brand and breadth of recognition for business. Thus, it seems reasonable to assume that broadly entrenched ratings firms like S&P still maintain an important advantage over smaller, younger firms that seem to benefit from the 2006 Act. But while the Act has not yet proven to be materially adverse, it is difficult to predict the long-term consequences of government action that seeks to promote competition within an industry.
State Education Funding and Book Adoption Rate
The company’s Education division derives its revenue in large part from the purchase of textbooks by state education departments and school districts, the policies for which are determined on the state and local level. As part of the funding and policy procedure, the required curriculum textbooks, typically for grades K through 12, are decided upon, budgeted for, and purchased. Not surprisingly, this “book adoption” process has a great impact on the Education segment’s performance. Book adoption rates and education funding are highly cyclical and subject to wide year-to-year fluctuations; for instance, in 2006, state book adoptions fell 30%. Financial results of the Education segment tend to correlate highly with these book adoption cycles. The process is also highly seasonal with the standard school calendar, with most purchases of textbooks coming in the second and third quarters.
Continued College Enrollment
The Education segment is also affected by growth trends in college enrollment. Both non-profit and for-profit colleges have produced increasing numbers of enrolled students working towards bachelors and advanced degrees. As the job market increasingly values an educated workforce, high school graduates--especially in the U.S.--are enrolling in higher education at the greatest levels in history. Enrollment trends indicated an approximate 6% increase in 2006 and are expected to continue between 3-5% over the next several years. McGraw-Hill is well-positioned to take advantage of this uptick as the demand for college textbooks increases.
Comparison to Competitors
The company maintains market share dominance in its two largest segments, Education and Financial Services, each of which have a number of formidable competitors. The most notable competitors by segment are:
- Education: Houghton Mifflin, Pearson, Reed Elsevier
- Financial Services:Moody's (MCO), Fitch, A.M. Best, Dominion Bond Rating Service
- Information & Media: Most business publication or online media (e.g., Dow Jones (DJ), and any consumer satisfaction market research firms
Financial Services
Market Shares
The entire credit rating market is an estimated $4.5 billion per year industry, growing at a double digit pace. The company’s major competitors are Moody’s, Fitch, A.M. Best, and Dominion Bond Rating Services. Standard and Poor’s is arguably the largest, though its approximate 40-41% market share maintains only a small margin over Moody’s 40% share. Fitch, A.M. Best and Dominion are substantially smaller by measure of market share. Several smaller firms have created niches for themselves by specializing on a particular industry or type of issue. For instance, A.M. Best specializes within the insurance industry.
Operating Metrics
As the two dominant, comparable players in the credit rating industry, Standard & Poor's and Moody's can be compared along several operating metrics. All figures for S&P are for this segment of McGraw-Hill alone, and do not include figures from the company's other segments. While S&P has lower operating margins, it is slightly more efficiently run, with CapEx as a percentage of sales being lower than Moody's, and with greater revenue generated per employee.
Education
The textbook publishing market has four major players, with McGraw-Hill arguably the largest. Houghton Mifflin, Pearson, and Reed Elsevier each have over $1 billion in annual sales, while McGraw-Hill generated over $2.5 billion in 2006 revenue (approximately 40% market share). The textbook publishing market has significant barriers to entry, including brand trust and high switching costs due to quality products, extensive and deep relationships required to have books adopted and brought to market, and distribution channels that accompany the process. It is unlikely, therefore, that any “new” significant threat should emerge to this segment.
Comparing operating results for this segment is not particularly easy, given that none of the major competitors are publicly traded. Nonetheless, Houghton Mifflin has demonstrated operating margins anywhere between 4 and 20% over the previous five years, which compares with McGraw-Hill's margins consistently hovering around 13%.
Information & Media
This is perhaps McGraw-Hill’s most competitive segment. Competition within the media industry coupled with lower-cost alternatives for consumers and advertisers (i.e., Internet) provides an intensely difficult environment for publishers and media companies. JD Power and Associates is the most insulated from competition given its dominance in the automotive industry. Much as companies must show their creditworthiness via S&P’s or Moody’s ratings, many companies also do some sort of consumer satisfaction tests to gain the trust and business from potential customers.
References
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