Fool on the Street: McGraw-Hill's Getting Its Balance

Here at The Motley Fool, we believe individual investors should have the same access to information as Wall Street. In light of that, we listened in on some investment bank conferences with major companies, and we're giving you the rundown. We call this series "Fool on the Street."

If you haven't looked closely at the makeup of McGraw-Hill (NYSE: MHP  ) , you might think it's the publisher of the always-informative BusinessWeek magazine and not much else. But as I pored over the company's recent presentation at Bear Stearns' latest annual media conference, I was struck by just how much more the company offers. Because I'm convinced McGraw-Hill's true diversity is not well known, I'd like to pass along to my Foolish friends some of my observations from the company's recent presentation.

To be sure, BusinessWeek is a major part of the company's information and media segment, along with Aviation Week, a multimedia purveyor of information on aviation and aerospace; Platts, a respected source of information on energy developments; J.D. Power, a consumer-satisfaction surveyor and marketing-information firm; and McGraw-Hill Construction, compendium of information and resources on the design and construction industry.

But the company's Standard & Poor's brand -- with which I'd venture you're generally familiar -- provides a range of independent credit ratings on corporate and government entities, infrastructure projects, and structured finance transactions. It also offers equity research and compiles its well-known indices. The McGraw-Hill education segment publishes textbooks and provides other learning materials for K-12 and higher education, and the company also operates nine television stations, including four ABC affiliates.

With that as a backdrop, the company's story at the conference was presented by Harold "Terry" McGraw III, McGraw-Hill's chairman, president, and CEO. After leading with a list of expectations for the company this year, including a double-digit earnings increase, growth from all of the operating segments, and margin expansion in all segments -- he also capped these expectations by promising a "continued management commitment to creating shareholder value." In looking at the company's composition, McGraw spent the majority of his time on the financial-services (read, Standard & Poor's) segment and on the financial markets' expected effects on the segment's own financial performance.

Financial services to the front
In view of the oft-discussed housing-market softness in the U.S. -- along with the basic fact that Standard & Poor's revenues are affected materially by the number of financial instruments it rates -- McGraw reiterated an expectation of "double-digit top- and bottom-line growth in our financial-services segment in 2007, [along with] margin expansion, despite an estimated decline of about 10% to 15% in U.S. residential mortgage-backed securities [transactions]."

And as with most business-news commentators today, McGraw felt a need to discuss the lowest rung of mortgage lending: "We realize that there has been concern about the subprime mortgage market, so I appreciate the opportunity to share a perspective on the credit quality of residential mortgage-backed securities and collateralized debt obligations rated by Standard & Poor's, along with the prospects for our structured finance business as well."

What is that perspective? McGraw noted the likelihood that 2006 vintage residential mortgage-backed securities transactions will underperform those of 2005. At the same time, however, he said, "S&P does not believe that 2006 transactions will perform as badly as some have suggested. S&P is anticipating losses in the 5.25% to 7.75% range, which is slightly above vintage year 2000, the previous worst-performing year, with average cumulative losses of about 5%."

Nevertheless, despite the increasingly trumpeted weakness in the subprime market, McGraw expects the company's financial-services area to benefit from, among other things, a higher level of corporate debt issuance, strong merger-related debt-financing activity, and an active flow of financings in Europe. In addition, collateralized debt obligations (CDOs) likely will show continued strength in the U.S. and abroad. As McGraw noted, the transaction volume in CDOs grew more than 140% year over year in January, with even higher rates in some parts of the world.

The expanding variety of its rating efforts and monitoring services benefits Standard & Poor's, especially when one class of financial instrument falls on hard times. As McGraw put it: "Over many years, we've increased the diversity and the resiliency of our portfolio at Standard and Poor's. That crucial point sometimes gets lost in all the headlines about problems in the subprime market. Today, S&P is more global, more diverse, and more resilient than at any time in its past."

More students = more money
Turning to the education unit, McGraw noted that nearly half of its revenue comes from the higher-education, professional, and international area, with the remainder being generated from the McGraw-Hill school group. Postsecondary education is becoming available to progressively greater numbers of Americans -- with 17 million students enrolled in more than 4,000 U.S. colleges and universities -- and the company clearly benefits.

According to McGraw, the former number is likely to expand to 19.5 million within the next decade. "At the same time," he said, "technology is removing geographic barriers and expanding access to quality education. A new generation of online products will enhance the learning experience for students and improve productivity for instructors."

McGraw expects the education market to grow at a 4% to 6% clip this year, but he anticipates that his company's educational unit will exceed that pace. That stronger growth likely will result from its participation in virtually all the new state adoption markets, along with the careful timing of new product introductions "to pursue the bigger growth opportunities available to us starting in 2007." He also believes that his company's educational unit will benefit from a strengthened and streamlined organization, an increasing level of educational accountability created by the No Child Left Behind Act, and an expansion in the addressable market.

Concluding with an admittedly brief look at the information and media services unit, McGraw noted, "I often refer to this segment as our incubator." For it, he sees solid growth at both J.D. Power and Platts, along with a continuing evolution for BusinessWeek into a multimedia brand. Nevertheless, he expects print advertising to be "sluggish versus 2006." Indeed, after the publication of the first nine issues of the year, BusinessWeek saw its ad-page count fall off by 7%. That decline has been offset somewhat by a one-time increase in its ad-page rate of 4.6%.

Foolish bottom line
So McGraw-Hill, it seems to me, is an attractive company with something of a natural growth pattern based upon an expansion in the volume of the financial ratings and monitoring opportunities, along with a worldwide expansion in education. At the same time, somewhat like Meredith (NYSE: MDP  ) , the Time unit of Time Warner (NYSE: TWX  ) , and other magazine publishers -- and, to some extent, Washington Post (NYSE: WPO  ) and even Dow Jones (NYSE: DJ  ) , it must contend with a decline in ad volumes.

Nevertheless, the financial-services unit clearly can be a significant growth driver, with help coming from the education group. Perhaps for that reason, McGraw-Hill shares are up a solid 18% over the past year, after staking the investor to an attractive 1.3% forward dividend yield. Furthermore, management expects to buy back about 15 million shares this year, and in January, the board authorized the repurchase of an additional 45 million shares. With these factors in mind, I'd suggest that Fools with an interest in either financial services or media keep McGraw-Hill prominently displayed on their watch lists.

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Fool contributor David Lee Smith does not own shares in any of the companies mentioned. He welcomes your comments or questions. The Motley Fool has a disclosure policy.


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